CHAPTER 3

AUDIT OF INVENTORIES
AND COST OF GOODS SOLD
AUDIT PROGRAM FOR
INVENTORIES

Audit Objectives

To determine that:

a. Inventories included in the balance sheet physically exist.

b. Inventories represent items held for sale or use in the normal course of business.
c. Inventory quantities include all products, materials, and supplies owned by the company
(on hand, in transit, or stored at outside locations).
d. The entity has legal title or similar rights of ownership to the inventories.
e. Inventories are properly stated at cost (except when market is lower)
f. Inventories are properly described and classified in the financial statements and
disclosures are adequate.

Audit Procedures
1. Observe physical inventory counts.
a. Test shipping and receiving cutoff procedures.
b. Account for all inventory tags and count sheets used in recording the physical
inventory count.
c. Test the clerical accuracy of inventory listings.
d. Trace test counts recorded during the physical inventory observation to the
inventory listing.
e. Reconcile physical counts to perpetual records and general ledger balances and
investigate significant variations.
f. Test inventory transactions between a preliminary physical inventory date and
the balance sheet date.

2. Obtain confirmation of inventories at locations outside the entity.

3. Review perpetual inventory records, production records, and purchasing records for indications
of current activities.

4. Analytically review the relationship of inventory balances to recent purchasing, production,

and sales activities, and to anticipated sales volume.

5. Examine paid vendors' invoices, consignment agreement, and contracts.

6. Review direct labor rates.

7. Test the computation of standard overhead rates.

8. Examine analysis of purchasing and manufacturing standard cost variances.

9. Examine inventory turnover analysis.

10. Review industry experience and trends.

11. Tour the plant. Inquire of production and sales personnel concerning possible excess
or obsolete inventory items.

12. Examine sales after year-end and open purchase order commitments.

13. Obtain confirmation of inventories pledge under loan agreements.

14. Review drafts of the financial statements.

15. Compare the disclosures made in the financial statements to the requirements of
 generally accepted accounting principles.

PAS 2 par. 6 defines “Inventories” as assets

a. held for sale in the ordinary course of business;
b. in the process of production for such sale; or
c. in the form of materials or supplies to be consumed in the production process or in the
rendering of services.

Par. 10 further states that the cost of inventories shall comprise all costs of purchase, costs of
conversion and other costs incurred in bringing the inventories to their present location and
condition.

CHAPTER 3
PROBLEMS
PROBLEM NO. 1
PASSAGE OF TITLE

Gobel Company reviewed its inventories and found the following items:

1 In the shipping room was a product costing $13,400 when the physical count was taken. Because
it was marked "Hold for shipping instructions", it was not included in the count. The customer order
was dated December 15, but the product was shipped and the customer billed on January 4, 2010.

2 On December 27, 2009, merchandise costing $11,648 was received and recorded. The invoice
accompanying the merchandise was marked "on consignment."

3 The company received merchandise costing $4,625 on January 2, 2010. The invoice which was
recorded on January 3, 2010 showed shipment was made under FOB shipping point on December
31, 2009. The merchandise was not included in the inventory because it was not on hand when
the physical count was taken.

4 A product, fabricated to order for a particular customer was completed and in the shipping room
on December 31. Although it was shipped on January 5, 2010, the customer was billed on
December 31, 2009 and it was excluded from the inventory.

5 Merchandise costing $16,666 was received on January 5, 2010, and the related purchase invoice
was recorded January 6. The shipment of this merchandise was made on December 31, 2009,
FOB destination.

6 A product costing $150,000 was sold on an installment basis on December 10, 2009. It was
delivered to the customer on that date. The product was included in inventory because the
company still holds legal title. The company's experience suggests that full payment on
installment sales is reasonably assured.

7 An item costing $65,000 was sold and delivered to the customer on December 29, 2009. The
goods were included in the inventory because the sale was with a repurchase agreement that
require Gpbel Company to buyback the inventory on January 15, 2010.

REQUIRED: Indicate which of the above items are to be included in the inventory balance at
December 31, 2009. State your reason for the treatment you suggest.

