ACREV 426 – AUDIT OF INVENTORY AP-03

INTERNAL CONTROL OVER INVENTORIES AND COST OF GOODS SOLD

Special significance is given to inventories both in accounting and auditing because of the following
reasons:

1. Inventories usually constitute the largest current asset of a company and are very susceptible to
errors or irregularities.
2. The inventory is in different locations, which makes physical control and counting difficult.
3. The determination of inventory value directly affects the cost of goods sold and has a major
impact upon net income.
4. The determination of inventory quality, condition, and value is a complex and difficult task for
the auditor to perform. Many items such as precious gems, construction in progress, agricultural
products, present problems of identification and valuation.

The following good internal control provides accurate cost data for inventories:

1. Purchasing Function
1. Delegation to a separate department or to a single person the responsibility to make all
purchases of materials and services
2. Separation of the purchasing, receiving, and recording functions
3. Preparation of serially numbered purchase orders, for all purchases and forwarding of
copies to the accounting and receiving departments.
2. Receiving Function
All goods received by the company -without exception – should be cleared through a receiving
department that is independent of purchasing, storing, and shipping departments. The receiving
department is responsible for
1. Determination of quantities of goods received
2. Detection of damaged merchandise
3. Preparation of receiving of reports, and
4. The prompt transmittal of goods received to the storeroom.
3. Storing Function. Storeroom should count, inspect, and acknowledge receipt of goods delivered
to them and notify the accounting department of the amount received and placed in stock.
4. Issuing Function. Require prenumbered requisitions for all items issued from the storeroom. In
trading concerns, shipping orders serve to authorize issuance of merchandise.
5. Production Function
1. Responsibility for the goods must be fixed, usually on factory supervisors.
2. Regular inspection procedures for goods in process to reveal defective work.
3. Control procedures for goods scrapped during the process of production.
6. Shipping Function
1. Shipments should be made based on approved sales order.
2. Delivery receipt should be prepared and a copy is sent to the billing department for the
preparation of sales invoice.
7. Cost Accounting System
An adequate cost accounting system is necessary to account for the usage of raw materials and
supplies, to determine the content and value of goods in process, and to compute the finished
goods inventory.

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8. Perpetual Inventory System. These record serves the following purposes:

1. Provide information essential to intelligent purchasing, sales, ad production-planning
policies
2. Allow companies to control the high costs of holding excessive inventory, while minimizing
the risk of running out of stock
3. Discourage inventory theft and waste.

AUDIT WORKING PAPERS

1. Lead schedule
2. Inventory List
3. Working paper for Inventory Test Counts
4. Working paper for Test of Pricing of Inventories
5. Working paper for Test of Extensions
6. Working paper for Purchases and Sales Cut-off Test

AUDIT PROCEDURES FOR INVENTORIES

Existence or Occurrence/Rights and Obligations

• Review the client’s plan for taking the physical inventory

• Observe the physical count and make random test counts
• Trace client’s physical counts to perpetual records and inventory sheets
• Vouch the validity of the perpetual records and inventory sheets against the physical count
• Vouch a sample of additions to perpetual inventory to supporting receiving reports

Rights and Obligations

• Vouch a sample of inventory requisition to customer or department order

• Review purchases and sales cutoffs
• Review inventory on consignment
• Confirm inventory held at public warehouses and with third parties

Completeness

• Account for the numerical sequence of inventory purchase requisitions

• Trace a sample of receiving reports for inventory to the perpetual inventory records
• Perform analytical procedures
• Account for inventory tags and count sheets

Valuation

• Test pricing method used by client

• Apply lower of cost or NRV rule
• For manufacturing, test cost accumulation process and review overhead allocation and rates

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Presentation and Disclosure

• Review purchase and sales commitments

• Determine whether any inventory has been pledged
• Evaluate FS presentation of inventories and cost of goods sold, including the adequacy of
disclosure

