Unit Four: Auditing For Inventory Cost Of Goods Sold

Inventories are major items on the balance sheet, i.e. in total assets, especially in the current asset section.
Inventories play also a very significant and important role in preparation of income statement and
determination of net income or loss. The inventory and warehousing cycle is unique because of its close
relationships to other transaction cycles.

The audit of inventory, especially tests of the year-end inventory balance, is often the most complex and time
consuming part of the audit. Factors affecting the complexity of the audit of inventory include:
a) Inventory is often the largest account on the balance sheet.
b) Inventory is often in different locations, making physical control and counting difficult.
c) Diverse inventory items such as jewels, chemicals, and electronic parts are often difficult for auditors
to observe and value.
d) Inventory valuation is also difficult when estimation of inventory obsolescence is necessary and when
manufacturing costs must be allocated to inventory.
e) 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.
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
ACCOUNTS AND CLASSES OF TRANSACTIONS BUSINESS FUNCTIONS AND THE
RELATED DOCUMENTS AND RECORDS
Inventory takes many different forms, depending on the nature of the business. For retail or wholesale
businesses, the largest account in the financial statements is often merchandise inventory available for sale.
To study the inventory and warehousing cycle, we will use an example of a manufacturing company, whose
inventory may include raw materials, purchased parts and supplies for use in production, goods in the
process of being manufactured, and finished goods available for sale.
1. Process Purchase Orders: The inventory and warehousing cycle begins with the acquisition of raw
materials for production. Purchase requisitions are forms used to request the purchasing department
to order inventory. These requisitions may be initiated by stockroom personnel as raw materials are
needed, by automated computer software when raw materials reach a predetermined level, by orders
placed for the materials required to produce a customer order, orby orders initiated on the basis of a
periodic raw materials count.
2. Receive Raw Materials: Receipt of the ordered materials, which is also part of the acquisition and
payment cycle, involves the inspection of material received for quantity and quality. The receiving
department prepares a receiving report that becomes a part of the documentation before payment is
made.
3. Store Raw Materials: Once received, materials are normally stored in a stockroom. When another
department needs materials for production, personnel submit a properly approved materials

1
 requisition, work order, or similar document or electronic notice that indicates the type and quantity
of materials needed. This requisition document is used to update the perpetual inventory master files
and record transfers from raw materials to work-in-process accounts.
4. Process the Goods: Companies determine the finished goods items and quantities they will produce
based on specific orders from customers, sales forecasts, predetermined finished goods inventory
levels, and economical production runs.
5. Cost accounting records: consist of master files, spreadsheets, and reports that accumulate material,
labor, and overhead costs by job or process as those costs are incurred. When jobs or products are
completed, the related costs are transferred from work-in-process to finished goods based on
production department reports.
6. Store Finished Goods: When finished goods are completed, they are placed in the stockroom to
await shipment.
7. Ship Finished Goods: Shipping completed goods is part of the sales and collection cycle. For most
sales transactions, the actual shipment becomes the trigger for recognizing the related accounts
receivable and sales in the accounting system.

Some of these documents and records may exist for this transaction cycle includes:
 Production and schedule  Production data information
 Receiving report  Cost accumulation and variance report
 Material requisition  Inventory status report
 Inventory master file  Shipping Order
The audit of the inventory and warehousing cycle can be divided into five activities within the cycle:
o Acquire and record raw materials, labor, and overhead
o Internally transfer assets and costs
o Ship goods and record revenue and costs
o Physically observe inventory
o Price and compile inventory

Internal Control over Inventories

Well-conceived inventory control system should ensure that
 all purchases authorized
 accounting system ensures timely, accurate, complete recording
 receipt of inventory properly accounted for
 cost accounting system up to date
 perpetual inventory system exist
 inventory reviewed for obsolescence
The followings are internal control procedures that should exist in the client’s business to control
inventory properly
 Purchase or other commitment should be initiated only by authorized personnel, preferably on the basis
of competitive bid.
 Purchase orders for good and materials are placed as needed and for optimum quantity
2
  Follow up should be made on purchase orders if delivery has not been made by the scheduled delivery
date
 Incoming shipment should be accepted only if the receiving department has authorization in the form
of a copy of purchase order.
 Quantity and quality of goods received should be as specified before payment is authorized
 Terms, prices, and clerical accuracy of vendors invoice should be correct before payment is authorized
 Inventory quantity should be adequately protected against losses from theft, spoilage, unauthorized
withdrawal by employee.
 Difference between book and physical inventories should be ascertained, differences adjusted and the
amount of overage or shortage should be properly accounted for.
 Proper authorization should be existed for inventory quantity removed from stock
 All transactions pertaining to the issue or sales of inventories quantity should be accounted for and
entered in the controlling record.
 Inventory issues should be valued according to an acceptable method and the costs should be accounted
for in a manner that provides adequate information for management including variance from standard
 There should be reviews of damaged, obsolete and slow moving inventories should be carried out. Any
write - offs should be authorized.
 All receipts and issues should be recorded on inventory cards.
 Inventory levels should be checked against the records by a person independent of the stores personnel,
and material differences investigated.
 Where continuous inventory records are not kept adequately a full count should be held at least once a
year.
 Access to the stores should be restricted
 Proper segregation of duties and physical safeguards of inventory to prevent
fictitious inventory.
 Purchase requisition, purchase order, receiving report and vouchers are
prenumbered and accounted for
 There should be procedures to include goods out on consignment and exclude
goods led on consignment
 All receiving reports and delivery notes should be processed daily..
 There should be review of cost accumulation, standard costs, and variance reports
by person of appropriate level.