Solution:
1. Included - Merchandise, except "special orders" should be included in the
inventory until shipped.
2. Excluded - Gobel Company does not possess legal title because the merchandise
was received on a consignment basis.
3. Included - Because the purchase was made under FOB shipping point term, the
merchandise should be included in the inventory on the shipping date.
4. Excluded - A product that is manufactured for a particular customer (special order)
is considered sold upon its completion.
5. Excluded - The merchandise was purchased under FOB destination term and was
 not received until January 5, 2009.
6. Excluded - The sale is recognized even though legal title has not passed.
7. Included - This is actually a loan transaction with the inventory as collateral.

PROBLEM NO. 2
DETERMINING INVENTORY QUANTITY

The management of Plum Company has engaged you to assist in the preparation of the year-end
(December 31) financial statements. The company's year-end inventory of 43,500 units is based on a
physical count taken on December 31 under your observation. During the month of December, sales
totaled 138,630 units including 40,000 units shipped on consignment to Apple Corp. A letter received
from Apple Corp. indicates that as of December 31, it has sold 15,200 units and was still trying to sell
the remainder.

A review of the December purchase orders to various suppliers shows the following:

Purchase Invoice Quantity Date Date

Order Date Date in Units Shipped Received Terms

12/31/09 1/2/10 4,200 1/2/10 1/5/10 FOB Destination

12/05/09 1/2/10 3,600 12/17/09 12/22/09 FOB Destination
12/06/09 1/3/10 7,900 1/5/10 1/7/10 FOB Shipping point
12/18/09 12/20/09 8,000 12/29/09 1/2/10 FOB Shipping point
12/22/03 1/5/10 4,600 1/4/10 1/6/10 FOB Destination
12/27/09 1/7/10 3,500 1/5/10 1/7/10 FOB Destination

Plum Company uses the "passing of legal title" for inventory recognition.

REQUIRED: Compute the inventory level as of November 30.

Solution:
Inventory, December 31 43,500
Add: December sales
Consignment sales 15,200
Other sales (138,630-40,000) 98,630 113,830
TGAS 157,330
Less: December purchases
PO Date
12/05/09 3,600
12/18/09 8,000 11,600
Inventory, November 30 145,730

PROBLEM NO. 3
COMPUTING THE CORRECT ENDING INVENTORY AMOUNT

In your audit of the December 31, 2009 financial statements of Chevvy, Inc., you found the following
inventory-related transactions:

a. Goods costing $25,000 are on consignment with a customer. These goods were not included
in the physical count on December 31, 2009.

b. Goods costing $16,500 were delivered to Chevvy, Inc. on January 4, 2010. The invoice for
these goods was received and recorded on January 10, 2010. The invoice showed the shipment
was made on December 29, 2009, FOB shipping point.
 c. Goods costing $21,640 were shipped FOB shipping point on December 31, 2009 and were
received by the customer on January 2, 2010. Although the sale was recorded in 2009, these
goods were included in the 2009 ending inventory.

d. Goods costing$8,645 were shipped to a customer on December 31, 2009, FOB destination.
These goods were delivered to the customer on January 5, 2010 and were not included in the
inventory. The sale was properly taken up in 2010.

e. Goods costing $8,600 shipped by a vendor under FOB destination term, were received on
January 3, 2010, and thus were not included in the physical inventory. Because the related
invoice was received on December 31, 2009, this shipment was recorded as a purchase in 2009.

f. Goods valued at $51,000 were received from a vendor under consignment term. These goods
were not included in the physical count.

g. Chevvy, Inc. recorded as a 2009 sale a $64,300 shipment of goods to a customer on December
31, 2009, FOB destination. This shipment of goods costing $37,500 was received by the
customer on January 5, 2010, and was not included in the ending inventory figure.

Prior to any adjustments, Chevvy, Inc.'s ending inventory is valued at $445,346 and the reported net
income for the year is $1,648,723.

REQUIRED:
1. Determine the correct inventory amount to be reported in the financial statements of Chevvy,
Inc. for the year ended December 31, 2009.
2. Compute the adjusted net income for the year 2009.

