1.

INVENTORY AUDIT- IMPORTANCE AND PROCEDURES

What is an Inventory Audit?

Inventory audit also referred to as stock audit, refers to an accounting process, which takes into
account a company’s total stock of physical goods. This is especially needed in manufacturing
companies where raw materials need to be converted to finished goods and is a quintessential process
of maintaining a healthy business and for it to succeed. Inventory audit is considered mandatory for
keeping account of the quantity and quality of raw materials remaining in stock. This is because
anything more than 70% of product cost involves material cost. Additionally, inventory audit is
absolutely necessary for organisations with multiple branches as they tend to have a massive stock of
physical goods. Audit of essential physical inventories is generally conducted at or near the end of the
year.

Inventory auditing requires special attention because it is one of the most important activities that an
entity needs to accomplish at the end of each financial year after the inventory process is completed.
The difficulty of inventory auditing is given by their increased weight in the balance sheet, the many
locations where they are stored, the diversity of stocks by nature, and the multitude of valuation
methods. This activity has an impact on the outcome of the exercise through the objectives to be
achieved: accuracy, evaluation, existence, separation of exercises, completeness, optimization of costs
and stock levels. By inventory audit, we monitor the recording of all accounting operations (inventory
acquisition, exit, inventory) and prevent any possible malfunction, that is, the activity by which we
identify and examine the stocks in order to detect the irregularities between the accounting statements
provided by the accounting and the inventory. Proper inventory has direct implications on the
outcome of the activity, but also on the entity's economic performance.

Source:https://www.researchgate.net/publication/335526500_Importance_of_inventory_audit_to_incr
ase_the_credibility_of_financial_accounting_information

Inventories are one of the significant portions of entities current assets, especially for those entities in
the manufacturing, servicing and trading industry. For some entities, special audit consideration
should be applied for those companies with certain specialized nature of inventories (e.g., oil and gas
or precious metals). The audit of inventories presents the auditors with significant risk because:

1. they often represent a very substantial portion of current assets;

2. numerous valuation methods are used for inventories;
3. the valuation of inventories directly affects cost of goods sold; and
4. the determination of inventory quality, condition, and value is inherently complex.

The nature, timing and extent of the substantive audit procedures for inventories depends, to a great
extent, on the sophistication of the entity’s inventory and cost of sales application, the effectiveness of
controls over the application and the reasonableness of the applicable accounting estimation and non-
routine data processes (e.g., the processes for determining any write-downs to net realizable value and
for compiling the Physical, inventory, respectively). Other significant factors affecting the timing and
extent of our inventory procedures include:

1. the accounting methods used (e.g, actual or standard costs; first-in first out (“FIFO”); or
average costs);
2. The locations, types and condition of the inventory;
3. The entity's physical inventory procedures; and
 4. Economic conditions, specially those that affect the entity’s ability to sell the inventory at a
profit.

Source: http://www.summaryplanet.com/industrial-economics/Inventory-and-Production-Cycle.html

Importance of Inventory Audit

 Inventory tends to be the easiest assets to manipulate and hence it’s essential to keep a
constant vigil over it. Here are some reasons why inventory audit is considered paramount:
 Inventory audit is also required to match the actual quantity of items in stock against the
accounting records while also adjusting for differences and allowing for shrinkage so that the
ledger reflects accurate values.
 Inventory audit will be able to reveal which physical goods or products are over- or under-
stocked. This will allow you to properly and effectively stock your business thus helping
maximize profit.
 Inventory audit is necessary to reduce unnecessary investment on stocks and to ensure that
you have a proper line balancing in the process.
 Inventory audit is needed to compare actual physical counts and match it to business records:
When this count is conducted accurately, an inventory audit will be able to disclose the true
picture of what you actually hold as compared to the recorded stocks which, in turn, will give
you an understanding of the financial health of the company. Misstatement of inventory
balances often tends to have a direct effect on reported profit.
 Inventory audit is imperative to account for any sort of inventory losses resulting from,
wastage, pilferage, damage, obsolescence, and dormant stock.
 An inventory audit will also help determine the effectiveness of your warehouse procedures
and help reveal any issues within your organisation’s warehouse procedures, whether it is at
the receiving dock or during the actual packaging. This could help in highlighting any
potential inefficiencies in the process such as disorganisation of the warehouse and slow
retrieving methods.
 Inventory audit will help reveal any failure owing to lack of security which results in loss,
theft or misappropriation.
 High levels of stock generally result in unnecessary overstocking thus resulting in poor cash
flows and financial loss. An inventory audit at timely intervals will help remedy that issue.
Similarly, it helps in determining any obsolete inventory in stock or orders incorrectly
supplied to customers, which could not only lead to financial loss but also result in an
irreparable damage to the organisation’s reputation.

