MODULE 3
AUDIT OF INVENTORIES AND COST OF GOODS SOLD
Audit Objectives and Procedures
The audit objectives and procedures for the verification of inventories and cost of goods sold
are presented below. The audit program is appropriate not only for a trading concern but
also for a manufacturing company that takes a complete physical inventory to verify the
perpetual inventories at the close of each fiscal year.
ASSERTIONS
Existence or Occurrence
Completeness
Rights and Obligations
AUDIT OBJECTIVES
To determine whether
inventories exist at year-end
and represent items held for
sale in the ordinary course
of business.
To determine whether all
transactions related to
inventory are recorded in
the proper accounting
period.
To determine that inventory
listings are accurately
compiled, and inventory
quantities include all items
on hand and in transit.
To determine whether the
company has legal title or
ownership rights to
inventory items and
inventories exclude items
billed to customers or
owned by others.
AUDIT PROCEDURES
1. Obtain listings of
inventory and
reconcile to ledgers.
2. Observe the taking
of physical inventory
and conduct test
counts.
3. Confirm inventories
in public warehouse
and with consignees.
4. Obtain a final
inventory listing from
the client.
a. Trace test counts
made during the
inventory
observation into
inventory listing.
b. Test the clerical
accuracy of the
final inventory
listing.
5. Review the year-end
cut-off of purchases
and sales
transactions
6. Test numerical
sequence of
inventory purchase
requisition
7. Review entries to
cost of goods sold.
8. Perform analytical
review related to
inventories and cost
of goods sold.
9. Make inquiries of
management
regarding inventory
ownership and
examine
consignment
agreements.
 Valuation or Allocation
Presentation and Disclosure
To determine whether the
inventories are properly
stated with respect to:
• Cost determined by
an acceptable
method consistently
applied.
• Slow-moving,
excess, defective,
and obsolete items
identified and
reduced to
replacement cost or
net realizable value it
lower than cost.
To determine that the
inventories and cost of
goods sold are presented
and classified in the
financial statements in
accordance with
PAS/PFRS.
10. Evaluate the bases
and methods of
inventory pricing.
11. Vouch and test
inventory pricing
12. Check inventory for
quality and/or
obsolescence.
13. Determine the
existence of pledged
inventory
14. Evaluate financial
statement
presentation of
inventories and cost
of goods sold
including the
adequacy of
disclosure.

FOR CUTOFF PROBLEMS:

1. Determine the validity of the Sales or Purchase Transaction
In considering the validity of Sale or Purchase transaction, consider the following
items:
As a rule of thumb assumption, a SALE is valid upon delivery and a
PURCHASE is valid upon receipt.
XPN:
a. Goods in Transit
• FOB Shipping point/FOB Seller or Seller’s Location include as inventory
of buyer (PLUS FREIGHT IN).
• FOB Destination/FOB Buyer or Buyer’s Location include as inventory of
seller (exclude freight out)
• Cost of insurance and freight (CIF) include as inventory of buyer upon
delivery to carrier (plus cost of insurance and freight)
• Free Alongside (FAS) the Vessel include as inventory of buyer upon
possession of the carrier (exclude freight cost to Vessel, include freight
cost from Vessel to Customer).
• Ex-ship include as inventory of seller as the seller who delivers the goods
ex-ship bears all the expenses and risk of loss until the goods are
UNLOADED.
b. Special Sale/Purchase Agreement
• With delivery/receipt but not yet valid sale/purchase
i. Consignment agreement – Valid upon sale of consignee to third-
party customer.
 ii. Inventory Financing/Park Sale/Product Financing – Loan
agreement only, inventories were merely used as a collateral for
the loan.
• Without delivery/receipt but is already valid sale/purchase
i. Bill and Hold agreement (e.g., Special Order from customers)

2. Determine whether Sales/AR or Purchases/AP has been recorded in the Sales or

Purchase Journals. (Based on the recording of the related sales/purchase invoice)
3. Determine whether inventories were excluded or included in the year-end physical
count.
If the problem did not indicate whether goods under consideration has been included
or excluded from the count, the following assumptions are to be made:

SALES CUT-OFF
Deliveries on/before the count date: Deliveries after the count date:
EXCLUDED INCLUDED
COUNT DATE
Receipts on/before the count date: Receipts after the count date:
INCLUDED EXCLUDED
PURCHASE CUT-OFF

NOTE: All deliveries (on sale) made on or before the count date are EXCLUDED
from the count, all deliveries made after the count date are INCLUDED in the count,
unless otherwise stated by the problem.

All receipt (on purchases) of goods on or before the court date shall be
INCLUDED in the count. All receipts after the count date are EXCLUDED from the
count, unless otherwise stated by the problem.

It is a valid sale, the receivable should be recorded, the inventory should be

excluded.
It is not a valid sale, the receivables should not be recorded, the inventory should be
included.
It is a valid purchase, the payable should be recorded, the inventory should be
included.
If it is not a valid purchase, the payable should not be recorded. The inventory should
be excluded.