AUDIT PROGRAM FOR INVENTORIES AND CGS

A. Tests of Control
Examples of test of control for inventory and CGS are as follows:

 Observe and evaluate proper segregation of duties and test procedures for transfer and issuing
inventory.

3
 Review authorized production schedules and test procedures for establishing inventory levels and
inventory control.
 Check recorded inventory against suppliers’ invoices and goods received notes.
 Check sequential controls over purchase requisition, purchase order, receiving report and vouchers.
 Test the control procedures for the consignment goods.
 Check dates of receiving reports and delivery notes to dates to record the inventory movements in
perpetual inventory records.
 Examine and test procedures for taking physical inventory, accumulating costs, and developing
standard cost.
 Discuss with management and test procedures for identifying obsolete and slow-moving items
 Check that the classification of inventory is in compliance with accounting standard and company
accounting policies.
 Review inventory items are properly classified, disclosed and presented at fair value in the financial
statements.

B. Substantive Tests Of Account Balances for Inventory

1. Accuracy: Testing the accuracy of inventory requires obtaining a copy of the compilation of the physical
inventory quantities and prices. The inventory compilation is footed, and the mathematical extensions of
quantity multiplied by price are tested. Additionally, test counts made by the auditor during the physical
inventory and tag control information are traced into the compilation. Many times the client has adjusted
the general ledger inventory balance to agree to the physical inventory amount (referred to as book–to–
physical adjustment) before the auditor begins the substantive tests of account balances. If the client has
made the book to physical Adjustment, the totals from the compilation for inventory should agree with
the general ledger.
When the client maintains perpetual inventory system, the totals from the inventory compilation should
also be agreed to these records. The auditor can use computer-assisted audit techniques to accomplish
these audit steps. For example, the auditor can use a generalized or custom audit soft–ware package to
trace test control information into the client’s computer file of the inventory compilation. The extensions
and footing can also be tested at the same time.
2. Existence: is one of the more important audit objectives for the inventory account. Observation of the
physical inventory is the primary audit step used to verify this objective. If the auditor is satisfied with
the client’s physical inventory count, the auditor has sufficient, competent evidence on the validity or
existence of recorded inventory.
3. Completeness: The auditor must determine whether all inventories have been included in the inventory
compilation and the general ledger inventory account. The tests related to the observation of the physical
inventory count provide assurance that all goods on hand are included in inventory. Tracing test counts
and tag control information into the inventory compilation provides assurance that the inventory counted
during the physical inventory observation is included in the compilation. In some cases, inventory is held
on consignment by others or is stored in public warehouses. The auditor normally confirms or physically
observes such inventory.
4. Cutoff: In testing the cutoff objective for inventory, the auditor attempts to determine whether all sales of
finished goods and purchases of raw materials are recorded in the proper period. For sales cutoff, the
auditor can examine a sample of shipping documents for a few days before and after year-end for
4
 recording of inventory shipments in the proper period. For purchases cut off, the auditor can examine a
sample of receiving documents for a few days before and after year-end for recording of inventory
purchases in the proper period.
5. Ownership: The auditor must determine whether the recorded inventory is actually owned by the entity.
Two issues related to ownership can arise. First, the auditor must be sure that the inventory on hand
belongs to the client. If the client holds inventory on consignment, such inventory should not be included
in the physical inventor. Second, in some industries, goods are sold on a” bill-and hold” basis. In such a
case, the goods are treated as a sales but the client holds the goods until the customer needs them. Again,
the auditor must be certain that such goods are segregated and not counted at the time of the physical
inventory.
6. Valuation: A number of important valuation issues are related to inventory. The first issue relates to the
costs used to value the inventory items included in the compilation. When the client purchases inventory,
Valuation of the inventory can normally be accomplished by vouching the costs to vendors’ invoices.
When the client uses standard costs, the auditor audits the standard cost as discussed previously. The
second valuation issue relates to the lower-of –cost-or market tests for inventory. The auditor normally
performs such tests on large-dollar items or on the client’s various product lines. A third valuation issue
relates to obsolete, slow- moving, or excess inventory. The auditor should ask management about such
issues. When these issues exist, the inventory should be written down to its current market value. Finally,
the auditor should investigate any large adjustments between the amount of inventory shown in the
general ledger account and the amount determined from the physical inventory account for possible
misstatement.
7. Classification: In a manufacturing company, the auditor must determine that inventory is properly
classified as raw materials, work in process or finished good. In most manufacturing companies, proper
classification can be achieved by determining which manufacturing processing department has control of
the inventory on the date of the physical count. For example, if inventory tags are used to count inventory
and they are assigned numerically to department, classification can be verified at the physical inventory.
The auditor can ensure that each department is using the assigned tags. The tag control information by
department can be compared to the information on the inventory compilation to assure that it is properly
classified among raw materials, work in process, and finished goods.
8. Disclosure: Several important disclosure issues are related to inventory For example, management must
disclose the cost method, such as LIFO or FIFO, used to value inventory. Management must also disclose
the components (raw materials, work in process, and finished goods) of inventory either on the face of
the balance sheet or in the footnotes. Finally, if the entity uses LIFO to value inventory and there is a
material LIFO liquidation, footnote disclosure is normally required. Other information’s which requires
disclosure are:
 Long term purchase contract
 Purchase from related parties
 Pledged or assigned inventory
 Warranty obligation
 Unusual loss
 Consigned inventory