Source: https://www.vgnc.in/inventory-audit-importance-procedures/

2. BUSINESS FUCTION AND RELATED DOCUMENTS

2.1. Procedures flow in inventory cycle

a) Requisition and ordering of goods or raw materials

b) Receipts of goods or raw materials
c) Recording receipts and issues of goods or raw materials
d) Issuing of raw materials/finished goods from inventory
 e) Storekeeping procedures of raw materials/finished goods

2.2. Functions and documentations in the inventory cycle

Functions Documents Departments

Issue request for raw materials or goods Purchase requisition Storekeeping
Process purchase orders Purchase order Purchasing
Receive raw materials or goods Goods received report Storekeeping
Receive suppliers’ invoice Suppliers’ invoice Accounting (Purchasing in
some cases for checking)
Record in accounting records Purchase journal Accounting
Store raw materials or goods and recorded in Raw materials/Goods Storekeeping
inventory records perpetual records
Issue raw materials to production (Function Raw materials Storekeeping
occurs in manufacturing environment only) requisition
Cost accounting records Cost Accounting
OR OR
Dispatch goods Goods delivery report Storekeeping
Record the quantity of finished goods Finished goods perpetual Storekeeping
dispatched in inventory record (This function records
occurs in a manufacturing environment and
also occurs in a trading environment)
Cost accounting records Cost Accounting

DOCUMENTS:

PURCHASE REQUISITION

A purchase requisition form is a form made by the user department or maybe storeroom-personnel
that notifies the purchasing department of those items it wants to order, the quantity, and also
timeframe. It can even have the authorization to go ahead with the purchase.

Purchase Requisition originates with:

1. Storeroom Employee who observe what quantity on hand is at a set ordering point.
2. A Materials Record Clerk responsible for notifying the purchasing agent when to buy.
3. A Research, Engineering or Other department employee or supervisor who needs
materials of a special nature.
4. A computer programmed to alert the purchasing department when replenishment is
needed.

One copy of each purchase requisition remains with originator and the original is sent to purchasing
department for execution of the request.

Source: Cost Accounting 14th edition, William K. Carter

Source:file:///C:/ACCONTING%20FILES/2ND%20YEAR%20FILES/AIS%20PDF/AIS%20PDF
%20BY%20JAMES%20HALL.pdf

PURCHASE ORDER

Purchase orders, signed by the purchasing agent, or other official is a authorization to a vendor to
supply specified quantities of desired goods at agreed terms and at a designated time and place. For
accounting control, a purchase order can be issued for every purchase of materials, supplies or
equipment. When a purchase commitment is made by mail or telephone or though sales
representative, the purchase order serves as confirmation of the commitment.

Source:file:///C:/ACCONTING%20FILES/2ND%20YEAR%20FILES/AIS%20PDF/AIS%20PDF
%20BY%20JAMES%20HALL.pdf
GOODS RECEIVED REPORT

A document that indicates the quantity of goods received. This report is often matched in the accounts
payable department with the purchase order and the vendor’s invoice prior to paying the vendor.

Source:https://www.accountingcoach.com/terms/R/receiving-report#:~:text=A%20document%20that
%20indicates%20the,prior%20to%20paying%20the%20vendor.

