Auditing and Assurance Services A Systematic Approach 10th Edition Messier Solutions Manual 1

Chapter 13 - Auditing the Inventory Management Process
Solution Manual for Auditing and Assurance Services A

Systematic Approach 10th Edition Messier Glover Prawitt
0077732502 9780077732509
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CHAPTER 13
AUDITING THE INVENTORY MANAGEMENT PROCESS
Answers to Review Questions
13-1 Inventory represents one of the most complex parts of the audit because the assignment
of values to inventory quantities is difficult. There are also issues such as obsolescence
and “lower of cost or market” that affect the valuation of inventory. The complexity of
auditing inventory may also be affected by the degree of processing required to
manufacture products.
13-2 The inventory process is affected by control activities in the revenue, purchasing, and
human resource management processes. The purchasing process controls the acquisition
and payment of raw materials and overhead costs. The cost of direct and indirect labor
assigned to inventory is controlled through the human resource management process.
Last, finished goods are sold and accounted for as part of the revenue process.
13-3 A production schedule is used to determine the quantity of goods needed and the time at
which they are required to meet the production scheduling. The materials requisition is
the document that authorizes the release of raw materials from the raw materials
department. The inventory master file contains all the important information related to
the entity's inventory, including the perpetual inventory records for raw material, work in
process, and finished goods. Production data information is reported about the transfer of
goods and related cost accumulation at each stage of production. This information is used
to update the entity's perpetual inventory system and as input to generate the cost
accumulation and variance reports produced by the inventory system. The cost
accumulation and variance report summarizes the various costs charged to departments
and products and presents the results of inventory processing in terms of actual costs
versus standard or budgeted costs.
13-1
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13-4 The following duties are performed within the inventory management, raw materials
stores, and cost accounting functions:
Inventory management: Maintenance of inventory at appropriate levels;

issuance of purchase requisitions to the purchasing
department; managing inventory through planning
and scheduling manufacturing activities.
Raw materials stores: Custody of raw materials and issuance of raw
materials to manufacturing departments.
Cost accounting: Responsible for ensuring that costs are properly
attached to inventory as goods are processed
through the manufacturing function. Cost
accounting reviews the cost accumulation and
variance reports after such data are processed into
the accounting records.
13-5 The key segregation of duties in the inventory process and the errors or fraud that they can
prevent are:
Segregation of Duties Possible Errors or Fraud as a

Result of Conflicts in Duties
The inventory management function Production and inventory costs can be