FOR INVENTORY ESTIMATION PROBLEMS:

1. Gross Profit Method
Cost of Goods Available for Sale (Actual)* xx
Less: Cost of Sales (Estimate)** (xx)
Estimated ending inventory xx

*COGAS is actual that consider all items included in the computation of Cost of
goods available for sale. (Inventory, beg + Purchases + Freight-in – Purchase
discount – Purchase returns & allowances + Department transfer in – Department
transfer out – Abnormal spoilage, breakage, shrinkage)

**COS is estimated by:

Gross Sales x Cost Rate (if GP is based on sales)
Gross Sales / Selling Price rate (if GP is based on cost)
NOTE: For purpose of estimating Cost of Sales:
Assume that all sales were made under the normal GP rate thus, when
computing Gross Sales:
- Ignore sales discount to customers
- Add back special discounts to Gross Sales (e.g., Employee discounts)
- Deduct sales returns from gross sales
- Ignore sales allowances (Deduct if Sales returns and allowances as single
account is provided.
- Normal spoilage, breakage, shoplifting losses be added to gross sales at selling
price.

2. Retail Method

Cost of Goods Available for sale (at Retail) (a) xx

Less: Cost of Sales (at Retail) (b) (xx)
Estimated ending inventory (at Retail) xx
Multiply by: Cost rate (LCA or Ave) (c) %
Estimated ending inventory (at Cost) xx

COST RETAIL
Beginning inventory xx xx
Add: Purchase xx xx
Freight-in xx
Less: Purchase allowance (xx)
Purchase discount (xx)
Purchase returns (xx) (xx)
Add: Departmental transfer-in or xx xx
Debit
Less: Departmental transfer-out (xx) (xx)
or Credit
Less: Abnormal (xx) (xx)
spoilage/breakage/shrinkage
Add: Mark-ups, net of xx
cancellations
COGAS under xx / xx x% Cost rate
CONSERVATIVE under Lower
of Cost or
Average
(Conservative)

Less: Mark-downs, net of (xx)

cancellations
COGAS under AVERAGE xx / xx (a) x% Cost rate
APPROACH under
Average

Gross Sales xx
Less: Sales Return (xx)
Add: Special Discounts (Employee Discounts) xx
Normal Spoilage/Breakages/Shoplifting losses xx
Sales/Cost of Sales at Retail xx (b)
 NOTE: For FIFO Average, simply disregard in the computation the cost % the
beginning inventories:
Cost% = COGAS @ Cost – Beg inventory at Cost/COGAS @ Retail – Beg inventory
at Retail
Or
Net Purchases @ Cost / Net Purchases @ Retail

FOR INVENTORY VALUATION PROBLEMS:

Inventories shall be valued at lower or COST or NRV:
a. COST shall be measured through
1. SPECIFIC IDENTIFICATION/Perpetual
2. FIFO/Periodic – the cost shall be computed as: (# Inventory on hand*Cost of
latest purchases)
3. FIFO/Perpetual – the computation of cost shall be the same as FIFO/Periodic.
4. AVE/Periodic (also called WEIGHTED AVERAGE): (# of Inventory on
hand*WA unit Cost) WA unit Cost = COGAS / # of GAS
5. AVE/Perpetual (also called MOVING AVERAGE): (# of Inventory on hand*MA
unit Cost)

The average cost is recomputed after EVERY PURCHASE transaction. The

last moving average unit cost (after the last purchase transaction of the year)
shall be used for the computation of the inventory cost at year-end.

b. NET REALIZABLE VALUE shall be:

1. Finished goods/Merchandise Inventory = Estimated Selling price – Estimated
cost to sell
2. Work-in-progress inventory = Estimated Selling price – Estimated Cost to
complete – Estimated Cost to sell
3. Raw material and supplies – The NRV of raw materials shall be the Current
replacement cost (Current Purchase Price). The same shall be written down
only if the finished goods to which they are related to are also written down.

NOTE: The DIRECT WRITE-OFF METHOD is used in instances where the company holds
inventories that are not relatively the same from year-end to year-end. Thus, there shall be
no chances to recover any loss on write-down from one year over the next. If the NRV is
lower than the cost, the difference is automatically the loss on write-down for the year.
(Which is either added to cost of sale or recognized as a separate loss in the statement of
comprehensive income).

The ALLOWANCE METHOD is used in instances where the company holds inventories that
are relatively the from one year-end to another. Thus, there shall be a possibility of recovery
from inventory write-down from one year, unto the next year. The difference between cost
and NRV, where NRV is lower becomes the required allowance for inventory write-down
(like allowance for bad debts), to determine how much is the loss during the period, the
increment from the unadjusted balance of the account shall be determined. Thus, if cost is
lower than NRV, required balance is ZERO/NIL, any unadjusted credit balance of the
account shall generally be recognized as gain from recovery in the income statements (or
deducted from cost of sale).

Allowance for Inventory Write-down

Beginning Balance
Dr Adjustment for Gain on Recovery (or Cr Adjustment for Loss on Write-down for
reduction from COS) the period (or addition to COS)
Ending Balance
NOTE:
For Medium entities – Generally the same as full PFRS
For Small entities – Generally same as full PFRS with the following exceptions:

Balance sheet measurement: Lower of Cost or Market Value, where the difference if market
value is lower recognized in the profit or loss.