RECEIVING REPORT

A receiving report is an internal document used to record what materials and the company received
inventory. The receiving report is sent to other departments to notify them what items have been
received and are ready for use. Most large companies and even some smaller companies have multiple
departments to handle different operations. Some common departments include purchasing, shipping,
and receiving departments. The receiving department is used to collect or receive inventory or
materials when they arrive at the store or factory.

The receiving department is responsible for counting shipments received and matching the actual
number received with the number on the purchase order to see if the accurate number of goods was
received. Receiving departments are also in charge of checking packages for damaged goods. If a
percentage of goods are damage, the orders need to be returned. After the receiving department
examines the goods received, it fills out a receiving report.

Example: Receiving reports usually include a heading with the company name, address and
date along with a receiving report number. A receiving report also includes the date received,
FOB terms, shipping company used, and a list of items received. The items list usually has
space for descriptions, prices, quantities, and weights.
 Most receiving reports are made on carbon copy paper with multiple sheets. Once the report
is filled out, one sheet can be sent to accounting for recording, one sheet is sent to purchasing
to verify the order was purchased and received, and one sheet is sent to the department that
requested the order. The receiving department also keeps a copy of each receiving report on
file.

Source: https://www.myaccountingcourse.com/accounting-dictionary/receiving-report

The following information is typically included on a receiving report:

 Date and time on which the delivery was received

 Name of the shipping company that delivered the goods
 Name of each item received
 Quantity of each item received
 The authorizing purchase order number, if noted on the delivery documentation or box
 Condition of the items received. This can be a negative entry, where only damaged goods are
noted.

The receiving report can be used in several ways, including the following:

 Returns. If certain goods are to be returned, the receiving report documents the reason for the
return, such as damaged goods.
 Payables. The receiving report can be used as evidence of receipt in the three-way matching
process. This approach is more commonly used for larger-dollar purchases.
 Accruals. The accounting staff may use receiving reports that were completed near month-end
to accrue expenses for supplier invoices that have not yet arrived.
A master copy of each receiving report is stored in the receiving department. Copies are sent to other
departments as required by company procedures, such as the copy sent to the payables staff to
document received goods.

From a control perspective, it can be useful to uniquely number each receiving report. The sequence
of numbers can then be examined to see if any receiving reports are missing.

https://www.accountingtools.com/articles/2017/5/13/receiving-report

SUPPLIER INVOICE

Supplier invoices are the sales invoices and bills issued by supplying vendor and received by the
buying customer. Customers also refer to supplier invoices as vendor invoices. A supplier invoice
itemizes a transaction between the buyer and seller. If the seller extended credit to the buyer for the
sale, the invoice usually specifies payment terms and provides options for payment methods.

Suppliers may also opt to instead send a month-end statement as an invoice for all outstanding
transactions. In this case, a company needs to clearly indicate that no subsequent invoices will be sent.
In the past, invoices have been mostly recorded on paper with multiple copies generated so that the
buyer and seller each have a record of the transaction for their own records. Now, software generated
invoices are common and allow for easier searching and sorting of specific transactions or specific
dates.

Source:https://www.freshbooks.com/hub/invoicing/supplier-invoices#:~:text=Customers%20also
%20refer%20to%20supplier,provides%20options%20for%20payment%20methods.
PURCHASE JOURNAL
Defined as the main entry book that is used to record credit transactions credit purchases for resalable
purpose and the source document, which is use as evidence in recording transactions into purchase
journal is Supplier Invoice

Source:file:///C:/ACCONTING%20FILES/2ND%20YEAR%20FILES/AIS%20PDF/AIS%20PDF
%20BY%20JAMES%20HALL.pdf

RAW MATERIALS/ GOODS PERPETUAL RECORDS

A perpetual inventory system keeps continual track of your inventory balances. Updates are

automatically made when you receive or sell inventory. Purchases and returns are immediately
recorded in your inventory accounts. 

Raw materials inventory involve items used to make finished products. Raw materials can be
commodities or components that businesses buy or extract themselves. In sum, they’re all the stock
that hasn’t been used for manufacturing yet.
For accounting purposes, raw materials are considered an inventory asset, debited to raw materials
and credited to accounts payable. There are two different categories of raw materials — direct and
indirect.

