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Substantive Tests of Inventory and Cost of Goods Sold

Audit objectives for Inventory Balances

Existence: Recorded inventory exist

1. Before the client takes the physical inventory, review and approve the client’s written plan
for taking it.

2. Observe the client personnel physically counting inventory.

3. Confirm inventories on consignment and held in public warehouses.

Completeness: All inventory of the entity are recorded

1. Obtain a copy of pre-numbered inventory tags used by the client in taking inventory and
reconcile the tags to the listing.

2. For selected items, trace tags to listing

3. Perform cutoff procedures. Obtain the receiving report number of the last shipment
received prior to year-end and determine that the item is included in inventory. Also,
identify the last shipping document and determine, based on shipping terms, whether the
item was properly recorded in sales or inventory.

4. Perform analytical procedures.

Obligations/Rights: Inventory is owned by the entity

1. Determine that consigned inventory has been excluded from inventory and that inventory
pledged has been properly disclosed. Examine confirmations from financial institutions and
read minutes of the board of directors’ meetings

Valuation: Recorded inventory is valued in accordance with GAAP

1. Considering the method the client uses for inventory valuation, examine invoices for
inventory on hand or trace prior year’s inventory listing to verify cost.

2. For selected items, determine net realizable value (NRV) of the inventory and apply the
lower cost or NRV.

3. Verify computations in the inventory listing

4. Review the obsolescence of the inventory by:

a. Being alert while observing inventory being taken for damaged, slow-moving, or
scrap inventory.

b. Scanning perpetual records for slow-moving items and discussing their valuation
with client.

Presentation and Disclosure: Inventory is classified and disclosed in accordance with GAAP.
1. Determine whether accounts are classified and disclosed in the financial statements in
accordance with GAAP.

Audit objectives for Purchases

Occurrence: Recorded purchases are for items that were acquired.

Examine underlying documents for authenticity and reasonableness. Scan voucher register for
large or unusual items. Trace inventory purchased to perpetual records. Scan voucher register for
duplicate payments.

Completeness: Purchases that occurred are recorded

Trace a sequence of receiving reports to entries in the voucher register. Test cutoff. Account for
a sequence of entries in the voucher register.

Classification: Purchase transactions have been recorded in the proper accounts.

For a sample of entries in the purchases journal, verify the accuracy of account coding.

Accuracy (Valuation): Purchases are recorded at proper amounts.

Recompute invoices and compare invoice price to purchase order.

Audit objectives for Production

Occurrence: Recorded production transactions occurred.

For selected transactions, examine signed material requisitions, approved labor tickets, and
allocation of overhead.

Completeness: All production transactions that occurred are recorded

Account for a sequence for production reports.

Classification: Production transactions have been recorded in the proper accounts.

For a sample of entries in the purchases journal, verify the accuracy of account coding.

Accuracy (Valuation): Production transactions are recorded at proper amounts.

Test cost records by tracing to underlying documents such as bills of materials, labor tickets,
authorized labor rates, and standard overhead rates. Review variances.

Potential Misstatements - Inventory


Misstatement Examples Internal control weaknesses
or factors that increase the
risk of misstatement

1. Misstatement of Fraud – Intentional Ineffective board of directors,


Inventory costs misstatement of production audit committee, or internal
costs assigned to inventory or audit function;
intentional misstatement of
inventory prices
Ineffective cost accounting
Error – The assignment of direct system; failure to update
labor costs, direct material standard costs on a timely
costs, or factory overhead to basis.
inventory items is inaccurate. Ineffective input validation
- Erroneous pricing of control on the database of
inventory inventory costs; ineffective
supervision of the personnel
that enter the costs on the
final inventory schedule.
2. Misstatement of Fraud – Items are stolen with Ineffective physical controls
inventory quantities no journal entry reflecting the over inventories.
theft.
-Inventory quantities in Ineffective board of directors,
locations not visited by auditors audit committee, or internal
are systematically overstated audit function;
Error – Miscounting of Ineffective controls or
inventory by personnel involved supervision of physical
in physical inventory inventory.

3. Early (late) recognition Fraud – Intentional recording of Ineffective board of directors,


of purchases – “cutoff purchases in the subsequent audit committee, or internal
problems” period. audit function;
Error – recording of purchases Ineffective accounting
of the current period in a procedures that do not tie
subsequent period recorded purchases to
receiving data.

