AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE

The inventory and warehousing cycle is unique because of its close relationships to other transaction
cycles. For a manufacturing company, raw material enters the inventory and warehousing cycle from the
acquisition and payment cycle, while direct labor enters it from the payroll and personnel cycle. The
inventory and warehousing cycle ends with the sale of goods in the sales and collection cycle.

The audit of inventory, especially tests of the year-end inventory balance, is often the most complex and
time consuming part of the audit. As the audit of Phar-Mor demonstrates, finding misstatements in
inventory accounts can be challenging. Factors affecting the complexity of the audit of inventory
include:

• Inventory is often the largest account on the balance sheet.

• Inventory is often in different locations, making physical control and counting difficult.
• Diverse inventory items such as jewels, chemicals, and electronic parts are often difficult for
auditors to observe and value.
• Inventory valuation is also difficult when estimation of inventory obsolescence is necessary and
when manufacturing costs must be allocated to inventory.
• There are several acceptable inventory valuation methods and some organizations may prefer
to use different valuation methods for different parts of the inventory, which is acceptable
under accounting standards.
PARTS OF THE AUDIT OF INVENTORY

Now that you are familiar with the business functions and the related documents and records in the
inventory and warehousing cycle, we turn our attention to the audit of the cycle. The overall objective in
the audit of the inventory and warehousing cycle is to provide assurance that the financial statements
fairly account for raw materials, work in process, finished goods inventory, and cost of goods sold. The
audit of the inventory and warehousing cycle can be divided into five activities within the cycle:

1. Acquire and record raw materials, labor, and overhead

2. Internally transfer assets and costs
3. Ship goods and record revenue and costs
4. Physically observe inventory
5. Price and compile inventory
Cost accounting systems and controls of different companies vary more than most other audit areas
because of the wide variety of items of inventory and the level of sophistication desired by
management. For example, a company that manufactures farm machines may have completely different
cost records and internal controls than a steel fabricating shop that makes and installs custom-made
metal cabinets. Of course, small companies with owners actively involved in the manufacturing process
need less sophisticated records than large, multiproduct companies.

Cost accounting controls are those related to processes affecting physical inventory and the tracking of
related costs from the time raw materials are requisitioned to the completion of the manufactured
product and its transfer to storage. It is convenient to divide these controls into two broad categories:

1. Physical controls over raw materials, work-in-process, and finished goods inventory
2. Controls over the related costs

Perpetual inventory master files maintained by persons who do not have custody of or access to assets
are another useful cost accounting control for a number of reasons:

• They provide a record of inventory on hand, which is used to initiate production or acquisition of
additional materials or goods.
• They provide a record of the use of raw materials and the sale of finished goods, which can be
reviewed for obsolete or slow-moving items.
• They provide a record to pinpoint responsibility when there are differences between physical
counts and the amounts shown on the perpetual listings.
The concepts in auditing inventory cost accounting are no different from those dis cussed for other
transaction cycles: understand internal controls in the cost accounting system, assess planned control
risk, determine extent of testing controls, and design tests of controls and substantive tests of
transactions to meet transaction-related audit objectives. The auditor is concerned with four aspects of
cost accounting:

1. Physical controls over inventory

2. Documents and records for transferring inventory
3. Perpetual inventory master files
4. Unit cost records
Auditors must verify that the physical counts or perpetual record quantities are correctly priced and
compiled. Inventory price tests include all the tests of the client’s unit prices to determine whether they
are correct. Inventory compilation tests include testing the client’s summarization of the inventory
counts, recalculating price times quantity, footing the inventory summary, and tracing the totals to the
general ledger.

Clients need inventory compilation internal controls to ensure that the physical counts are correctly
summarized, priced at the same amount as the unit records, correctly extended and totaled, and
included in the perpetual inventory master file and related general ledger inventory accounts at the
proper amount. The most important internal control for accurate unit costs, extensions, and footings is
internal verification by a competent, independent person, who relies on adequate documents and
records that were used for taking the physical count. If the physical inventory counts are recorded by
the client on pre numbered tags and carefully reviewed before the personnel who counted the
inventory are released from the physical examination of inventory, there should be little risk of
misstatement in summarizing inventory count tags.

Audit of Pricing and Compilation

Inventory price tests

 Pricing and compilation controls

 Pricing and compilation procedures

 Valuation of inventory
Balance-Related Objectives: Inventory Pricing and Compilation

 Detail tie-in

 Existence

 Completeness

 Accuracy

 Classification

 Realizable value

 Rights