 Direct raw materials are all the materials that make up the finished product. Direct raw
materials are considered a part of the cost of goods produced, which is then divided into the
cost of goods sold and ending inventory.

 Indirect raw materials are materials that are consumed during the manufacturing process, but
aren’t a part of the final product.  Indirect raw materials typically fall under manufacturing
overhead and are added to the cost of goods sold. If only a small amount of an indirect raw
material is used, they are sometimes reported to an expense as incurred.

Source:https://quickbooks.intuit.com/r/growing-complex-businesses/5-inventory-types-from-raw-
materials-to-finished-goods/

“Storekeeping is that aspect of material control concerned with the physical storage of goods.” In
other words, storekeeping relates to art of preserving raw materials, work-in-progress and finished
goods in the stores.

Source:https://www.yourarticlelibrary.com/material-management/store-keeping-meaning-types-
objectives-functions-and-working-of-the-stores/26132

RAW MATERIALS REQUISITION

Materials should be protected from unauthorized use. To lessen the chance of theft, carelessness, or
misuse, no materials should be issued from the storeroom except on written authorization. The form
used to provide this control is known as the materials requisition or stores requisition. A materials
requisition or raw materials requisition is a source document that the production department uses
to request materials for manufacturing process. Information on the requisition is used to update the
stores record card, also known as the bin card, and the stores ledger. It’s also used to determine the
direct materials used on various jobs or products, along with the indirect materials used by various
cost centers

Source: https://www.accountingtools.com/articles/2017/5/8/material-requisition-form

Materials requisition is prepared by factory personnel authorized to withdraw materials from the
storeroom. The personnel authorized to perform this function may differ from company to company,
but such authority must be given to someone of responsibility. The most satisfactory arrangement
would be to have the production manager prepare all materials requisitions, but this is usually not
feasible. Another arrangement requires that the department supervisors approve (sign) all materials
requisitions for their respective departments. When the storeroom keeper receives a properly signed
requisition, the requisitioned materials are released. Both the storeroom keeper and the employee to
whom materials are issued should be required to sign the requisition. (Note that in a computerized
system signatures are replaced with passwords and other security codes.)

In a paper-based system, the materials requisition is usually prepared in quadruplicate. Two copies go
to the accounting department for recording; one copy goes to the storeroom keeper and serves as
authorization for issuing the materials; and the production manager or department supervisor who
prepared it retains one copy.

A material requisition form lists the items to be picked from inventory and used in the production
process or in the provision of a service to a customer, usually for a specific job.

The form usually has three purposes:

  To pick items from stock
 To relieve the inventory records in the amount of the items picked
 To charge the targeted job for the cost of the items requisitioned

Auditors may trace the flow of material requisition forms through a company, to see if inventory
items are being appropriately used and recorded as mandated by company materials handling
procedures. If not, the auditors may conclude that they cannot rely upon certain aspects of a
company's control systems as part of their audit activities, and so will bolster other audit activities.

Source: http://www.swlearning.com/pdfs/chapter/0324100949_2.PDF

COST ACCOUNTING RECORDS

After issuing the raw materials to production, cost accounting records is needed as an adequate cost
accounting system is an important part of the processing of goods function for all manufacturing
companies to track and produce accurate costs of all products.

The cost accounting records of the business accumulate the addition of inputs into work-in-process
inventory. It 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

The cost accounting system shows the relative profitability of the products for management planning
and control and values inventories for preparing financial statements. Two primary types of cost
systems exist job cost systems and process cost systems, but there are many variations and
combinations of these systems. In a job cost system, costs are accumulated by individual jobs when
the material is issued and labor costs are incurred. In a process cost system, they are accumulated by
processes, with unit costs for each process assigned to the products passing through the process.