should be segregated from the cost- manipulated, leading to an over- or
accounting function. understatement of inventory and net income.
The inventory stores function should be Unauthorized shipments can be made or the
segregated from the cost-accounting theft of goods can be covered up.
function.
The cost-accounting function should be Unauthorized shipments resulting in theft of
segregated from the general ledger goods, leading to an overstatement of
function. inventory.
The responsibility for supervising the Inventory shortages can be covered up
taking of physical inventory should be through the adjustment of the inventory
separated from the inventory records to the physical inventory resulting in
management and inventory stores an overstatement of inventory.
functions.
13-6 Industry-related factors and operating and engagement inherent risk factors affect the
inventory process. Industry factors include industry competition and changes in
technology. Operating and engagement characteristics are (1) the susceptibility of the
products sold by the entity to theft, (2) the difficulty in auditing and valuing inventory,
and (3) possible related-party transactions for the acquisition of raw materials and sale of
the finished product.
13-7 The three major steps in assessing control risk in the inventory process are:
13-2
1. Understand and document the inventory internal control system based on the planned
level of control risk.
2. Plan and perform tests of controls on inventory process transactions.
3. Assess and document control risk for the inventory process.
13-8 The following control activities can be used by the entity to prevent unauthorized
inventory production:
 Preparation and review of an authorized production schedule.
 Use of material requirements planning and/or just-in-time inventory systems.
 Review of inventory levels by the inventory management department.
13-3
13-9 Substantive analytical procedures that can be used to test inventory and related account
balances include:
 Compare raw material, finished goods, and total inventory turnover to previous
periods’ and industry averages.
 Compare days outstanding in inventory to previous periods and industry data.
 Compare gross profit percentage by product line with previous periods' and industry
data.
 Compare actual cost of goods sold to budgeted amounts.
 Compare current-year standard costs with prior periods' after considering current
conditions.
 Compare actual manufacturing overhead costs with budgeted or standard
manufacturing overhead costs.
13-10 To audit standard costs, the auditor should first review the entity's policies and procedures
for constructing standard costs. Once the policies and procedures are understood, the
auditor normally tests the component cost buildup for materials, labor, and overhead for
a representative sample of standard product costs. The material component requires
testing of the quantity and type of materials included in the product and the price of the
materials. The quantity and type of materials are tested by reviewing the engineering
specifications for the product. Labor costs require evidence about the type and amount of
labor needed for production and the labor rate. The amount of labor necessary to assemble
a product can be tested by reviewing engineering estimates, which may be based on time-
and-motion studies or historical information. The labor rates for each type of labor
necessary to assemble a product can be tested by examining a schedule of authorized
wages. Overhead costs are tested by reviewing the entity's method of overhead allocation
for reasonableness, compliance with GAAP, and consistency. The auditor examines the
costs included in overhead to ensure that such costs are appropriate costs assignable to the
product and that the inclusion or exclusion of such costs is consistent from one period to
the next.
13-11 During the observation of the physical inventory count, the auditor should perform the
following procedures:
 Ensure that no production is scheduled. Or, if production is scheduled, ensure that
proper controls are established for movement between departments in order to prevent
double counting.
 Ensure that there is no movement of goods during the inventory count. If movement
is necessary, the auditor and entity personnel must ensure that the goods are not double
counted and that all goods are counted.
 Ensure that the entity's count teams are following the inventory count instructions.
 Ensure that inventory tags are issued sequentially to individual departments. If the
entity uses another method of counting inventory, such as detailed inventory listings,
the auditor should obtain copies of the listings prior to the start of the inventory count.
 Perform test counts and record a sample of counts in the working papers.
13-4
 Obtain tag control information for testing the entity's inventory compilation. Tag
control information includes documentation of the numerical sequence of all inventory
tags and accounting for all used and unused inventory tags.
 Obtain cutoff information, including the number of the last shipping and receiving
documents issued on the date of the physical inventory count.
 Observe the condition of the inventory for items that may be obsolete, slow moving, or
carried in excess quantities.
 Inquire about goods held on consignment for others or held on a "bill-and-hold" basis.
The auditor must also inquire about goods held on consignment for the entity.
13-12 Possible causes of book-to-physical inventory differences include:

 Inventory cutoff errors.
 Unreported scrap or spoilage.
 Theft.
13-13 Example disclosure items for inventory and related accounts include:
 Cost method (e.g. FIFO, LIFO, retail method).
 Components of inventory.
 Long-term purchase contracts.
 Consigned inventory.
 Purchases from related parties.
 LIFO liquidations.
 Pledged or assigned inventory.
 Disclosure of unusual losses from write-downs of inventory or losses on long-term
purchase commitments.
 Warranty obligations.
Answers to Multiple-Choice Questions
13-14 d 13-21 b
13-15 a 13-22 d
13-16 c 13-23 d
13-17 b 13-24 b
13-18 d 13-25 a
13-19 c 13-26 d
13-20 d
13-5
Solutions to Problems
13-27 The identification and explanation of the systems and control weaknesses are as follows:
 The purchase requisition is not approved. A responsible person in the stores
department should approve the purchase requisition. The approval should be indicated
on the purchase requisition after the approver is satisfied that it was properly prepared
based on a need to replace stores or the proper request from a user department.
 Purchase requisition number 2 is not required. Purchase requisitions are unnecessarily
sent from the stores department to the receiving room. The receiving room does not
make any use of the purchase requisitions, and no purpose seems to exist for the
receiving room to obtain a copy. A copy of the requisition might be sent from the
stores department directly to the accounts payable department, where it can be
compared to the purchase order to verify that merchandise requisitioned by an
authorized employee has been properly ordered.
 Purchase requisitions and purchase orders are not compared in the stores department.
Although purchase orders are attached to purchase requisitions in the stores
department, there is no indication that any comparison is made of the two documents.
Prior to attaching the purchase order to the purchase requisition, the requisitioner's
functions should include a check that (1) prices are reasonable, (2) the quality of the
materials ordered is acceptable, (3) delivery dates are in accordance with company
needs, and (4) all pertinent data on the purchase order and purchase requisition (e.g.,
quantities, specifications, delivery dates, etc.) are in agreement. Since the requisitioner
will be charged for the materials ordered, the requisitioner is the logical person to
perform these steps.
 Purchase orders and purchase requisitions should not be combined and filed with the
unmatched purchase requisitions in the stores department. A separate file should be
maintained for the combined and matched documents. The unmatched purchase
requisitions file can serve as a control over merchandise requisitioned but not yet
ordered.
 Preliminary review should be made before preparing purchase orders. Prior to
preparation of the purchase order, the purchase office should review the company's
need for the specific materials requisitioned and approve the request.
 The purchase office should attempt to obtain the highest-quality merchandise at the
lowest possible price, and the procedures that are followed to achieve this should be
included on the flowchart. There is no indication that the purchase office submits
purchase orders to competitive bidding when appropriate. That office should be
directly involved with vendors in determining the cost of materials ordered and should
be primarily responsible for deciding at what price materials should be ordered and
which vendors should be used.
13-6
 The purchase office does not review the invoice prior to processing approval. The
purchase office should review the vendor's invoice for overall accuracy and
completeness, verifying quantity, prices, specifications, terms, dates, etc., and if the
invoice is in agreement with the purchase order, receiving report, and purchase
requisition, the purchase office should clearly indicate on the invoice that it is approved
for payment processing. The approved invoice should be sent to the accounts payable
department.
 The copy of the purchase order sent to the receiving room generally should not show
quantities ordered, thus forcing the department to count goods received. In addition
to counting the merchandise received from the vendor, receiving department personnel
should examine the condition and quality of the merchandise upon receipt.
 There is no indication of the procedures in effect when the quantity of merchandise
received differs from what was ordered. Procedures for handling overshipments
should be clearly outlined and included on the flowchart.
 The receiving report is not sent to the stores department. A copy of the receiving report
should be sent from the receiving room directly to the stores department with the
materials received. The stores department, after verifying the accuracy of the receiving
report, should indicate approval on that copy and send it to the accounts payable
department. The copy sent to the accounts payable department will serve as proof that
the company received the materials ordered and are in the user department.
 There is no indication of control over vouchers in the accounts payable department. In
the accounts payable department a record of all vouchers submitted to the cashier
should be maintained, and a copy of the vouchers should be filed in an alphabetical
vendor reference file.
 There is no indication of control over dollar amounts on vouchers. Accounts payable
personnel should prepare and maintain control sheets on the dollar amounts of
vouchers. Such sheets should be sent to departments posting transactions to general
and subsidiary ledgers.
 There is no examination of documents prior to voucher preparation. In addition to the
matching procedure, the mathematical accuracy of all documents should be verified
prior to preparation of vouchers.
 The controller should not be responsible for cash disbursements. The cash
disbursement function should be the responsibility of the treasurer, not the controller,
so as to provide proper segregation of duties between the custody of assets and the
recording of transactions.
 There is no indication of the company's procedures for handling purchase returns.
Although separate return procedures may be in effect and included on a separate
flowchart, some indications of this should be included as part of the purchases
flowchart.
 Discrepancy procedures are not indicated. The flowchart should indicate what
procedures are followed whenever matching reveals a difference between the
information on the documents compared.
 There is no indication of any control over prenumbered forms. All prenumbered
documents should be accounted for.
13-7
13-28 a. Evidence found in the working papers to support the fact that the audit was adequately
planned and assistants were properly supervised would be:
 Documentation indicating discussions with entity personnel concerning
developments affecting the entity that require recognition in the audit plan.
 Documentation of a pre-audit planning conference among audit firm personnel to
develop an audit strategy by reviewing and considering matters noted in prior years'
working papers, changes in accounting and auditing standards, etc.
 An internal control write-up documenting that the internal control system had been
reviewed.
 Audit programs tailored to the strengths and weaknesses of the internal control
system (i.e., tested the relevant assertions).
 Audit programs indicating steps that were assigned to and completed by individual
assistants.
 A budget indicating the time to be spent in each audit area.
 Individual working papers signed by reviewers to document review, approval, and
responsibility.
 Confirmations that all questions raised by assistants were answered.
b. Substantive tests that would document management’s completeness assertion as it

