Chapter Four

Audit of the Inventory and Warehousing Cycle

4.1. Introduction
Inventories are tangible property held for sale in the ordinary course of business, or in the process of
production for such sale, or for consumption in the production of goods or services for sale, including
maintenance supplies and consumable stores and spare parts meant for replacement in the normal
course.
Inventories normally comprise raw materials including components,
work-in-process, finished goods including by-products, maintenance
supplies, stores and spare parts, and loose tools.
Inventories normally constitute a significant portion of the total assets particularly in the case of
manufacturing and trading entities as well as some service rendering entities. Audit of inventories,
therefore, assumes special importance.
4.2. Audit of Inventory
The audit of inventory, especially test of the year-end inventory balance is often the most complex and
time consuming part of the audit. Lack of information held on stock holdings resulting in poor decision
and inability to meet the demands and objectives of the business. Therefore, Inventory is
recognized as a complex area to audit because of the following reasons:
 By their very nature, inventories normally turn over rapidly
 Inventories are susceptible to obsolescence and spoilage.
Further, some of the items of inventory may be slow-moving while
others may follow a seasonal pattern of movement.
 Inventory is generally a major item in B/sheet. Thus way, it is
known as the largest account in working capital.
 A location of inventory at different area makes physical control
and counting difficult.
 Physical condition (e.g., stage of completion of work-in-process
in certain industries) and existence of certain items of
inventories may be difficult to determine.
 Valuation of inventories may involve varying degrees of
estimation, including expert opinions, e.g., in the case of
jewelry.
In an inventory audit, the auditor uses several analytical
procedures to check the company’s inventory methods and confirm
that the financial records and actual physical count of goods
match. An inventory audit is considered a generally accepted
auditing procedure.
Inventory is a key asset in a company’s financial statements. Such as,
income statement, the balance sheet, and the statement of cash flow.
These three core statements are intricately linked to each other.

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Companies typically put in place internal controls such as a custodian of
inventory or a segregation of duties between the custodian of inventory and the
individual with access to the perpetual records to reduce risks of
inventory fraud and misappropriation.

4.2. Internal Control Evaluation

The auditor should study and evaluate the system of internal control
relating to inventories, to determine the nature, timing and extent of
his/her other audit procedures. The auditor should particularly review
the following aspects of internal control relating to inventories.
 The control procedures should provide for segregation of such
functions whose combination may permit the commitment or concealment
of fraud or error; for example, persons undertaking the physical
verification of stocks should be different from those responsible for
store-keeping in respect of those stocks.
 The stores procedures should provide for the use of pre-numbered
standardized forms.
 There should be a system of cross-checking the data generated by
different operating departments.
 The auditor should also review specific controls over receipts,
issues, physical inventories, and inventory records.
4.3. Business Functions in the Cycle and Related Documents
and Records
Activities
Describe the business functions and the related documents and records in the inventory and
warehousing cycle.

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.
The inventory and warehousing cycle can be thought of as comprising
two separate but closely related systems, one involving the physical
flow of goods and the other the related costs.

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Six functions make up the inventory and warehousing cycle. Each of
these is discussed next.
1.Process Purchase Orders
The inventory and warehousing cycle begins with acquisition of
raw materials for production. Purchase requisitions are forms
used to request the purchasing department to order inventory.
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. The
stockroom keeper issue a document when another department needs
materials for production, personnel submit a properly approved
materials 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
Processing inventory varies greatly from company to company. 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.
Two primary types of cost systems exist:
 Job cost systems- job cost system and
 Process cost systems, and others
Indeed, Cost accounting record consist the following documents:
 Master files,
 Spreadsheets, and
 Reports that accumulate material, labor, and overhead costs by job or process as those costs are
incurred.

4.2. Client's procedures Over Inventory Taking

 The two methods of inventory taking are periodical and continuous.
4.2.1. Periodical Inventory Taking

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  Is necessary in most cases, i.e. where continuous inventory
taking is not carried out.
 It will usually be undertaken on or around the financial year end.
Whether continuous or periodical inventory taking occurs, the
practice is the same that is the auditor must ensure that the
inventory is properly counted, identified and recorded.
4.2.2. Continuous Inventory Taking
Where a suitable record of inventory is maintained, it is often backed
up by a program of continuous inventory taking as part of general
inventory control procedures. This program should ensure the following
outcomes.
 Adequate records are kept up to date.
 The records are amended as a result of physical inspection, and
there are appropriate reports and investigation procedures for
discrepancies.
 No disruption caused by a periodical inventory take
 More accurate and regular inventory taking, earlier
identification of errors moving inventory, etc
 Increased discipline over storekeepers caused by the surprise
elements of random checks
NB: Auditing guideline allows auditors to rely on the continuous inventory taking procedures, rather
than a full year-end count.
4.2.3. Physical counts
From the audit point of view, the inventory records substantiated by
physical counts are most important. Therefore, physical counts used in
both periodical and continuous systems.
4.3. Parts of the audit of the inventory
Activities
Explain the five parts of the audit of the inventory and warehousing cycle.