The source and form of information that goes into the cost accounting system varies widely among
companies. The cost accounting system may account for the work-in-process based only on the
quantity of units of inputs used or may have cost dollars included. If just the quantity of inputs is
tracked at this stage, then cost dollars are attached later. The movement of goods may be tracked
using technology such as bar codes, weight measures, or even inventory locations. Alternatively, the
tracking system may be as simple as recording the quantity of the inventory item removed from
stores.

Each company determines which costs to track individually, sometimes called direct tracing, and
which to allocate. The costs that are tracked individually are called direct costs and those that are
allocated are called indirect costs or overhead. Direct costs are traced and added to work-in-process in
the cost accounting records. For example, those human resources costs that are traced to inventory
production are generally called direct labor and increase the work-in-process balance.

Source: https://farhatlectures.com/auditing-inventory-and-warehousing-cycle-cpa-exam-auditing-and-
attestation/

Following are some of the main heads in which costs are generally required to be compiled:

1. Materials: Adequate records of receipts, issues and balances and the consumption of each
item of material including bought out components, are required to be maintained both in
 quantities and value. The cost of loss of material in transit, during storage or for other reasons
is to be worked out separately and the treatment of such losses in the accounts indicated. The
cost shall include all direct charges up to works. If the quantity and value of material
consumed are determined on any basis other than actual, the method adopted shall be
indicated in the cost records. The overall reconciliation of such values of material with actual
and the treatment of such variations shall also be kept as record.

2. Consumable Stores, Small Tools and Machinery, Spares etc: Adequate records showing
the receipts, issues and balance including consumption of each item are to be maintained in
the same manner as for materials. Losses are also to be similarly dealt with. Items which have
not been moved at all for 24 months are reported separately.

3. Wages and Salaries: Proper records shall be maintained to show the attendance and earnings
of all employees and the departments or cost centres and the work on which they are
employed. The system of remuneration and incentives paid, if any, are also to be indicated.
Idle time cost is calculated and recorded separately. If wages are charged on a basis other than
actual, reconciliation is to be made and the treatment of the actual is to be suitably indicated.

4. Service Department Expenditure: Expenses for these departments are to be calculated

separately. The allocation and/or apportionment of expenses to these departments are required
to be shown.

5. Depreciation: The amount of depreciation to be charged to cost should not be less than the
amount worked out in accordance with Companies Act, 1956. Proper and suitable records
should be maintained in respect of depreciable fixed assets. It can be included as part of
manufacturing overheads of the concerned departments or manufacturing units.

6. Royalty and Payment of Technical Aid: Basis of calculating the amount of royalty and
charging royalty and other allied payments to production costs are to be recorded.

7. Overheads: These must be segregated into works, administration, selling and distribution
overheads. The method of their collection, allocation, apportionment and recovery to output
are to be indicated. The accounting of variances is to be explained if overheads are charged on
the basis of other than actual.

8. Work-in-Progress: The value of work-in-progress should include materials, wages,

overheads and depreciation. The records should also show the quantities of work-in-progress.

9. Reconciliation of Cost and Financial Accounts: In order to ensure accuracy, this is to be

done periodically.

10. Stock Verification: Records of stock verification should be maintained in respect of all raw
materials, components, stores, spare parts including loose tools and other materials kept in
stocks. The cost records should also indicate the method of dealing with discrepancies arising
out of such verifications.

Source:https://www.yourarticlelibrary.com/cost-accounting/cost-accounting-records-11-general-
features/56170

Master files, spread sheets, and reports that accumulate material, labour, and overhead as the costs are
incurred. We need to update the Cost accounting record because we need to keep track of how much
things are cost as per unit. Two ways job order costing and process costing.
Sources: https://youtu.be/8jS4y1UCDqA

Job Order Sheet

Source: file:///C:/Users/Bianca/Downloads/Cost-Accounting-by-Raiborn-8e.pdf

GOODS DELIVERY REPORT

A delivery note is a document that accompanies a shipment of goods, and provides a list of the
products and quantity of the goods included in the delivery. It can also be known as a ‘dispatch note’
or a ‘goods received note’. Although they are normally printed, delivery notes can also be sent by
email.