relates to inventory quantities would be:
 Observation of physical inventory counts.
 Analytical procedures for the relationship of inventory balances to purchase,
production, and sales activities.
 Inspection of shipping and receiving documentation for proper amounts and dates
to verify proper cutoff procedures.
 Obtaining of confirmation of inventories at locations outside the entity.
 Tracing of test counts recorded during the physical inventory observation to the
inventory listing.
 Accounting for all inventory tags and count sheets used in recording the physical
inventory counts.
 Recomputation of the inventory calculations for clerical accuracy.
 Reconciliation of physical counts to perpetual records and general ledger balances
and investigation of significant differences.
13-29 a. When an entity uses statistical sampling to estimate inventories, the auditor should
perform procedures similar to the following:
 The auditor should review the entity's procedures and methods for determining
inventories to ascertain if they are sufficiently reliable to produce results
substantially the same as those that would be obtained by a 100 percent inventory
count.
 The auditor should be satisfied that the statistical sampling plan to be used by the
entity has statistical validity, that it will be properly applied, and that the planned
tolerable and expected misstatement and risk of incorrect acceptance will be
reasonable in the circumstances.
 The auditor should ascertain that proper steps have been taken to ensure that all
13-8
parts and supplies in the warehouse are included in the perpetual inventory records.
This would normally be checked in advance of the physical count.
 The auditor should be present when the sample is drawn to make sure that the
requirements for random selection are properly observed and that all items in the
inventory have an equal or determinable probability of selection.
 The auditor must be present to observe counts and must be satisfied with the entity's
counting procedures. The inventory observation can be made either during or after
the year-end of the period under audit if well-kept perpetual records are maintained
and the entity makes periodic comparisons of physical counts with such records.
 The auditor should review the statistical evaluation and be satisfied that the
estimated value of the precision at a given level of reliability meets the materiality
requirements set for the audit.
b. In addition to the above, the following standard audit procedures for verification of
physical quantities should be performed whether the entity conducts a periodic physical
count for all or part of its inventory:
 Review and be satisfied with the entity's physical inventory-taking procedures.
 Observe the physical count.
 Make test counts where appropriate.
 Trace selected count data to the inventory compilation.
 Select items from compilation and trace them to original count data.
 Select items from the warehouse at random and trace these items to the perpetual
inventory records.
 Verify footings.
 Compare inventory compilation amounts to the subsidiary ledger control and
investigate significant differences.
 Ascertain that there was a proper purchases and sales cutoff.
 Review the treatment of merchandise in transit and consigned merchandise.
 Confirm merchandise in warehouses.
 Perform analytical procedures for inventories.
 Account for all entity inventory count sheets.
 Be sure inventory items are properly classified, in good condition, and of proper
quality.
13-9
13-30 The substantive auditing procedures Kachelmeier may consider performing include:
(a) Using the perpetual inventory file