MULTIPLE CHOICE- THEORY

1. When auditing inventories, an auditor would least likely verify that
A. The financial statement presentation of inventories is appropriate
B. Damaged goods and obsolete items have been properly accounted for
C. The client has used proper inventory pricing
D. All inventory owned by the client is on hand at the time of the count
2. The primary objective of a CPA’s observation of a client’s physical count is to
A. Discover whether a client has counted particular inventory items or group of items
B. Provide an appraisal of the quality of merchandise on hand on the day of the physical count
C. Obtain direct knowledge that the inventory exists and has been properly counted
D. Allow the auditor to supervise the conduct of the count so as to obtain assurance that
inventory quantities are reasonably counted
3. The audit of year-end physical inventories should include steps to verify that the client’s
purchases and sales cut-offs are adequate. The audit steps should be designed to detect
whether merchandise included in the physical count at year-end was not recorded as a
A. Sale in the subsequent period
B. Sale in the current period
C. Purchase in the current period
D. Purchase return in the subsequent period
4. After counting for a sequence of inventory tags, an auditor traces a sample of tags to the
physical inventory listing to obtain evidence that all items
A. Included in the listing have been counted
B. Represented by inventory tags are included in the listing
C. Included in the listing are represented by inventory tags
D. Represented by inventory tags are bona fide
5. An auditor selected items for test counts while observing a client’s physical inventory. The
auditor then traced the test counts to the client’s inventory listing. This procedure most likely
obtained evidence concerning management’s assertion of
A. Rights and obligations
B. Existence or occurrence
C. Valuation
D. Completeness
6. In a manufacturing company, which one of the following audit procedures would give the least
assurance of the valuation of inventory at the audit date?
A. Testing the computation of standard overhead rates
B. Examining paid vendor’s invoices

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C. Reviewing direct labor rates

D. Obtaining confirmation of inventories pledged under loan agreements
7. Which of the following auditing procedures most likely would provide assurance about a
manufacturing entity’s inventory valuation?
A. Obtaining confirmation of inventories pledged under loan agreements
B. Reviewing shipping and receiving cut-off procedures for inventories
C. Tracing test counts to the entity’s inventory listing
D. Testing the entity’s computation of standard overhead rates

PROBLEM SOLVING
Problem 1.

Indicate which of these items would typically be reported as inventory in the financial statements. If
an item should not be reported as inventory, indicate how it should be reported in the financial
statements.

a. Goods out on consignment at another company’s store.

b. Goods sold on an installment basis.
c. Goods purchased fob shipping point that are in transit at December 31.
d. Goods purchased fob destination that are in transit at December 31.
e. Goods sold to another company, for which our company has signed an agreement to repurchase
at a set price that covers all costs related to inventory.
f. Goods sold where large returns are predictable.
g. Goods sold fob shipping point that are in transit at December 3 1.
h. Freight charges on goods purchased.
i. Factory labor costs incurred on goods still unsold.
j. Interest costs incurred for inventories that are routinely manufactured.
k. Cost incurred to advertise goods held for resale.
l. Materials on hand not yet placed into production by a manufacturing firm.
m. Office supplies
n. Raw materials on which a manufacturing firm has started production, but which are not
completely processed
o. Factory supplies
p. Goods held on consignment from another company
q. Costs identified with units completed by a manufacturing firm, but not yet sold
r. Goods sold fob destination that are in transit at December 31
s. Temporary investments in stocks and bonds that will be resold in the near future.

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ACREV 426 – AUDIT OF INVENTORY AP-03

Problem 2. Purchases Cutoff

The following purchase transactions occurred during the last few days of Yellow Orange Company’s
business year, which ends October 31, or in the first few days after that date. A periodic inventory
system is used.

1. An invoice for P30,000, terms fob shipping point, was received and entered November 1. The
invoice shows that the material was shipped October 29, but the receiving report indicates
receipts of goods on November 3.
2. An invoice for P27,000, terms fob destination, was received and entered November 2. The
receiving report indicates that the goods were received October 29.
3. An invoice for P31,500, terms fob shipping point, was received October 15 but never entered.
Attached to it is a receiving report indicating that the goods were received October 18. Across
the face of the receiving report is the following notation:” Merchandise not of same quality as
ordered – returned for credit October 19.”
4. An invoice for P36,000, terms fob shipping point, was received and entered October 27. The
receiving report attached to the invoice indicates that the shipment was received October 27 in
satisfactory condition.
5. An invoice for P51,000, terms fob destination, was received and entered October 28. The
receiving report indicates that the merchandise was received November 2.

Before preparing financial statements for the year, you are instructed to review these transactions
and to determine whether any correcting entries are required and whether the inventory of P775,000
determined by physical count on October 31 should be changed.

Requirement: Complete the schedule shown on the following page, and state the correct inventory
at October 31. Assume that the books have not been closed.

Purchase Purchase
and and related
Related payable Should Was
Payable were Inventory Inventory Peso Adj.
should be recognized Correcting Journal be included Included Needed to
Trans. recognized in (month) Entries Needed in Oct. EI? in Oct EI? October EI
in (month)
1.

2.

3.
4.
5.

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ACREV 426 – AUDIT OF INVENTORY AP-03

Problem 3. Sales Cutoff Test

On December 15, 2022, under your observation, your client took a complete physical inventory
and adjusted the financial perpetual inventory control account to agree with the physical inventory.

