PRACTICAL AUDITING Prepared by: Roda R.

Santos

Module 5
INVENTORIES AND RELATED EXPENSES

EXPECTED LEARNING OUTCOMES

After reading this chapter, you should be able to

(a) describe the sequence of activities in the conversion cycle and warehousing cycle;
(b) cite the general internal control procedures in the conversion and warehousing cycle;
(c) state the auditor's principal objectives in auditing inventories and related expense;
(d) apply audit procedures to establish management's assertions on inventories and related
expense balances;
(e) prepare working papers to establish correct balances of inventories and related expenses;
(f) formulate audit adjustments to bring inventories and related expenses to correct balances;
and
(g) evaluate the appropriateness of the presentation of inventories and related expenses in the
financial statements.

Inventories, as defined by IAS 2, are assets that are held for sale in the normal course of
business, or are in the process of production for such sale, or are in the form of materials or
supplies to be used in the production process or in rendering of services. In case of a service
provider, inventories include the cost of the service for which the enterprise has not yet recognized
the related revenue.

Inventories become expenses when the related revenue is recognized, that is at the point of
sale. Enterprises presenting expenses following the function of expense method in the statement
of comprehensive income shows the related expense as cost of goods sold. Those following the
nature of expense method present purchases adjusted by the increase or decrease in inventory
amounts as part of operating expenses. The decline in net realizable value of inventory is another
expense relating to inventories that may warrant separate presentation. The recovery in net
realizable value of inventory, or the gain arising from the adjustment in the valuation allowance of
inventory, is shown as other operating income or a deduction from the amount of inventory that
is shown as expense in profit or loss.
A misstatement of inventories, results in misstatement of expenses and profit in the statement of
comprehensive income and in misstatement of assets presented in the statement of financial
position.

The Warehousing Cycle and Conversion Cycle

The acquisition of goods or services and issuance of inventories is the inventory and
warehousing cycle. This group of activities includes the following sequential steps:

1) An employee or a department recognizes a need for the purchase of goods, prepares a

requisition form and sends it to the purchasing department;
2) The purchasing department locates an appropriate supplier, after considering quality and
price, and prepares and issues a purchase order to the supplier;
3) The receiving department receives and inspects the goods, verifying quality and quantity,
and prepares a receiving report.
4) The receiving department transfers the goods to the warehouse.
5) The goods are transferred from the warehouse to the production department, upon
requisition by latter.

Separate departments shall undertake the foregoing activities separately for effective internal
control. Merchandising companies deliver the goods from the warehouse directly to the customers
or to the company's authorized sales agents of distributors. Shipment of goods to customers,
sales agents or the company's own store (or retail outlet) shall only be made upon proper
authorization by the management.
PRACTICAL AUDITING Prepared by: Roda R. Santos

The purchasing department shall prepare at least three copies of the purchase order: one
copy is sent to the vendor, another is sent to the receiving department, and another copy must be
sent to the accounting department for proper recording of purchases and corresponding liability.
Likewise, the receiving department also sends one copy each of the receiving report to the
accounting department, the storeroom, and the purchasing department.

Manufacturing entities are engaged in another set of activities after the warehousing cycle.
This set of activities is called the conversion cycle. This stars when the warehouse, upon the
requisition of the production department, Issues materials to production. The production
department converts these materials into finished goods by additionally incurring costs of direct
labor and overhead. The conversion process may involve one or two or more production
departments, depending on the nature of the manufacturing process. The transfers of materials
from the warehouse to the production department, and transfers of goods from one production
department to another or to the finished goods warehouse and the shipment of goods to the
customers must be accounted for using an appropriate cost accounting system

To monitor the costs incurred in the production department, a manufacturing company applies
either a job order cost system or a process system, depending on the nature of its products and
its production process. The information developed by an appropriate cost accounting system
provides reliable basis for formulation of management policies for purchasing, production and
sales.

Internal Control over Inventories

Inventories are assets that become the major source of the company's revenue, thus
internal control procedures must be adopted by an entity to safeguard inventories and to ensure
that there is reliable information on inventories. To determine the extent of audit procedures
necessary to achieve the foregoing objectives, the auditor considers the internal control adopted
by the client to safeguard inventories.

Internal control procedures on inventories focus on the following:

a) Physical inspection and counting of all items of inventories received by the company from
suppliers to immediately remedy any discrepancy between delivery and purchase order.
b) Keeping inventories in a warehouse that restricts access to unauthorized persons;
c) Monitoring movements of inventories, from receiving department to the stockroom, to the
production department, to finished goods warehouse, to shipping department, etc.;
d) Appropriate storage of inventories by classification, using Inventory tags, so that inventory
requirements are served without undue delay:
e) Monitoring Inventory quantities to minimize losses due to stockouts and losses from
obsolescence;
f) Conducting a periodic obsolete inventory review;
g) Periodic reconciliation of stock cards inventory and physical inventory
h) Auditing of bill of materials, which is a record of parts used to construct a product; and
i) Creating a procedure to track scrap transactions.