 Recalculate the beginning and ending balances (prices x quantities), foot, and create a
report to be used to reconcile the totals with the general ledger or agree beginning balance
with the prior year's working papers.
 Calculate the quantity balances as of the physical inventory date for comparison to the
physical inventory file. Alternatively, update the physical inventory file for purchases and
sales from January 6 to January 31, 2015, for comparison to the perpetual inventory at
January 31, 2015.
 Select and print out a sample of items received and shipped for the periods (1) before and
after January 5 and 31, 2015, for cutoff testing, (2) between January 5 and January 31,
2015, for vouching or analytical procedures, and (3) prior to January 5, 2015, for tests of
details or analytical procedures.
 Compare quantities sold during the year to quantities on hand at year-end. Print out a report
of items for which turnover is less than expected. Alternatively, calculate the number of
days' sales in inventory for selected items.
 Select items noted as possibly unsalable or obsolete during the physical inventory
observation and print out information about purchases and sales for further consideration.
 Recalculate the prices used to value the year-end FIFO inventory by matching prices and
quantities to the most recent purchases.
 Select a sample of items for comparison to current sales prices.
 Identify and print out unusual transactions. These are transactions other than purchases or
sales for the year, or physical inventory adjustments as of January 5, 2015.
 Recalculate the ending inventory by taking the beginning balances plus purchases, less
sales, and print out the differences.
 Recalculate the cost of sales for selected items sold during the year.
(b) Using the physical inventory and test count files

 Account for all inventory tag numbers used and print out a report of missing or duplicate
numbers for follow-up.
 Search for tag numbers noted during the physical inventory observation as being voided or
not used.
 Compare the physical inventory file to the file of test counts and print out a report of
differences for auditor follow-up.
 Combine the quantities for each item appearing on more than one inventory tag number for
comparison to the perpetual file.
 Compare the quantities on the file to the calculated quantity balances on the perpetual
inventory file as of January 5, 2015. Alternatively, compare the physical inventory file
updated to year end to the perpetual inventory file.
 Calculate the quantities and dollar amounts of the book-to-physical adjustments for each
item and the total adjustment. Print out a report to reconcile the total adjustment to the
adjustment recorded in the general ledger before year-end.
 Using the calculated book-to-physical adjustments for each item, compare the quantities
and dollar amounts of each adjustment to the perpetual inventory file as of January 5, 2015,
13-10
and print out a report of differences for follow-up.
13-11
13-31
Basic Inventory-Auditing Procedures How a Generalized Audit Software
Package and Tape of the Inventory File
Data Might Be Helpful
1. Observation of the physical count, 1. By determining which items are to be
making and recording test counts test counted by selecting a random
where applicable. sample of a representative number of
items from the inventory file as of the
date of the physical count.
2. Testing of the mathematical 2. By mathematically computing the
accuracy of the inventory dollar value of each inventory item
compilation. counted by multiplying the quantity on
hand by the cost per unit and verifying
the addition of the extended dollar
values.
3. Comparison of the auditor's test 3. By arranging test counts in an
counts to the inventory records. electronic file format identical to the
inventory file and matching the data
files.
4. Comparison of physical count data 4. By comparing the total extended
to inventory records. values of all inventory items counted
and the extended values of each
inventory item counted to the
inventory records.
5. Testing of the inventory pricing by 5. By preparing an electronic data file in
obtaining a list of costs per item a format identical to the inventory file
from buyers, vendors, or other and matching the data files.
sources.
6. Examination of purchases and 6. By listing a sample of items on the
sales cutoff. inventory file for which the date of last
purchase and date of last sale are on or
immediately prior to the date of the
physical count.
7. Ascertainment of the propriety of 7. By listing items located in public
items of inventory located in warehouses.
public warehouses.
8. Analysis of inventory for evidence 8. By listing items on the inventory file
of possible obsolescence. for which the quantity on hand is
excessive in relation to the quantity
sold during the year.
13-12
9. Analysis of inventory for evidence 9. By listing items on the inventory file