Illustrative cases:

Case No.1

Ball Company’s inventory at December 31, 2019 was P1,500,000 based on a physical count of goods
priced at cost, and before any necessary year-end adjustment relating to the following:
1. Included in the physical count were goods billed to a customer F.O.B shipping point on
December 31, 2019. These goods had a cost of P30,000 and were picked up by the carrier on
January 10, 2020.

2. Goods shipped F.O.B shipping point on December 28, 2019, from a vendor to Ball were received
on January 4, 2020. The invoice cost was P50,000.

As auditor of Ball Company, compute the adjusted balance of Inventory on December 31, 2019 and
prepare the proposed adjusting entries.

Answer:

Unadjusted Inventory balance P 1,500,000

Add: Purchased inventory, FOB shipping point 50,000

Adjusted Inventory, 12/31/2019 P 1,550,000

Proposed Adjusting Entry

Merchandise Inventory P 50,000


Accounts Payable P 50,000
To record purchase of inventory on account, FOB shipping point,
on December 28, 2019.

Case No. 2

Mindoro Auto Parts sells new parts for foreign automobiles to auto dealers. Company policy
requires that a prenumbered shipping document be issued for each sale. At the time of pick up or
shipment, the shipping clerk writes the date on the shipping document. The last shipment made in the
fiscal year ended August 31, 2020, was recorded on document 2167. Shipments are billed in the order
the billing clerk receives the shipping documents.

For late August and early September, shipping documents are billed on sales invoices as follows:

Shipping Document No. Sales Invoice No.

August 2163 4332


August 2164 4326

August 2165 4327


August 2166 4330

August 2167 4331


September 2168 4328

September 2169 4329


September 2170 4333

September 2171 4335


September 2172 4334

The August and September sales journal have the following information included:

Sales Journal – August 2020

Day of Month Sales Invoice No. Amount of Sale

30 4326 P 726.11
30 4329 P1,914.30

31 4327 P 419.83
31 4328 P 620.22

31 4330 P 47.74

Sales Journal – September 2020

Day of Month Sales Invoice No. Amount of Sale

1 4331 P 2,641.31
1 4332 P 106.39

1 4333 P 852.06
2 4335 P 1,250.50

2 4334 P 646.58

Required:

1. Which sales invoice, if any, are recorded in the wrong accounting period, assuming a periodic
inventory? Prepare an adjusting journal entry to correct the financial statement for the year
ended August 31, 2020.

2. How much is the sales and inventory for the year ended August 31, 2020 assuming the
unadjusted balance of Sales is P320,000 and unadjusted balance of inventory is P150,000,
assuming sales are recorded for 130% of cost.

Answer:

Sales Invoice No. Shipping Document No. Error in Sales Cutoff Overstatement or
Understatement of
August 31 Sales
4326 2164 None
4329 2169 P 1,914.30 Overstatement
4327 2165 None

4328 2168 P 620.22 Overstatement


4330 2166 None

4331 2163 P2,614.31 Understatement


4332 2167 P 106.39 Understatement

4333 2170 None


4335 2171 None

4334 2172 None


Net Understatement, P 213.18
August 31

Proposed Adjusting entry:

Accounts Receivable P213.18


Sales P213.18

2. Unadjusted Sales, August 31, 2020 P325,000.00

Add: Net understatement of sales 213.18

Adjusted Sales, August 31, 2020 P324,786.82

Unadjusted Inventory, August 31, 2020 P 150,000.00

Less: Net understatement of sales (P213.18/130%) 163.98

Adjusted Inventory, August 31, 2020 P 149,836.02

Case No. 3

The management of Maligaya Company has engaged you to assist in the preparation of year-end
(December 31, 2019) financial statements. You are told that on November 30, the correct inventory
level was 150,000 units. During the month of December, sales totalled 50,000 units including the 25,000
units shipped on consignment to Tower Company. A letter received from Tower indicates that as of
December 31, it had sold 12,000 units and was still trying to sell the remainder. A review of the
December purchase orders, to various suppliers, shows the following:

Date of Invoice Date Quantity in Date Shipped Date Received Terms


Purchase Units
Order
12/02/2019 01/03/2020 10,000 01/02/2020 01/03/2020 Shipping
12/11/2019 01/03/2020 8,000 12/22/2019 12/24/2019 Destination

12/13/2019 01/02/2020 13,000 12/28/2019 01/02/2019 Shipping


12/23/2019 12/26/2020 12,000 01/02/2020 01/03/2019 Shipping

12/28/2019 01/20/2020 10,000 12/31/2019 01/05/2019 Destination


12/31/2019 01/10/2020 15,000 01/03/2020 01/06/2019 Destination

Maligaya Company uses the “passing of legal title” for inventory recognition.

Required: Determine the number of units which should be included in the inventory as of December 31,
2019.

Solution:

Inventory as of November 30 150,000

Less: Sales in December

Total shipment 50,000

Less: goods delivered on consignment

Not yet sold by December 31 13,000 37,000

Total Inventory 113,000

Add: Purchases

Received on 12/24/2019 8,000

Shipped on 12/28/2019 13,000 21,000

Inventory, December 31, 2019 134,000

Case No. 4

Detdet Company uses the retail inventory method to estimate its inventory for interim
statement purposes. Data relating to the computation of the inventory at July 31, 2020, are as follows:

Cost Retail
Inventory Beginning P70,000 P110,000
Purchases 350,000 500,000
Additional mark-ups 90,000
Sales 600,000
Estimated normal shoplifting losses 10,000

Under the approximately lower of average cost or market retail method, how much is the estimated
inventory of Detdet Company at July 31, 2020?
Solution:

Cost Retail
Inventory Beginning P70,000 P110,000
Purchases 350,000 500,000
Additional mark-ups 90,000
Total P420,000 P700,000
Cost Ratio = P420,000/P700,000 = 60%
Less: Sales 600,000
Estimated normal shoplifting losses 10,000
Inventory 7/31/2020, at retail P 90,000
Inventory 7/31/2020, at cost (P90,000 x 60%) P 54,000

Case No. 5

The following information is available for Creole Company for 2019:

Net Sales P1,800,000


Freight-in 45,000
Purchase Discounts 25,000
Ending inventory 120,000

The gross margin is 40% of net sales. What is the cost of goods available for sale?

Solution:
Net Sales P 1,800,000
Cost Ratio 60%
Cost of Goods Sold P 1,080,000
Add: Ending inventory 120,000
Cost of Goods Available for Sales P 1,200,000

Case No. 6

You were assigned to audit the factory accounts of D. Silang Gear Manufacturing Corporation for
the year ended December 31, 2019. The following data were gathered: Manufacturing cost totalled
P900,000. Cost of goods manufactured was P800,000 of which factory overhead was 75% of direct labor.
Overhead was 25% of total manufacturing cost. Beginning work-in-process inventory January 1 was 60%
of ending work-in-process inventory, December 31, 2019.

Manufacturing costs for the year ended December 31, 2019 submitted to you by the factory
accountant were as follows:
Raw materials used P 400,000
Direct Labor 275,000
Factory Overhead 225,000
Total P1,850,000

Assume cost percentage relationship as stated are correct.

1. What should be the adjustment on manufacturing cost at December 31, 2019?


2. How much is the work-in-process, December 31, 2019 should be?

Solution:
Per client Per audit (Over) Under
1. Raw materials used P 400,000 P 375,000 (P25,000)
Direct Labor 275,000 300,000 25,000
Factory Overhead 225,000 225,000 -
Total P 900,000 P 900,000 -

Computations:

Let DL = Direct Labor


25% ( P900,000) = 75% DL
DL = P225,000/75%
DL = P300,000

Total Manufacturing costs P900,000


Less: Direct Labor P300,000
Factory Overhead 225,000 525,000
Raw Materials Used P 375,000

Adjustment should be:


Direct Labor P 25,000
Raw Materials Used P25,000

2. Let X = Work in process, 12/31/2019

Cost of goods manufactured = Total Manufacturing Cost + Work in process 1/1/2019 –


Work-in-process 12/31/2019

P 800,000 = P900,000 + 60%X – X


40%X = P 100,000
X = P 100,000/40%
X = P 250,000