5
 Physical Inventory, Pricing, and Compilation:Physical inventory, pricing, and compilation are
each equally important in the audit of inventory because a misstatement in any one activity results in
misstated inventory and cost of goods sold.

1. Balance-Related Audit Objectives and Tests of Details of Balances for physical observation for
inventory
Auditors often first familiarize themselves with the client’s inventory by conducting a tour of the client’s
inventory facilities, including receiving, storage, production, planning, and record keeping areas. The tour
should be led by a supervisor who can answer questions about production, especially about any changes in
internal controls and other processes since last year.

Inventory Observation Requirements: To meet the requirement, auditors must:

♣ Be present at the time the client counts their inventory for determining year-end balances
♣ Observe the client’s counting procedures
♣ Make inquiries of client personnel about their counting procedures
♣ Make their own independent tests of the physical count

An essential point in the auditing standards is the distinction between who observes the physical inventory
count and who is responsible for taking the count. The client is responsible for setting up the procedures for
taking an accurate physical inventory and actually making and recording the counts. The auditor is
responsible for evaluating and observing the client’s procedures, including doing test counts of the inventory
and drawing conclusions about the adequacy of the physical inventory.

The most important part of the observation of inventory is determining whether the physical count is being
taken in accordance with the client’s instructions. To do this effectively, it is essential that the auditor be
present while the physical count is taking place. When the client’s employees are not following the inventory
instructions, the auditor must either contact the supervisor to correct the problem or modify the physical
observation procedures. For example, if the procedures require one team to count the inventory and a second
team to recount it as a test of accuracy, the auditor should inform management if both teams are observed
counting together.

The auditor’s observation of inventory is generally accepted auditing procedure. The primary reason for
observing the clients physical inventory is to establish the validity or existence of the inventory. The
observation of the physical inventory also provides evidence on the ownership and valuation audit
objectives. Based on the physical inventory count, the client compiles the physical inventory. Prior to the
physical count of the inventory, the auditor should be familiar with the inventory location, the major items in
inventory and the client’s instructions for counting inventory. During observation of physical inventory, the
auditor should do the following.
 Ensure that no production is scheduled or if production is scheduled, ensure that proper control are
established for movement between departments in order to prevent double counting.

6
  Ensure that there is no movement of goods during the inventory count. If movement is necessary, the
auditor and client personnel must ensure that the goods are not double counted and that all goods are
counted.

 Make sure that the clients count teams are following the inventory count instruction, the auditor
notify the client’s representation in charge of the area.

 Ensure that inventory tags are issued sequentially to individual departments for many inventory
counts; the goods are marked with multi copy inventory tags. The count teams record the type and
quantity of inventory on each tag, and one copy of each tag is then used to compile the inventory,
such as detailed inventory listing on handheld computers, the auditor should obtain copies of the
listing or files prior to the start of the inventory count.

 Perform test counts and record a sample of counts in the working papers. This information will be
used to test the accuracy and completeness of the client’s inventory compilation.

 Obtain tag control information for testing the client’s inventory compilation. Tag control information
includes documentation of the numerical sequence of all inventory tags and accounting for all used
and unused inventory tags. If inventory listings are used by the clients, copies of listing will
accomplish the objectives of documenting the entire inventory count.