of possible overstocking or slow- for which the quantity on hand is
moving items. excessive in relation to the quantity
sold during the year.
10. Performance of an overall test for 10. By listing items, if any, with negative
accuracy of inventory master file. quantities or costs.
13-32 a. 6
b. 3
c. 1
d. 4
e. 2
Solution to Discussion Case
13-33 a. The auditors did not follow several audit procedures in a satisfactory manner,
including:
 Control of count sheets during and after the inventory. There may not have been
adequate supervision and instruction of the inventory observation teams by the
auditors. There is no evidence that there was adequate preplanning of the inventory
count. Even though it is difficult to spend continuous time in the upper decks,
there must be a careful control over their contents and planned counting must still
be observed.
 Although the late addition of such sheets is highly irregular, the auditors did very
little to satisfy themselves of their accuracy. The altering of count sheets after the
auditors left could have been prevented by "lining out" unused portions of the count
sheet prior to leaving the inventory observation. Test counts of lines on sheets
could also have detected the changes.
 Physically examining inventory represented on additional count sheets with
specific assurances that the items did not represent duplications in the count.
Tracing the items to purchase invoices does not prove existence at the inventory
date, only that the items were at one time bona fide.
 Questions about inventory turnover and similar comparisons should have been
raised and addressed.
 If the additional items listed on the four additional sheets, the changing of unit
designations, or the fictitious amounts added to completed sheets created unusual
balances in specific inventory items, a review of the inventory balances and
comparison with previous years’ would have indicated unusual increases. Because
of the weaknesses in inventory control, audit procedures should have been
expanded.
b. Failure to obtain adequate evidence to support management's assertions can result in

13-13
legal liability from injured third parties and in fines and sanctions by the PCAOB and
the SEC. Possible PCAOB and SEC sanctions are discussed in Chapter 20. For
example, SEC sanctions can involve prohibition of appearing before the commission,
prohibition from accepting new SEC entities, and/or required peer reviews.
c. The following auditing standards (AICPA Clarified Standards) require that the auditor
communicate specific information to the audit committee. AU-C 265,
"Communicating Internal Control-Related Matters Identified in an Audit,” requires that
the auditor report to the audit committee, or to a similar level of authority if the entity
does not have an audit committee, matters which are referred to as reportable
conditions. AU-C 240, "Consideration of Fraud in a Financial Statement Audit,” and
AU-C 250, "Consideration of Laws and Regulations in an Audit of Financial
Statements,” state that the auditor should inform the audit committee or board of
directors of material fraud that is identified. AU-C 260, "The Auditor’s
Communication with Those Charged with Governance,” and PCAOB AS No. 16,
“Communications with Audit Committees,” require that the auditor communicate
certain matters related to the conduct of the audit to the audit committee and those
individuals responsible for oversight of the financial reporting process. For AU-C 260
the communication should address the following matters:
 The auditor's responsibility under GAAS.
 Significant accounting policies.
 Management judgments and accounting estimates.
 Significant audit adjustments.
 Disagreements with management.
 Consultation with other accountants.
 Major issues discussed with management prior to retention.
 Difficulties encountered during the audit.
AS No. 16 requires the following communications:

 Terms of the engagement (objectives and responsibilities)
 Information from the audit committee relevant to the audit
 An overview of the audit strategy, significant risks, and timing of the audit
 Timely observations arising from the audit that are significant to the financial
reporting process (e.g., quality of accounting policies and practices, unusual
transactions, quality of accounting estimates, difficult or contentious matters,
uncorrected or corrected misstatements, disagreements with management,
difficulties in performing the audit)
Solutions to Internet Assignment

13-34 A search of the SEC’s website should identify a recent company that has been cited by
the SEC for financial reporting problems related to inventory. For example SEC v. Thor
Industries is a litigation case where the SEC alleges that a fraud at the company resulted
in higher accounting profits being reported due to outdated inventory prices in the
accounting system.
13-14
13-15

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Chapter 13 - Auditing the Inventory Management Process

Solution Manual for Auditing and Assurance Services A

Answers to Review Questions

Inventory management: Maintenance of inventory at appropriate levels;

Segregation of Duties Possible Errors or Fraud as a

The inventory management function Production and inventory costs can be

13-12 Possible causes of book-to-physical inventory differences include:

Answers to Multiple-Choice Questions

b. Substantive tests that would document management’s completeness assertion as it

(a) Using the perpetual inventory file

(b) Using the physical inventory and test count files

and print out a report of differences for follow-up.

9. Analysis of inventory for evidence 9. By listing items on the inventory file

Solution to Discussion Case

b. Failure to obtain adequate evidence to support management's assertions can result in

AS No. 16 requires the following communications:

Solutions to Internet Assignment

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