Solution: (1) (2)

Inventory Net Income
Per client's book 445,346 1,648,723
a. Goods on consignment 25,000 25,000
b. Goods purchased FOB shipping point 16,500 0
c. Goods sold FOB shipping point (21,640) (21,640)
d. Goods sold FOB destination 8,645 8,645
e. Goods purchased FOB destination 0 8,600
f. Goods received on consignment 0 0
g. Goods sold FOB destination 37,500 (26,800)
Corrected balance 511,351 1,642,528

PROBLEM NO. 4
INVENTORY VALUATION

Zebra Home Improvements Company installs replacement siding windows, and louvered glass doors
for family homes. In your audit of the company's financial statements for the year ended December 31,
2009, you have gathered the following data concerning inventory.

At December 31, 2009, the balance in Zebra's Raw Materials Inventory account was $502,000, and
the Allowance for Inventory Write-down had a balance of $32,600. The relevant inventory cost and
market data at December 31, 2009 are summarized in the schedule below.

Replace- Sales Net Realiza- Normal

Cost ment Cost Price ble value Profit

Aluminum siding $89,000 $86,000 $91,500 $87,000 $6,400

Mahogany siding 94,000 92,000 93,000 85,000 7,440
Louvered glass doors 125,000 135,000 129,000 111,000 11,610
Glass windows 194,000 114,000 205,000 197,000 20,500
Total $502,000 $427,000 $518,500 $480,000 $45,950

REQUIRED:
1. Determine the proper balance in the Allowance for Inventory Write-down at December 31, 2009.
Solution:
Cost NRV LCM
Aluminum siding 89,000 87,000 87,000
Mahogany siding 94,000 85,000 85,000
Louvered glass door 125,000 111,000 111,000
Glass windows 194,000 197,000 194,000
502,000 480,000 477,000

Required allowance (502,000-477,000) 25,000

2. What is the entry to recognize the change in allowance on December 31, 2009?

Entry:
Allowance for inventory write-down 7,600
Gain on inventory recovery 7,600

Required allowance 25,000

Allowance balance 32,600
(7,600)

PROBLEM NO. 5
PERPETUAL INVENTORY SYSTEM

Your client took a complete physical inventory under your observation as of December 15 and
adjusted the inventory control account (perpetual inventory method) to agree with physical inventory.
You have decided to accept the balance of the control account as of December 31, after reflecting
transactions recorded therein from December 16 to 31, in connection with your financial statement
audit for the year ended December 31.

Your examination of the sales cut-off as of December 15 and December 31 revealed the following items
not previously considered.

Credited to
Cost Sales Price Shipped Billed Inv. Control

$5,650 $7,200 12/14 12/17 12/17

2,430 4,650 12/13 12/20 12/13
6,870 9,200 1/3 12/31 12/31

REQUIRED: What adjusting journal entries, if any, would you make for each of these items?
Solution:
Adjusting Journal Entries
December 31

1. Inventory 5,650
Inventory over and short 5,650
To reverse erroneous adjustment to
 physical count at December 15

2. Sales 9,200
Accounts receivable 9,200
To reverse sale recoded 12/31
not shipped till 1/2

3. Inventory 6,870
Cost of sales 6,870
To reverse cost of sale
recorded 12/31 but not shipped
till 1/2

PROBLEM NO. 6
PURCHASES CUTOFF

You are engage in an audit of the financial statements of Carnaval Company for the year ended
October 31, 2009, and have observed the physical inventory count on that date.

All merchandise received up to and including October 30, 2009 has been included in the physical
count. The following lists of invoices are for purchase of merchandise and are entered in the purchases
journal for the months of October and November 2009, respectively:
Date
Date of Merchandise
Amount FOB Invoice Received

October 2009

$7,200 Destination October 19 October 21

4,400 Destination October 20 October 22
9,250 Shipping point October 20 October 30
3,900 Destination October 25 November 3
2,500 Destination November 4 October 29
10,250 Shipping point October 25 October 30
9,200 Shipping point October 25 October 30
13,600 Destination October 21 October 30
34,600 Destination October 29 October 30

November 2009

$2,000 Destination October 29 November 4

4,850 Destination October 30 October 31
6,420 Shipping point October 27 October 30
7,220 Shipping point November 2 October 30
12,820 Shipping point October 23 November 3
14,200 Shipping point October 23 November 3
15,000 Destination October 27 November 3

No perpetual inventory records are maintained and the physical inventory count is to be used as a
basis for the financial statements.

