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Chapter21: Audit of the inventory and warehousing cycle

Inventory and warehousing cycle: is unique because of its close relationships to other transaction .cycles .Raw material enter the inventory and warehousing cycle from the Acquisition and payment cycle .Direct labor enter the inventory and warehousing cycle from the Payroll and personnel cycle.The inventory and warehousing cycle ends with the sale of goods in the Sales and collection cycleThe audit of inventory is often: -The most complex Time-consuming part of the audit:Factors affecting the complexity of the audit of inventory including the following Inventory is generally a major item on the balance sheet, and it is often the largest item making -1 .(up the accounts included in working capital(current assets current liability .The inventory is in different locations, which makes physical control and counting difficult -2 The diversity of the item in inventories creates difficulties for the auditor. Such items as jewels, -3 .foods, present problems of observation and valuation The valuation of inventory is also difficult because of such factors as obsolescence and need to -4 .allocate manufacturing costs to inventory :Flow of inventory and costs Raw material work-in-process Direct labor Manufacturing overhead Finished goods cost of goods sold

:Business functions in the cycle and related documents and records Process purchase orders-1 (Start from storekeeper(now use computer Purchase requisitions through store keeper or computer Request the purchasing department place orders for inventory items Purchase orderSupplierPart of the Acquisition and payment cycle Review raw material-2 Material received should be inspected for quantity and quality The receiving department produces a receiving report that becomes a part of the necessary .documentation before payment is made The material is sent to the storeroom and the receiving documents or electronic notifications of the receipt of goods are typically sent to purchasing, the storeroom, accounts payable to notify .accounts section for payment. Control and accountability are necessary for all transfers Part of the Acquisition and payment cycle Store raw materials-3 .When materials are received, the are stored in the stockroom until needed for production -

(Process the goods(materials-4 .Issue raw materials for production. The issue must properly authorized A separate production control department often is responsible for the determination of the type .and quantity of production Within various production departments, provision must be made to account for the quantities .produced, control of scrap, quality controls, and physical protection of the material in process Two types of cost systems exist: -Job cost systems Process cost systemsStore finished goods-5 As finished goods are completed by the production department, they are placed in the stockroom .to await shipment Part of the Sales and collection cycle (Ship finished goods(sold-6 .Shipment of finished goods must be authorized by a properly approved shipping document .An integral part of the Sales and collection cycle Process purchase orders Flow of inventory Purchase requisition purchase order Receive raw materials Store raw materials Receive raw materials Receivingreport Vendor's (supplier) invoice Process the goods Put material in storage Raw materials perpetual* inventory master file Store Ship finished finished goods goods Put materials Put in completed production goods in storage Raw - Finished materials goods *requisition perpetual * inventory Cost - master file accounting Cost records accounting records

Ship finished goods Shipping document Finished goods perpetual inventory master file Cost accounting records

Related documentation

On chronological order* Required by which job or process ** Perpetual inventory master files separate perpetual timely records of inventories are normally kept for raw materials and finished goods Include: -only information about the units of inventory acquired, sold, and on hand .or also information about unit costs-

Parts of the audit of inventory Acquire and record raw materials, labor, and overhead -1 Includes the first three business function: -process purchase orders receive raw materials statements store raw materials-

fairly stated in financial

Transfer assets to production and costs -2 Includes the fourth and fifth business function: -process the goods store finished goodsThese separate records are independent of other cycles and are tested as part of the audit of the .inventory and warehousing cycle Ship finished goods for customers and record revenue and cost of goods sold -3 Physical observe inventory-4 Auditor is required to physically observe inventory counts to determine whether recorded .inventory actually exists. Should not rely in client count Price and compile inventory-5 .Price test: audit procedure to verify these costs costs used to value the physical inventory must be tested to determine whether the client has :correctly followed an inventory method that is in accordance with GAAPconsistent with previous years Compile test: the auditor must verify whether the physical counts were correctly summarized, the inventory quantities and prices were correctly extended and the extended inventory was correctly .footed Part of audit Cycle in which tested Acquire and record raw materials, labor and overhead Acquisition and payment cycle internally Transfer assets to production and costs Inventory and warehousing cycle Ship finished goods for customers and record revenue and cost Sales and collection cycle of goods sold Physical observe inventory Inventory and warehousing cycle Price and compile inventory Inventory and warehousing cycle .Transfer assets to production and costs -2 Audit of cost accounting records Cost accounting controls: are these related to the units of the physical inventory and related costs from the point at which raw materials are requisitioned to the point at which the manufactured .product is completed and transferred to storage :Divide the controls into :Physical controls over inventory(there is three type of inventory) of -1 raw materials: inventory of material acquired but not used .work-in-process: inventory units not yet processed finished goods inventory: inventory of units complete but not yet sold (Controls over the related costs(of raw materials, work-in-process, finished goods inventory -2