 Obtain cutoff information, including the numbers of the last shipping and receiving document issued
on the date of the physical inventory count.

 Observe the condition of the inventory for items that may be obsolete, slow moving or carried in
excess quantity.

 Inquiry about goods held on consignment for others or held on a bill and hold basis, such items
should not be included in the clients inventory. The auditor must also inquire about goods held on
consignment for the client. These goods should be included in the inventory count. If these audit
procedures are followed, the auditor has reasonable assurance that a proper inventory count has been
taken.

Balance-Related Audit Objective and Common Inventory Observation Procedures

Balance-Related Common Inventory Observation Procedures

Audit Objective
Inventory as  Select a random sample of tag numbers and identify the tag with
recorded on tags that number attached to the actual inventory.
exists (existence).  Observe whether movement of inventory takes place during the
count.
Existing inventory is  Examine inventory to make sure it is tagged.
counted and tagged,  Observe whether movement of inventory takes place during the
and tags are count.
accounted for to  Inquire as to inventory in other locations.
make sure none are  Account for all used and unused tags to make sure none are lost or
7
missing intentionally omitted.
(completeness).  Record the tag numbers for those used and unused for subsequent
follow-up.
Inventory is counted  Recount client’s counts to make sure the recorded counts are
accurately accurate on the tags (also check descriptions and unit of count, such
(accuracy). as dozen or gross).
 Compare physical counts with perpetual inventory master file.
 Record client’s counts for subsequent testing.
Inventory is  Examine inventory descriptions on the tags and compare with the
classified correctly actual inventory for raw material, work-in-process, and finished
on the tags goods.
(classification).  Evaluate whether the percent of completion recorded on the tags for
work-in-process is reasonable.
Information is  Record in the audit files for subsequent follow-up the last shipping
obtained to make document number used at year-end.
sure sales and  Make sure the inventory for the above item was excluded from the
inventory purchases physical count.
are recorded in the  Review shipping area for inventory set aside for shipment but not
proper period counted.
(cutoff).  Record in the audit files for subsequent follow-up the last receiving
report number used at year-end.
 Make sure the inventory for the above item was included in the
physical count.
 Review receiving area for inventory that should be included in the
physical count.
Obsolete and  Test for obsolete inventory by inquiry of factory employees and
unusable inventory management and alertness for items that are damaged, rust- or dust-
items are excluded covered, or located in inappropriate places.
or noted (realizable
value).
The client has rights  Inquire about consignment or customer inventory included on
to inventory client’s premises.
recorded on tags  Be alert for inventory that is set aside or specially marked as
(rights). indications of non-ownership.

2. Balance-Related Audit Objectives and Tests of Details of Balances for Inventory Pricing and
Compilation
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.

8
Balance-Related Audit Common Inventory Pricing
Objective and Compilation Procedures
Inventory in the inventory ♥ Perform compilation tests (see existence, completeness,
listing schedule agrees with the and accuracy objectives).
physical inventory counts, the ♥ Foot the inventory listing schedules for raw materials,
extensions are correct, and the work-in-process, and finished goods.
total is correctly added and ♥ Trace the totals to the general ledger.
agrees with the general ledger ♥ Extend the quantity times the price on selected items.
(detail tie-in).
Inventory items in the inventory ♥ Trace inventory listed in the schedule to inventory tags
listing schedule exist and auditor’s recorded counts for existence and
(existence). description
♥ Account for unused tag numbers shown in the auditor’s
documentation to make sure no tags have been added.

Existing inventory items are ♥ Trace from inventory tags to the inventory listing
included in the inventory listing schedules and make sure inventory on tags is included.
schedule (completeness). ♥ Account for tag numbers to make sure none have been
deleted.
Inventory items in the inventory ♥ Trace inventory listed in the schedule to inventory tags
listing schedule are accurate and auditor’s recorded counts for quantity and
(accuracy). description.
♥ Perform price tests of inventory. For a discussion of price
tests.
Inventory items in the inventory ♥ Verify the classification into raw materials, work-in-
listing schedule are correctly process, and finished goods by comparing the
classified (classification). descriptions on inventory tags and auditor’s recorded test
counts withthe inventory listing schedule.
Inventory items in the inventory ♥ Perform tests of lower of cost or market, selling price,
listing are stated at realizable and obsolescence.
value (realizable value).
The client has rights to ♥ Trace inventory tags identified as non-owned during the
inventory items in the inventory physical observation to the inventory listing schedule to
listing schedule (rights). make sure these have not been included.
♥ Review contracts with suppliers and customers and
inquire of management for the possibility of the inclusion
of consigned or other non-owned inventory, or the
exclusion of owned inventory.