REQUIRED:
1. What adjusting entries would you propose in view of the facts adduced?
Solution:
1. Adjusting Journal Entries
 a. Accounts payable 3,900
Purchases 3,900
To reverse entry made for October 25 invoice.

b. Purchases 45,510
Accounts payable 45,510
To set up liability for the following October
31 invoices:

Invoice date Amount

October 30 4,850
October 27 6,420
November 2 7,220
October 23 12,820
October 23 14,200
45,510

2. What adjustment, if any, would you suggest to the physical inventory as originally taken?

2. The physical inventory at October 31 should be increased by US$31,870.

Invoice date Amount

October 30 4,850
October 23 12,820
October 23 14,200
31,870

PROBLEM NO. 7
CORRECTING INVENTORY ERRORS

Morning Dew's annual income for the period 2005-2009 is as follows:

Net Income
Year (loss)

2005 $148,000
2006 345,000
2007 649,000
2008 (150,000)
2009 200,000

A review of the company's records reveals the following inventory errors:

2005 $3,000 understatement, end of the year

2006 6,000 overstatement, end of the year
2008 4,500 understatement, end of the year
2009 11,000 overstatement, end of the year

REQUIRED: Compute the adjusted net income for each year.

Solution;
2005 2006 2007 2008 2009
Unadusted net income/ (loss) 148,000 345,000 649,000 (150,000) 200,000
2005 understatement end inv 3,000 (3,000)
2006 overstatement of end inv (6,000) 6,000
 2008 understatement end inv 4,500 (4,500)
2009 overstatement end inv (11,000)
151,000 336,000 655,000 (145,500) 184,500

PROBLEM NO. 8
CORRECTING THE PHYSICAL INVENTORY COUNT

In your audit of the Rainbow Company, you noted that a physical inventory count on December 31,
2009, showed merchandise costing $850,000 was on hand at that date. Your examination reveals the
following items are all excluded from the inventory per count.

1 Merchandise of $20,000 which was held on consignment.

2 Goods costing $39,500 which was shipped FOB destination on December 31, 2009. These
goods were delivered to the customer on January 6, 2010.
 3 Goods costing $16,800 which was shipped FOB shipping point to a customer on December 29,
2009. The customer received these goods on January 2, 2010.

4 Merchandise costing $76,150 shipped by a seller FOB destination on December 28, 2009,
and received by Rainbow Company on January 3, 2010.

5 Goods costing $16,444 shipped by a vendor FOB seller on December 31, 2009, and received by
Rainbow Company on January 4, 2010.

REQUIRED: Compute the correct inventory amount at December 31, 2009.

Solution:
Inventory per physical count 850,000
Add: Goods sold FOB destination 39,500
Goods purchased FOB seller 16,444 55,944
905,944

PROBLEM NO. 1
CORRECTING INVENTORY ERRORS

Baileys Company is a manufacturer of small tools. The following information was obtained from the
company's accounting records for the year ended December 31, 2009.

Inventory at December 31, 2009 (based on physical count in

Baileys' warehouse at cost on December 31, 2009 $1,870,000
Accounts payable at December 31, 2009 1,415,000
Net sales (sales less sales returns) 9,693,400

Your audit reveals the following information:

1 The physical count included tools billed to a customer FOB shipping point on December 31,
2009. These tools cost $64,000 and were billed at $78,500. They were in the shipping area
waiting to be picked up by the customer.

2 Goods shipped FOB shipping point by a vendor were in transit on December 31, 2009. These
goods with invoice cost of $93,400 were shipped on December 29, 2003.

3 Work in process inventory costing $27,000 was sent to a job contractor for further processing.

4 Not included in the physical count were goods returned by customers on December 31, 2009.
These goods costing $49,000 were inspected and returned to inventory on January 7, 2010.
Credit memos for$67,800 were issued to the customers at that date.

5 In transit to a customer on December 31, 2009, were tools costing $17,740 shipped FOB
destination on December 26, 2009. A sales invoice for $29,400 was issued on January 3, 2010
when Baileys company was notified by the customer that the tools had been received.

