Audit of the Inventory

and Warehousing
Cycle

Chapter 21

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 1

 Learning Objective 1

Describe the business functions

and the related documents and
records in the inventory and
warehousing cycle.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 2

 Flow of Inventory and Costs
Raw Materials Work in Process
Beginning Raw Beginning Cost of
inventory materials inventory goods
used manufactured
Purchases Ending
inventory
Ending
inventory
Cost of
Direct Labor Finished Goods goods sold
Actual Applied Beginning Cost of
inventory goods sold
Manufacturing Overhead
Ending
Actual Applied inventory

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 3

 Functions in the Inventory and
Warehousing Cycle
Process Receive Store Process Store Ship
purchase raw raw the finished finished
orders materials materials goods goods goods

Put Put Put

Flow Receive Ship
materials materials completed
of raw finished
in in goods in
inventory materials storage production storage
goods

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 4

 Learning Objective 2

Describe how e-commerce

affects inventory management.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 5

 How E-Commerce Affects
Inventory Management
The Internet enables clients to provide
expanded descriptions of their
inventory on a real-time basis.

The use of the Internet and other e-commerce

applications may lead to financial reporting
risks if access to inventory databases and
systems is not adequately controlled.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 6

 Learning Objective 3

Explain the five parts of the audit

of the inventory and warehousing
cycle.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 7

 Audit of Inventory
Part of audit Cycle in which tested
Acquire and record Acquisition and
raw materials, labor, payment plus
and overhead. payroll and personnel

Internally transfer Inventory and

assets and costs. warehousing

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 8

 Audit of Inventory
Part of audit Cycle in which tested
Ship goods and record
Sales and collection
revenue and costs.

Physically observe Inventory and

inventory. warehousing

Price and compile Inventory and

inventory. warehousing

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 9

 Learning Objective 4

Design and perform audit tests

of cost accounting.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 10

 Cost Accounting Controls

1. Physical controls over raw

materials, work in process,
and finished goods inventory

2. Controls over the related costs

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 11

 Methodology for Designing Tests of
Balances Accounts Receivable
Understand internal Assess planned control
control cost risk cost
accounting system. accounting system.

Determine extent of testing controls.

Design tests of controls and substantive tests of

transactions for the cost accounting system
to meet transaction-related audit objectives.

Audit Sample Items to

Timing
procedures size select

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 12

 Tests of Cost Accounting

Physical Controls

Documents and records for

transferring inventory

Perpetual inventory master files

Unit cost records

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 13

 Learning Objective 5

Apply analytical procedures to

the accounts in the inventory
and warehousing cycle.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 14

 Analytical Procedures for
Manufacturing Equipment
Analytical procedure Possible misstatement
Overstatement or
Compare gross margin
understatement of
percentage with that of
inventory and cost
previous years.
of goods sold
Obsolete inventory
Compare inventory turnover
(cost of goods sold divided by
Overstatement or
average inventory) with that
understatement
of previous year.
of inventory

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 15

 Analytical Procedures for
Manufacturing Equipment
Analytical procedure Possible misstatement
Overstatement or
Compare unit costs of understatement of unit
inventory with those costs, which affect
of previous years. inventory and cost of
goods sold
Misstatements in
Compare extended inventory compilation, unit costs, or
value with that of previous extensions, which affect
years. inventory and cost of
goods sold

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 16

 Analytical Procedures for
Manufacturing Equipment
Analytical procedure Possible misstatement
Misstatements of unit costs
Compare current year
of inventory, especially
manufacturing costs with those
direct labor and
of previous years (variable
manufacturing overhead,
costs should be adjusted for
which affect inventory and
changes in volume).
cost of goods sold

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 17

 Methodology for Designing Tests
of Balances Other Accounts
Phase I

Identify client risks affecting the inventory and

warehousing cycle.

Set tolerable misstatement and assess inherent

risk for the inventory and warehousing cycle.

Assess control risk for several cycles.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 18

 Methodology for Designing Tests
of Balances Other Accounts
Phase II

Design and perform tests of controls and

substantive tests of transactions
for several cycles.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 19

 Methodology for Designing Tests
of Balances Other Accounts
Phase III

Design and perform analytical procedures

for the inventory and warehousing cycle.

Design tests of details of inventory to satisfy

balance-related audit objectives.
Audit Sample Items to
Timing
procedures size select

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 20

 Learning Objective 6

Design and perform physical

observation audit tests
for inventory.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 21

 Controls

Proper instructions for the physical count

Supervision by responsible personnel

Independent interval verification of the counts

Independent reconciliations of the physical

counts with perpetual inventory master files

Adequate control over count sheets or tags

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 22

 Audit Decisions

Timing
Sample
size

Selection
of items

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 23

 Physical Observation Tests

The most important part of the observation of

inventory is determining whether the physical
count is being taken in accordance with the
clients instructions.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 24

 Balance-Related Audit Objectives:
Physical Inventory Observation
Inventory as recorded
Existence
on tags exist.

Existing inventory is
Completeness
counted and tagged.

Inventory is counted
Accuracy
accurately.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 25

 Balance-Related Audit Objectives:
Physical Inventory Observation
Inventory is classified
Classification
correctly on the tags.

Transactions are recorded

Cutoff
in the proper period.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 26

 Balance-Related Audit Objectives:
Physical Inventory Observation
Obsolete and unusable
Realizable
inventory items are
Value
excluded or noted.

The client has rights

Rights to inventory recorded
on tags.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 27

 Learning Objective7

Design and perform audit tests

of pricing and compilation
for inventory.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 28

 Audit of Pricing and Compilation

Inventory price tests

Inventory compilation tests

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 29

 Audit of Pricing and Compilation

Pricing and compilation controls

Pricing and compilation procedures

Valuation of inventory

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 30

 Balance-Related Objectives:
Inventory Pricing and Compilation

Detail tie-in Existence

Completeness Accuracy

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 31

 Balance-Related Objectives:
Inventory Pricing and Compilation

Realizable
Classification
value

Presentation
Rights
and disclosure

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 32

 Valuation of Inventory

Pricing purchased inventory

Pricing manufactured inventory

Cost or market

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 33

 Learning Objective 8

Integrate the various parts of

the audit of the inventory
and warehousing cycle.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 34

 Interrelationship of Various
Audit Tests
Tests of acquisition
and payment cycle

Raw materials Work in process

Acquisitions of Other manufacturing
raw materials overhead

Raw material used Raw material used

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 35

 Interrelationship of Various
Audit Tests
Tests of payroll and
personnel cycle

Work in process Work in process

Direct labor Indirect labor

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 36

 Interrelationship of Various
Audit Tests
Inventory tests
Tests of cost accounting records
Tests of physical inventory observation
Tests of pricing and compilation

Raw materials Work in process

Ending inventory Ending inventory

Finished goods
Ending inventory

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 37

 Interrelationship of Various
Audit Tests
Work in process Finished goods
Cost of goods Cost of goods
manufactured manufactured

Finished goods
Tests of sales
and Cost of goods sold
collection cycle

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 21 - 38

 End of Chapter 21

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