.All companies need physical controls over their assets to prevent loss from misuse, theft, spoilage -

:Methods to protect inventory The use of physically segregated, limited-access storage areas for raw materials, work-in-1 .process, finished goods inventory .The assignment of custody of inventory to specific responsible individuals -2 .Approved prenumberd documents for authorizing movement of inventory -3 Prepetual inventory master files maintained by persons who do not have custody of or access to -4 .assets :Perpetual inventory master files are important for a number of reasons (Provide records of inventory on hand(how much to order, produce, and to sell .Provide records of inventory raw materials used, finished goods sold Provide records to fix responsibility Test of cost accounting :(In auditing cost accounting the auditor is concerned with(purpose of cost accounting records Physical control over inventory -1 An auditor's tests of the adequacy of the physical controls over inventory of raw materials, work- .in-process, and finished goods must be restricted to observation and inquiry of clients .That is mean test the possibility of counting these inventory If the auditor concludes that the physical controls are inadequate(inventory difficult to count), the .auditor should expand observation of physical inventory tests to make sure that an adequate count Documents and records for transferring inventory -2 The auditor's primary concerns in verifying the transfer of inventory from one location to another (are : That the recorded transfers exist(existence (The transfers that have actually taken place are recorded(completeness .The quantity, description, and date of all recorded transfers are accurate store->>raw material transfer for process->>store finished goods waiting for shippingPrepetual inventory master files -3 Adequate perpetual inventory master files have a major effect on the timing and extent of the .auditor's physical examination(investigation) of inventory .To check the adequacy of master files If adequate: less time for testing inventory (Less test(investigation .Rely on documentationUnit cost records-4 .Adequate cost accounting records Analytical procedures Analytical procedures are as important in auditing inventory and warehousing as in any other cycle Use of comparison and relationships to assess the reasonableness of inventory balance(if there is .(any unusual fluctuations
Analytical procedures
.Compare inventory gross margin% over the years .Compare inventory turnover over the years Compare unit costs of inventory over the years Compare extended inventory value over the years Compare current year manufacturing cost over the years

Possible misstatements
Overstatement or understatement of inventory and CGS Overstatement or understatement of inventory. Obsolete inventory which .affects inventory and CGS Overstatement or understatement of unit costs which affects inventory .and CGS Misstatements in compilation, unit costs, or existence which affects .inventory and CGS Misstatements of unit costs of inventory, especially direct labor and .manufacturing overhead, which affects inventory and CGS

Methodology for designing TDB Phase 1 Identify client business risks affecting inventory and warehousing cycle Enables the auditor to discuss : -inventory valuation Potential obsolescenceThe existence of consignment inventory intermingled with owned .(inventory(type A useful starting point for becoming familiar with the client's inventory is for the auditor to tour .the client's facilities, including receiving, storage, production, planning, and record- keeping areas The tour should be led by a supervisor who can answer question about production, especially .about any changes in the past years . Set tolerable misstatement and assess inherent risk for the inventory and warehousing cycle First decides the preliminary judgment about materiality for the entire balance sheet -1 Next the auditor allocates the preliminary judgment amount(this materiality) to each significant -2 balance sheet account Inventory is typically one of the most material items in the financial statements for manufacturing, .wholesale, and retailer companies .Inherent risk is often assessed at a relatively high level for companies with significant inventory (easiest for misuse, theft, spoiled ) Assess control risk for several cycles The test results from several cycles other than inventory and warehousing also affect TDB for (inventory. Four cycle: -inventory and warehousing cycle(cost accounting system (sales and collection cycle(sales only (acquisition and payment cycle(acquisition only .payroll and personnel cycle Phase 11 design and perform TOC & STOT for several cycles Phase 111 Design and perform AP for the inventory and warehousing cycle Design test of details of inventory to satisfy balance-related audit objective. Decide on Audit procedures Sample size Items to select timing -

Physical observe inventory-4 .Auditor attend(observe) the count MGT responsibility: to conduct the count(Prepare perpetual master files(record-keeping (Auditor responsibility: to observe (adequacy, conduct in proper manner .Must conduct periodic count regardless the size of company and even is adequate Count should supervise by reasonable person .(Independent verification(internal auditor Price and compile inventory-5 .Inventory price tests: all tests of the client's unit prices to determine whether they are correct (method of pricing according to GAAP, and consistency applied ) Inventory compilation tests: all tests of the summarization of the physical quantities, the extension .of price times quantity, footing the inventory summary, and tracing the totals to the general ledger