6 At exactly 5:00 pm on December 31, 2009, goods costing $31,200 were received from a vendor.
These were recorded on a receiving report dated January 2, 2010. The related invoice was
recorded on December 31, 2009, but the goods were not included in the physical count.

7 Included in the physical count were goods received from a vendor on December 27, 2009.
However, the related invoice for $36,000 was not recorded because the accounting department's
copy of the receiving report was lost.
 CEBU CPAR CENTER, INC. www.Cebu-CPAR.com
8 A monthly freight bill for $16,000 was received on January 3, 2010. It is specifically related
to merchandise bought in December 2009, one-half of which was still in the inventory at
December 31, 2009. The freight was not included in either the inventory or in accounts
payable at December 31, 2009.

REQUIRED: Compute for the adjusted amount of Inventory, Accounts Payable, and Net
Sales Solution:
Accounts
Inventory Payable Net Sales
Unadjusted balances 1,870,000 1,415,000 9,693,400
1. (78,500)
2. 93,400 93,400
3. 27,000
4. 49,000 (67,800)
5. 17,740
6. 31,200
7. 36,000
8. 8,000 16,000
Adjusted balance 2,096,340 1,560,400 9,547,100

PROBLEM NO. 10
During your audit of the records of the Manaoag Corporation for the year ended December
31, 2006, the following facts were disclosed:
Raw materials inventory, 1/1/2006 P 720,200
Raw materials purchases 5,232,800
Direct labor 4,900,000
Manufacturing overhead applied (150% of direct labor) 7,350,000
Finished goods inventory, 1/1/2006 1,240,000
Selling expenses 8,112,800
Administrative expenses 7,377,200

Your examination disclosed the following additional information:

a) Purchases of raw materials

Month Units UnitPrice Amount
January – February 55,000 P17.76 P 976,800
March – April 45,000 20.00 900,000
May – June 25,000 19.60 490,000
July – August 35,000 20.00 700,000
September – October 45,000 20.40 918,000
November – December 60,000 20.80 1,248,000
265,000 P5,232,800

b) Data with respect to quantities are as follows:

Units
Explanation 1/1/06 12/31/06
Raw materials 35,000 ?
Work in process (80% completed) - 25,000
Finished goods 15,000 40,000
Sales, 200,000 units

c) Raw materials are issued at the beginning of the manufacturing process. During the year, no
returns, spoilage, or wastage occurred. Each unit of finished goods contains one unit of raw
materials.

d) Inventories are stated at cost as follows:

 Raw materials – according to the FIFO method
 Direct labor – at an average rate determined by correlating total direct labor cost with
effective production during the period
 Manufacturing overhead – at an applied rate of 150% of direct labor cost

11
CEBU CPAR CENTER, INC. www.Cebu-CPAR.com
QUESTIONS:
Based on the above and the result of your audit, answer the following:
1. The raw materials inventory as of December 31, 2006
is a. P992,000 c. P 936,000
b. P888,000 d. P1,040,000

12
2. The work in process inventory as of December 31,
2006 is a. P1,496,000 c. P1,746,000
b. P1,514,000 d. P1,776,000
3. The finished goods inventory as of December 31,
2006 is a. P2,793,600 c. P3,553,130
b. P3,334,000 d. P2,812,000
4. The cost of goods sold for the year ended December 31,
2006 is a. P16,897,000 c. P14,077,000
b. P14,161,400 d. P13,911,400
Suggested
Solution:
Question No. 1
Units
Raw materials, 1/1/06 35,000
Add Purchases 265,000
Raw materials available for use 300,000
Less raw materials, 12/31/06 (squeeze) 50,000
Goods placed in process 250,000
Less work-in-process, 12/31/06 25,000
Goods manufactured 225,000
Finished goods, 1/1/06 15,000
Total goods available for sale 240,000
Less finished goods, 12/31/06 40,000
Goods sold 200,000

Raw materials, 12/31/06 (50,000 units x P20.80) P1,040,000

Question No. 2
Raw materials [(10,000 units x P20.80) +
(15,000 units x P20.40)] P 514,000
Direct labor (25,000 units x 80% x P20a) 400,000
Factory overhead (25,000 units x 80% x P30b) 600,000
Work in process, 12/31/06 P1,514,000