Using delivery notes help a business get a better overview of their input and output, whilst also giving
their customers a way to check they have received all of the products they paid for. If anything is
missing, the recipient can quickly respond and contact the sender, using the delivery note to inform
both parties what is wrong with the delivery.

What is the purpose of a delivery note?

If you send a delivery note with your shipment of the goods it can be used as a checklist to ensure that
everything is there. Every item contained in a delivery note has to be in the accompanying shipment.

It also describes whether any goods in the original order are not enclosed - thereby providing an
overview of what the recipient has ordered and what has been sent in that particular delivery.

In some cases, a copy of the delivery note is signed by the recipient and then returned to the seller or
consignor as proof of delivery. This is then known as ‘recorded delivery’ or ‘signed for delivery’. If
the delivery note has been signed by the recipient, you can be safe in the knowledge your parcel has
reached its intended destination.

What should a delivery note include?

Although goods received notes are optional, each they should still follow a certain structure,
regardless of whether you use delivery note software or create your delivery note template on word.
There must be clear communication between both the sender and receiver. The delivery note must
therefore show:

 The name and contact details of the seller

 Name and contact details of the customer
 Date of issue
 Date of delivery of the goods
 A description of the goods contained in the order
 The quantity of each type of goods.

The delivery note may also optionally require the receiver’s signature (or stamp), which confirms the
delivery, was received.

Source: https://debitoor.com/dictionary/delivery-note?
fbclid=IwAR2fBlyWD3rU9JjjfeKDMusjzO3qgbJx4Cwwt53QI7x1PobSJDusDHyMhp8
Source: https://www.spreadsheet123.com/ExcelTemplates/delivery-note-template.html

FINISHED GOODS PERPETUAL RECORDS

Finished goods Record all jewelry items that have been completely manufactured in the finished
goods category. Assign an inventory number to each item. The following examples can be used to
track custom-made items or similar items that are mass-produced. Your inventory records should
include each item’s value, which includes cost of component parts and labor.
When you manufacture a large quantity of an item and the cost of parts and labor have been recorded,
keep a running inventory to track your merchandise as shown below. Inventory number ER456

When items are sold, record the inventory number on an appropriate sales form and delete the items
from your inventory. (See page 9.) Inventory number ER456

For consignment

Merchandise temporarily away from your store Maintain a complete and separate inventory for items
that are temporarily away from your premises, whether in your possession or in the hands of an
authorized party, such as a commissioned salesperson. Your inventory records can be recorded in the
same manner as on page 11 of this guide.
Step-by-step process for creating a perpetual inventory system

1. When a new piece of merchandise arrives, compare the purchase invoice to the merchandise to
make certain you received the correct item.

2. Assign a unique inventory number or number/letter combination, based on your inventory

identification system and record the inventory number in the perpetual inventory system, along with
the following:

a. A description of the item

b. The date the item was received
c. Your cost for the item
d. The manufacturer’s name
e. The quantity or weight

3. Record the inventory number on the purchase invoice that you received with the merchandise and
file the purchase invoice

4. Record the inventory number on the sales tag for the item. Information on the sales tag will help
track merchandise to the purchase invoice and perpetual inventory. In addition to the inventory
number, you may want to include the following information on the sales tag:

a. Unique inventory number

b. Cost code for items
c. Category code
d. Retail price
e. Carat weight, color, clarity of stones
f. Supplier code

5. When an item of jewelry is sold, record the inventory number, date of sale, customer’s name, and
address, and selling price on the sales receipt. (See sample on the next page.) It also may be helpful to
record a brief description of the item on the sales receipt. Instead of writing the information on the
sales receipt, some jewelers attach the sales tag to the receipt. The sales receipt should be a three-part
form. Enter the date of the sale into the perpetual inventory system. Most jewelers also enter the sale
price and divide the form accordingly.

a. Part one goes to the customer.

b. Part two is filed for inventory purposes; and
c. Part three goes to your accountant or bookkeeper.

Source: https://www.jacksondieken.com/media/1365/inventory-record-keeping-guide.pdf