As of December 31, 2022, you decided to accept the balance of the control account after
examining transactions recorded in that account between December 15 and December 31, 2022. The
audit was for the year ended December 31, 2022.

In the course of conducting your examination of the sales cutoffs as of December 15 and
December 31, 2022 you discovered the following items:

Item Cost Price Sales Price Date Shipped Date Billed Date Inventory
Control Credited
A P60,000 P78,000 12.13.22 12.17.22 12.17.22
B 77,000 101,400 01.02.23 12.29.22 12.29.22
C 52,000 67,600 12.17.22 12.29.22 12.29.22
D 87,000 113,100 12.14.22 12.16.22 12.16.22
E 49,500 64,500 12.25.22 01.02.23 01.02.23

Requirement: Assuming that all of these items are material: What audit adjustments should be
proposed for each item – if any? In formulating your audit adjustments that the client’s recorded have
not yet been closed.

Problem 4. Correcting Inventory Errors

Mabes Corporation, a manufacturer of small tools, provided the following information from its
accounting records for the year ended December 31, 2022:

Inventory at December 31, 2022 (based on physical count of goods in P1,750,000

Mabes’s plant at cost on December 31, 2022
Accounts payable at December 31, 2022 1,200,000
Net Sales (sales less sales returns) 8,500,000

Additional information is as follows:

1. Included in the physical count were tools billed to a customer FOB Shipping point on December
31, 2022. These tools had a cost of P28,000 and had been billed at P35,000. The shipment was
on Mabes’s loading dock waiting to be picked up by the common carrier.
2. Goods were in transit from a vendor to Mabes on December 31, 2022. The invoice cost was
P50,000, and the goods were shipped FOB shipping point on December 29, 2022.
3. Work-in-process inventory costing P20,000 was sent to an outside processor for plating on
December 30, 2022.
4. Tools returned by customers and held pending inspection in the returned goods area on
December 31, 2022, were not included in the physical count. On January 8, 2023, the tools

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costing P26,000 were inspected and returned to inventory. Credit memos totaling P40,000 were
issued to customers on the same date.
5. Tools shipped to a customer FOB destination on December 26, 2022, were in transit at
December 31, 2022, and had a cost of P25,000. Upon notification of receipt by the customer on
January 2, 2022, Mabes issued a sales invoice for P42,000.
6. Goods, with an invoice cost of P30,000, received from a vendor at 5:00 p.m. on December 31,
2022, were recorded on a receiving report dated January 2, 2023. The goods were not included
in the physical count, but the invoice was included in accounts payable at December 31, 2022.
7. Goods received from a vendor on December 26, 2022, were included in the physical count.
However, the related P60,000 vendor invoice was not included in accounts payable at December
31, 2022, because the accounts payable copy of the receiving report was lost.
8. On January 3, 2023, a monthly freight bill in the amount of P4,000 was received. The bill
specifically related to merchandise purchased in December 2022, one-half of which was still in
the inventory at December 31, 2022. The freight charges were not included in either the
inventory or in accounts payable at December 31, 2022.

Required:

Using the format below, prepare a schedule of adjustments as of December 31, 2022, to the initial
amounts per Mabes’s accounting records. Show separately the effect, if any, of each of the eight
transactions on the December 31, 2022, amounts. If the transactions would have no effect on the initial
amount shown, state NONE.

Inventory Accounts Payable Net Sales

Initial Amounts P1,750,000 P1,200,000 P8,500,000
Adjustments
[Increase/(Decrease)]
1
2
3
4
5
6
7
8
Total Adjustments
Adjusted Amounts

Problem 5. Gross Profit Rate and Inventory Fire Loss

Shark, Inc. was organized on January 1, 2022. On December 31, 2023, the company lost most of
its inventory in a warehouse fire just before the year-end count of inventory was to take place. The
company records disclosed the following data:

2022 2023
Inventory, January 1 P0 P 204,000

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Purchases 860,000 692,000

Purchase returns and allowances 46,120 64,600
Sales 788,000 836,000
Sales Returns and allowances 16,000 20,000

On January 1, 2023, Shark’s pricing policy was changed so that the gross profit rate would be
three percentage points higher than the one earned in 2022.

Salvaged undamaged merchandise was marked to sell at P24,000 while damaged merchandise
marked to sell at P16,000 had an estimated realizable value of P3,600.

1. What is the company’s gross profit rate beginning January 1, 2023?

A. 24% B. 21% C. 17% D. 20%

2. How much is the inventory fire loss?

A. P189,400 B. P 183,640 C. P 164,920 D. P 254,000