Labor unit cost (P4,900,000/245,000* units) P20a

Overhead unit cost (P7,350,000/245,000* units) P30b

*Equivalent production for labor and overhead

Started, finished and sold [(200,000 units - 15,000
units) x 100%] 185,000
Started, finished and on hand (40,000 units x 100%) 40,000
Started, and in process (25,000 units x 80%) 20,000
Total 245,000
Question No. 3
Raw materials [(30,000 units x P20.40)
+(10,000 units x P20)] P 812,000
Direct labor (40,000 units x P20a) 800,000
Factory overhead (40,000 units x P30b) 1,200,000
Finished goods inventory, 12/31/06 P2,812,000
Question No. 4
Raw materials, 1/1/06 P 720,200
Add purchases 5,232,800
Raw materials available for use 5,953,000
Less raw materials, 12/31/06 (see no. 1) 1,040,000
Direct materials used 4,913,000
Direct labor 4,900,000
Factory overhead 7,350,000
Total manufacturing cost 17,163,000
Add work-in-process, 1/1/06 -
Total cost placed in process 17,163,000
Less work-in-process, 12/31/06 (see no. 2) 1,514,000
Cost of goods manufactured 15,649,000
Add finished goods, 1/1/06 1,240,000
Total goods available for sale 16,889,000
Less finished goods, 12/31/06 (see no. 3) 2,812,000
Cost of goods sold P14,077,000
 Answers: 1) D; 2) B; 3) D; 4) C

PROBLEM NO. 11
You obtained the following information in connection with your audit of Villasis Corporation:
Cost Retail
Beginning inventory P1,987,200 P2,760,000
Sales 7,812,000
Purchases 4,688,640 6,512,000
Freight in 94,560
Mark ups 720,000
Mark up cancellations 120,000
Markdown 240,000
Markdown cancellations 40,000

Villasis Corp. uses the retail inventory method in estimating the values of its inventories and
costs.
QUESTIONS:
Based on the above and the result of your audit, answer the following:
1. The cost ratio to be used considering the provisions of PAS 2
is a. 68.58% c. 70.00%
b. 69.20% d. 75.78%
2. The estimated ending inventory at retail is
a. P2,300,000 c. P1,940,000
b. P2,060,000 d. P1,860,000
3. The estimated ending inventory at cost is
a. P1,412,786 c. P1,302,000
b. P1,275,588 d. P1,287,120
4. The estimated cost of goods sold is
a. P5,468,400 c. P5,357,614
b. P5,494,812 d. P4,685,117

Suggested Solution:

Question No. 1
Cost Retail
Beginning inventory P1,987,200 P2,760,000
Purchases 4,688,640 6,512,000
Freight in 94,560
Net mark up (P720,000 - P120,000) 600,000
Net mark down (P240,000 - P40,000) 200,000
Goods available for sale P6,770,400 P9,672,000

Cost ratio (P6,770,400/P9,672,000) 70%

PAS 2 par. 22 states that the retail inventory method is often used in the retail industry for
measuring inventories of large numbers of rapidly changing items with similar margins for
which it is impracticable to use other costing methods. The cost of inventory is determined by
reducing the sales value of the inventory by the appropriate percentage gross margin. The
percentage used takes into consideration inventory that has been marked down to below its
original selling price. An average percentage for each retail department is often used.

Previously, the conventional approach (lower of average cost or market valuation) is often
used if the problem is silent. The conventional approach ignores markdown in the computation
of cost ratio. However, since PAS 2 specifically states that the percentage should take into
consideration inventory that has been marked down to below its original selling price, the cost
ratio was computed using the average method.

Question No. 2
Goods available for sale at retail P9,672,000
Less sales 7,812,000
Ending inventory, at retail P1,860,000

Question No. 3
Ending inventory, at cost (P1,860,000 x 70%) P1,302,000

Question No. 4
Goods available for sale at cost P6,770,400
Less ending inventory, at cost 1,302,000
Estimated cost of sales P5,468,400

Answers: 1) C; 2) D; 3) C; 4) A