The overall objective in the audit of the inventory and warehousing

cycle is to provide assurance that the financial statements fairly
account for raw materials, work-in-process, finished goods inventory,
and cost of goods sold.
The audit of the inventory and warehousing cycle can be divided into
five activities within the cycle:

s/ Part of Audit Cycle in which Tested

n

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1 Acquire and record raw materials, labor, Acquisition and payment plus payroll and
and overhead personnel
2 Internally transfer assets and costs Inventory and warehousing
3 Ship goods and record revenue and costs Sales and collection
4 Physically observe inventory Inventory and warehousing
5 Price and compile inventory Inventory and warehousing
1. Acquire and record raw materials, labor, and overhead

The auditor obtains an understanding of internal controls over these

three functions and then performs tests of controls and substantive
tests of transactions in both the acquisition and payment cycle and
the payroll and personnel cycle. These tests should satisfy auditors
that control affecting the acquisitions of raw materials and
manufacturing costs are operating effectively and that acquisition
transactions are correctly stated.
When direct labor is a significant part of manufactured inventory,
auditors should verify the proper accounting for these costs in the
payroll and personnel cycle.
2. Internally transfer assets and costs
Inter transfers of inventory include acquisition of raw material,
convert in work in process to finished goods are tested as part of the
audit of the inventory and warehousing cycle.
3. Ship goods and Record Revenue and Costs
Recording shipments and related costs is part of the sales and collection cycle.
Therefore, auditors shall obtain an understanding and test internal
controls over recording shipments as a part of auditing that cycle,
including procedures to verify the accuracy of the credits to
inventory recorded in perpetual inventory master files.
4. Physically observe inventory
Auditors must observe the client taking a physical inventory count to
determine whether recorded inventory actually exists at the balance
sheet date and is correctly counted by the client. Physical
examination is an essential type of evidence used to verify the
existence and count of inventory.
5. Price and compile inventory
Costs used to value inventory must be tested to determine whether the
client has correctly followed an inventory method that is both in
accordance with accounting standards and consistent with previous
years. Audit procedures used to verify these costs are called price
tests. In addition, the auditor must perform inventory
compilation tests, which are tests to verify whether the physical

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counts were correctly summarized, the inventory quantities and prices
were correctly extended, and the extended inventory correctly footed
to equal the general ledger inventory balance.
4.4. Audit of Cost Accounting.
Activities
Design and perform audit tests of cost accounting.

Our discussion of the audit of cost accounting begins with the

internal transfer of assets from raw materials to work-in-process to
finished goods inventory. We also focus on systems and controls
related to the transfer of inventory costs that is accounted for in
the cost accounting records.
Cost accounting controls are those related to processes affecting physical
inventory and the tracking of related costs from the time raw
materials are requisitioned to the completion of the manufactured
product and its transfer to storage.
The auditor is concerned with four aspects of cost accounting:
1. Physical controls over inventory
2. Documents and records for transferring inventory
3. Perpetual inventory master files
4. Unit cost records

4.5. Analytical Procedures

Activities
Apply analytical procedures to the accounts in the inventory and warehousing cycle.
Analytical procedures are important in auditing inventory and
warehousing, as they are in all other cycles. In addition to
performing analytical procedures that examine the relationship of
inventory account balances with other financial statement auditors
often use nonfinancial information to assess the reasonableness of
inventory-related balances.
For example, auditors may need knowledge about the size and weight of
inventory products, their methods of storage and the capacity of
storage facilities (available square footage) to determine whether
recorded inventory is consistent with available inventory storage.
After performing the appropriate tests of the cost accounting records
and analytical procedures, auditors have a basis for designing and
performing tests of details of the ending inventory balance.

S/N Analytical procedure Possible misstatement

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1 Compare gross margin Overstatement or understatement
percentage with that of of inventory and cost of goods
previous years sold
2 Compare inventory turnover Obsolete inventory Overstatement
(cost of goods sold divided by or Understatement of inventory
average inventory) with that
of previous year
3 Compare unit costs of Overstatement or understatement
inventory with those of of unit costs, which affect
previous years inventory and cost of goods sold
4 Compare extended inventory Misstatements in compilation,
value with that of previous unit costs, or extensions, which
years affect inventory and cost of
goods sold
5 Compare current year Misstatements of unit costs of
manufacturing costs with those inventory, especially direct
of previous years (variable labor and manufacturing overhead,
costs should be adjusted for which affect inventory and cost
changes of goods sold
in volume)
Methodology for Designing Tests of Balances – Inventory
Identify client business risks Phase I
Affecting inventory

Set tolerable misstatement and assess Phase I

inherent risk for inventor

Assess control risk for several cycles

Phase I

Design and perform tests of

controls and substantive tests of
transactions
Phase II

Design and perform

analytical procedures Phase III
for inventory

Audit procedures
Phase III
Design tests of details of inventory to
satisfy balance- related audit objectives Sample size
Phase III
Items to select
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Timing
 Controls Over Perpetual Inventory Master Files

 Proper instructions for the physical count

 Supervision by responsible personnel
 Independent internal verification of the counts
 Independent reconciliations of the physical counts with
perpetual inventory master files
 Adequate control over count sheets or tags
4.6. Balance-Related Audit Objectives
1. Existence:
-Inventory balances exist at balance sheet date
2. Completeness:
-Inventory balances include all inventory transactions that have
taken place during the period
3. Accuracy:
-Inventory is counted accurately.
4. Classification:
-Inventory is classified correctly on the tags.
5. Cutoff:
- Transactions are recorded in the proper period.
6. Realizable value:
- Obsolete and unusable inventory items are excluded or noted.
7. Rights and obligation:
- Organization has title to inventory as of the balance sheet date
8. Valuation or allocation
-Recorded balances reflect true underlying economic value of
those assets
9. Presentation and disclosure
- Inventory is properly classified on the balance sheet and
disclosed in the notes to the financial statements
4.7. Fraud-Related Substantive Procedures for Inventory and
Cost of Goods Sold
 Observe all inventory locations simultaneously
 Confirm inventories at locations that are outside the entity
 Compare carrying inventory amounts to recent sales amounts
 Examine consignment agreements and determine that
consignments are properly accounted for

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 Send confirmations to vendors confirming invoices and
unusual terms
 Determine if there are bulk sales at steep discounts