Chapter 11 – Substantive Test of Inventories and Cost of Sales: Reflection

Today I learned about the audit objectives for inventories, cost of sales and
related accounts, describe the primary substantive audit procedures for inventories, cost
of sales and related accounts and lastly to identify assertions by audit procedures for
inventories, cost of sales and related accounts.

Inventory is a significant portion of an entity's current assets, particularly for those

in the manufacturing, serving, and trading industries. Special audit consideration should
be given to some entities, particularly those with specialized inventories (e.g. oil and gas
or precious metals). The audit of inventories represents significant risk to auditors
because: (1) they frequently represent a significant portion of current assets; (2)
numerous valuation methods are used for inventories; (3) the valuation of inventories
has a direct impact on cost of goods sold; and (4) determining inventory quality,
condition, and value is inherently complex.

The nature, timing, and scope of substantive audit procedures for inventories are
heavily influenced by 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 important factors influencing the nature, timing, and
scope of our inventory procedures are: (1) the accounting methods used (e.g., actual or
standard costs; first-in, first-out ("FIFO") or average costs); (2) The inventory's locations,
types, and condition; (3) The entity's physical inventory procedures; and (4) Economic
conditions, particularly those affecting the entity's ability to sell the inventory at a profit.

All inventories included on the SFP are held by the entity or by others for the
entity, and purchases (cost of sales) have actually occurred and pertain to the entity.
Completeness The SFP includes all inventories owned by the entity at the reporting
date, and the SCI includes all cost of sales. Cut-off purchases (cost of sales) have been
recorded in the appropriate accounting period, and valuation and allocation, as well as
inventories, are carried at the lower of cost and net realizable value ("NRV").
Obligations Regarding Rights The entity owns or has a legal right to all of the
inventories reported on the SFP. Inventories are properly classified, described, and
disclosed in the financial statements, including notes, in accordance with the applicable
PFRSS. Inventory pledges are properly disclosed.

Audit Procedures for Inventory Balances and Cost of Sales The auditor's primary
substantive procedures for inventory balances and cost of sales / cost of goods sold
typically include the following: (1) observing inventory counts and performing test
counts; (2) reconciling inventory summary sheet with general ledger; (3) confirming
inventories held by others; and (4) Performing purchases and inventory cut-offs; (5)
Verifying appropriate valuation in accordance with accounting principles. (6) Carrying
out the lower of cost or net realizable value test; (7) determining whether any
inventories have been pledged and reviewing purchase commitment; and (8) carrying
out the test of details on cost of goods sold; and (9) carrying out analytical procedures.

The cost of goods sold testing is performed concurrently with inventory testing for
balance sheet purposes. Cost of goods components can be broadly classified into two
major components. First, the auditor must determine the total amount of inventory sold.
If the auditor has been able to test the amount of inventory that is readily available on
hand, in addition to the initial amount, the amount can be calculated by simple addition.
Furthermore, the auditor must compute the inventory sold on a unit basis. This is mostly
accomplished by selecting items from a list of items sold by the company on a per-unit
basis. However, in addition to these fundamental calculations, the auditor is expected to
have a procedure in place to ensure that he can provide a true and fair assessment of
the overall policies in place. There are a few things to consider when determining the
audit procedure for the cost of goods sold. These concerns are about the overall
procedures that will be followed to ensure that there are no issues that will prevent the
auditor from making an accurate judgment.

In conclusion, substantive testing is an audit procedure that looks for errors in

financial statements and supporting documentation. These tests are required as
evidence to support the assertion that an entity's financial records are complete, valid,
and accurate. An auditor can employ a variety of substantive tests. Additional audit
testing may be required if substantive testing reveals errors or misstatements. A
summary of any errors discovered is also included in a management letter that is
shared with the client's audit committee. Internal audit staff at a company may also
conduct substantive testing. This can provide assurance that internal recordation
systems are functioning as intended. If not, the systems can be improved to eliminate
the issues, resulting in a cleaner audit when the external auditors conduct their tests at
the end of the fiscal year. Internally conducted substantive testing may take place at any
time of year.