Audit Objectives

The auditor examines inventories principally to achieve the following objectives:

● determine the existence of inventories, and that the client has rights to these assets;
● establish the completeness of inventories,
● establish the clerical accuracy of records and supporting schedules for inventories and
related expenses; determine that the measurement of inventories and related expenses
is appropriate, and
● determine that the presentation and disclosure of inventories and related expenses are
adequate.

Audit Procedures
PRACTICAL AUDITING Prepared by: Roda R. Santos

To establish existence of inventories and to satisfy themselves about the condition of

inventories at the reporting date, the auditors observe the physical count of inventories, conducted
by the client's personnel. It is not the auditors' function to take inventory; the auditors merely
observe the taking of the inventory.

If the client has a physical inventory system, the physical inventory count determines the
balance in inventory accounts at yearend; as such, the count is conducted at the reporting date.

If the client has a perpetual inventory system, the physical inventory count may be
conducted at any convenient time during the reporting period. If the count is conducted at the end
of the reporting period, the auditor has to reconcile the Inventory amount determined through
physical count and the ledger balance in the stock cards, and appropriate adjustments must be
made to update the inventory records. If the count is conducted earlier than the end of the
reporting period, roll forward procedures must be undertaken to ensure that the inventory balance
at yearend equals the physical goods.

The auditors normally participate in the client's advanced planning of the physical
inventory and review the written instructions prepared by management for the employees who
will make the counts. During the physical inventory, the auditors will note that all goods are being
counted and that controls exist to prevent double counting of items and omission of items from
the count. Also, the auditors will make test counts of numerous items and compare these counts
with the quantities reported by the client's counting teams.

If the auditors do not observe the taking of the inventory because it is impossible to do so,
some audit procedures must be undertaken to validate the existence of and the amount reported
as inventory. For the auditors to be satisfied in such situations, the client generally must have
effective internal control over inventories, and at some point the auditors must observe or make
physical counts of the inventory.

The auditors should take exceptions for indications of goods that are damaged or
otherwise obsolete or non-salable. The auditor should test the net realizable value of goods by
reference to sale transactions during the subsequent reporting period. If evidence exists that the
price less cost to sell of goods will be less than cost, the prospective loss should be recognized
in the current period, as inventories in the statement of financial position are measured at the
lower of cost and net realizable value.

Goods stored in public warehouses and goods held by consignees should be confirmed
by direct communication with the custodian of the warehouse or the consignee. When the
amounts of inventory involved are significant, the auditors should consider performing
supplementary procedures, including review of the client's procedures for investigating
prospective warehouses and evaluating their performance, obtaining reports on Internal control
from the auditors of the warehouses, or observing the inventories at the warehouses.

The auditors' tests of the cost accounting system are designed to determine that
appropriate costs have been assigned to work-in-process, finished goods, and cost of goods sold.
The auditors must determine that the methods of measuring the cost of inventory are in conformity
with the cost formula applicable to the enterprise, in accordance with IAS 2 Inventories. The
auditors also perform tests of prices applied to inventories to determine whether the inventory
costing procedure used by the client has been properly applied.

To establish completeness and correctness of inventory balances, the auditor conducts a

purchase cutoff test by reviewing purchase invoices and receiving report several days before and
several days after the end of the reporting period, noting the date that the enterprise obtains
economic control or the date title passed) and the date the transaction was recorded in the
accounting records.

For audits of a manufacturing entity, the auditor has to review the bill of materials for a
sample of finished goods to test whether the cost of materials has been properly included in the
PRACTICAL AUDITING Prepared by: Roda R. Santos

cost of work in process or finished goods inventories. The auditors shall also trace the labor
charged to production based on time cards and labor routings to ensure that the client charges
labor that is supported by payroll records. Likewise, overhead costs charged to production shall
be validated to determine whether the company uses appropriate and consistent method of
allocating overhead to product manufactured.

Analytical review procedures may be conducted to disclose the presence of obsolete

inventory items, material errors in counting and pricing. Such analytical review procedures
include, but are not limited to, comparisons of inventories classified by major types to prior years'
amounts, comparisons of gross profit percentages by product line to prior years and industry
statistics, and comparison of this year's inventory turnover to prior years. Such reviews may
disclose material errors in counting, pricing and obsolete inventory items.

In the audit of a new client, the auditors must obtain evidence that the client's beginning
inventories are fairly stated, as errors in beginning inventory balances will misstate current year
profit. This evidence may be obtained by review of the audit working papers of the predecessor
auditor (if the client's financial statements were audited in the prior year), tests of the perpetual
inventory records, tests of the documents used in the physical inventory, and tests of the overall
reasonableness of the inventory figures, tests of transactions affecting inventory balances, and
other analytical review procedures.

The auditor determines whether inventories are properly presented and measured in the
financial statements. The financial statement should disclose the Inventory costing formula in use,
any amount of inventories pledged for liabilities, and significant sales or purchase commitments.