LESSON 7: SUBSTANTIVE TESTS OF INVENTORIES

INTRODUCTION

 Inventories
- IAS 2
- 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/supplies to be used in the
production process or in rendering of services
- In case of service provider
o Inventories include the cost of service for w/c the enterprise has not yet recognized
the unrelated 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
o Shows the related expense as cost of goods sold
- Those following the nature of expense method
o Present purchases adjusted by the increase/decrease in inventory amounts as part
of operating expenses
 Decline in net realizable value of inventory
o Another expense relating to inventories that may warrant separate presentation
 Recovery in net realizable value of inventory/Gain arising from the adjustment in the valuation
allowance of inventory
o Shown as other operating income/deduction from the amount of inventory that is
shown as expense in profit or loss
 Misstatement of inventories
o 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
 Warehousing & Conversion Cycles
o Acquisition of goods/services and issuance of inventories
o Includes the ff. sequential steps:
 Employee/dept. recognizes a need for the purchase of goods, prepares a
requisition form and sends it to the purchasing dept.
 Purchasing dept. locates an appropriate supplier, after considering quality and
price, and prepares & issues a purchase order to the supplier
 Receiving dept. receives and inspects the goods, verifying quality and quantity,
and prepares a receiving report
 Receiving dept. transfers the goods to the warehouse
 Goods are transferred from the warehouse to the production dept. upon
requisition by latter
 Separate depts. Shall undertake the foregoing activities separately for effective internal control.
 Merchandising companies
o Deliver the goods from the warehouse directly to the customers or to the company’s
authorized sales agents/distributors
 o Shipment of goods to customers, sales agents or the company’s own store (retail outlet)
 Shall only be made upon proper authorization by the management
 Purchasing dept. shall prepare at least three copies of the purchase order
o One copy is sent to the vendor
o Another is sent to receiving department
o Another company must be sent to the accounting dept. for proper recording of
purchases and corresponding liability
 Receiving dept. also sends one copy each of the receiving report to:
o Accounting dept.
o Storeroom
o Purchasing dept.
 Manufacturing entities are engaged in another set of activities after the warehousing cycle
o Set of activities = conversion cycle
o Starts when the warehouse, upon the requisition of the production department, issues
materials to production
o Production department converts these materials into finished goods by additionally
incurring costs of direct labor and overhead
 Conversion process may involve one or two or more production departments depending on the
nature of the manufacturing process
o Transfers of materials from the warehouse to production dept. and transfers of goods
from one production dept. 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 dept.
o 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
o The info. Developed by an appropriate cost accounting system provides reliable basis
 For formulation of management policies for purchasing, production and sales

INTERNAL CONTROLS

 Inventories are assets that become the major source of the company’s revenue
o Thus internal control procedures must be adopted by an entity to safeguard inventories
and to ensure that there is reliable info. On inventories
 Internal control procedures on inventories focus on the ff:
o Physical inspection & counting of all items of inventories received by the company from
suppliers to immediately remedy any discrepancy between delivery and purchase order
o Keeping inventories in a warehouse that restricts access to unauthorized persons
o Monitoring movements of inventories, from receiving dept., to the stockroom, to the
production dept., to finished goods warehouse, to shipping department, etc/
o Appropriate storage of inventories by classification, using inventory tags, so that
inventory requirements are served w/o undue delay
o Monitoring inventory quantities to minimize losses due to stockouts and losses from
obsolescence
 o Conducting a periodic obsolete inventory review
o Periodic reconciliation of stock cards inventory & physical inventory
o Auditing of bill of materials, w/c is a record of parts used to construct a product
o Creating a procedure to track scrap transactions

AUDIT 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 & supporting schedules for inventories and related
expenses
- Determine the measurement of inventories and related expenses is appropriate
- Determine that the presentation and disclosure of inventories and related expenses are
adequate

AUDIT PROCEDURES

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

inventories at the reporting date
o Auditors observe the physical count of inventories conducted by the client’s
personnel
o IT IS NOT THE AUDITOR’S FUNCTION TO TAKE INVENTORY
o Auditors merely observe the taking of the inventory
- If client has a physical inventory system, the physical inventory determines the balance in
inventory accounts at year-end
o Count is conducted at the reporting date
- If the client has a perpetual inventory sysyem
o The physical count may be conducted at any convenient time during the reporting
period
o If count is conducted at the end of reporting period
 Auditor has to reconcile the inventory amount determined through physical
count and ledger balance in the stock cards and appropriate adjustments
must be made to update the inventory records
o If count is conducted earlier than the end of the reporting period
 Roll forward procedures must be undertaken to ensure that the inventory
balance at year-end equals the physical goods
- Auditors normally participate in the client’s advanced planning of the physical inventory and
review the written instructions prepared by mgt. for employees who will make the counts
- Auditors will make test counts of numerous items and compare these counts with the
quantities reported by the client’s counting teams
- If auditors do not observe the taking of the inventory because it is impossible to do so
o Some audit procedures must be undertaken to validate the existence of and the
amount reported as inventory
o Client must have effective internal control over inventories, and at some point the
auditors must observe/make physical counts of the inventory
 - Auditors should take exceptions for indications of goods that are damaged or otherwise
obsolete or non-salable
- Auditor should test the net realizable value of goods by reference to sale transactions during
the subsequent reporting period
o 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
 Because 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
o Should be confirmed by direct communication w/ custodian of warehouse
o When the amounts of inventory involved are significant
 Auditors should consider performing supplementary procedures including
review of the client’s procedures for investigating prospective warehouses and
evaluating their perf., obtaining reports on internal control from the auditors of
the warehouses or observing the inventories at the warehouses
 Auditors’ tests of the cost accounting system are designed to determine that appropriate costs
have been assigned to work-in-process, finished goods and COGS.
o Auditor 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
o Auditor also perform tests of prices (NRV Testing) 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
o 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
ownership passed) & date the transaction was recorded in the accounting
records
 For audits of a manufacturing entity
o 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 cost of work in process or FGI
o Auditor shall also trace the labor charged to production based on timecards and labor
routings to ensure that the client charges labor that is supported by payroll records
o 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
o Comparisons of inventories classified by major types to prior years’ amounts
o Comparisons of gross profit percentages by product line to prior years’ and industry
statistics
o Comparison of this year’s inventory turnover to prior years
- May disclose material errors in counting, pricing and obsolete inventory items
 In audit of new client, auditor must obtain evidence that the client’s beginning inventory
balances will misstate current year profit
o May be obtained by review of audit working papers of the predecessor auditor (if
client’s FS were audited in the prior year), tests of perpetual inventory records, tests of
documents used in the physical inventory, tests of the overall reasonableness of
inventory figures, tests of transactions affecting inventory balances and other analytical
review procedures
 Auditor determines whether inventories are properly presented and measured in the FS
o FS should disclose the inventory costing formula in use, any amount of inventories
pledged for liabilities, and significant sale or purchase commitments