Unit 4: Auditing Objectives and Procedures for Inventories and Cost of Goods Sold

Chapter topics:
1. Sources and nature of inventories and cost of goods Sold
2. The auditors’ objectives in examination of inventories and cost of goods sold
3. Internal controls over inventories and cost of goods sold.
4. Audit procedures for inventories and cost of goods sold.
4.1 Sources and nature of inventories and cost of goods Sold:
The term inventory is used in this section to include:
1) Goods on hand ready for sale, either the merchandise of a trading concern or the finished
goods of a manufacturer;
(2) Goods in the process of production; and
(3) Goods to be consumed directly or indirectly in production, consisting of raw materials,
purchased parts, and supplies.

Inventories have received much attention in both the accounting and auditing literature, as well
as in discussions among professional accountants. The reasons for the special significance
attached to inventories are readily apparent:
1. The valuation of goods on hand and in process often presents complex and difficult issues
2. Determining the quantities of inventories may require specialized techniques
3. Inventories often represent the largest current asset of a company
4. Misstatements of inventories directly affect cost of goods sold and, therefore, net income
5. Management fraud has often involved the fraudulent overstatement of inventories

4.2 The auditors’ objectives in examination of inventories and cost of goods sold:
The auditors’ objectives in the examination of inventories (and cost of goods sold) are to
determine that:
1. Use the understanding of the client and its environment to consider inherent risks, including
fraud risks, related to inventories and cost of goods sold.
2. Obtain an understanding of internal control over inventories and cost of goods sold.
3. Assess the risks of material misstatement and design tests of controls and substantive
procedures that:

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 a. Verify the existence of inventories and the occurrence of transactions affecting cost of
goods sold.
b. Establish the completeness of recorded inventories.
c. Verify the cutoff of transactions affecting cost of goods sold.
d. Determine that the client has rights to the recorded inventories.
e. Establish the proper valuation of inventories and the accuracy of transactions
affecting cost of goods sold.
f. Determine that the presentation and disclosure of information about inventories and
cost of goods sold are appropriate, including disclosure of the classification of
inventories, accounting methods used, and inventories pledged as collateral for debt.

4.3 Internal control over inventories and cost of goods sold:

The importance of adequate internal control over inventories and cost of goods sold from the
viewpoint of both management and the auditors can scarcely be overemphasized. In some
companies, management stresses internal controls over cash and securities but pays little
attention to control over inventories. Since many types of inventories are composed of items not
particularly susceptible to theft, management may consider internal controls to be unnecessary in
this area. Such thinking ignores the fact that an internal control performs other functions just as
important as fraud prevention.

Good internal control is a means of providing accurate cost data for inventories and cost of goods
sold as well as accuracy in reporting physical quantities. Inadequate internal control may cause
losses by permitting erroneous cost data to be used by management in setting prices and in
making other decisions based on reported profit margins. If the accounts do not furnish a
realistic picture of the cost of inventories on hand, the cost of goods manufactured, and the cost
of goods sold, the financial statements may be grossly misleading both as to earnings and as to
financial position.
Purchasing, receiving, storing, issuing, processing, and shipping are the physical functions
directly connected with inventories; the cost accounting system and the perpetual inventory
records comprise the recording functions. Since the auditors are interested in the final products
of the recording functions, it is necessary for them to understand and appraise the cost

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accounting system and the perpetual inventory records, as well as the various procedures and
original documents underlying the preparation of financial data.

The Purchasing function

Adequate internal control over purchases requires, first of all, an organizational structure that
delegates to a separate department of the company exclusive authority to make all purchases of
materials and services. The purchasing, receiving, and recording functions should be clearly
separated and lodged in separate departments.

Serially numbered purchase orders should be prepared for all purchases, and copies forwarded to
the accounting and receiving department.

The 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) The determination of quantities of goods received,
2) The detection of damaged or defective merchandise,
3) The preparation of a receiving report, and
4) The prompt transmittal of goods received to the stores department.

The storing function

As goods are delivered to stores, they are counted, inspected, and receipted for. The stores
department will then notify the accounting department of the amount received and placed in
stock. In performing these functions, the stores department makes an important contribution to
overall control of inventory. By signing for the goods, it fixes its own responsibility, and by
notifying the accounting department of actual goods stored, it provides verification of the
receiving department’s work.

The issuing function

The stores department, being responsible for all goods under its control, has reason to insist that
for all items passing out of its hands it be given a prenumbered requisition, which serves as a
signed receipt from the department accepting the goods. Requisitions are usually prepared in

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triplicate one copy is retained by the department making the request; another acts as the stores
department’s receipt; and the third is a notice to the accounting department for cost distribution.

The production function

The system of internal control over goods in process may include regular inspection procedures
to reveal defective work. This aids in disclosing inefficiencies in the productive system and also
tends to prevent inflation of the goods in process inventory by the accumulation of cost for goods
that will eventually be scrapped.

Control procedures should also assure that goods scrapped during the process of production are
promptly reported to the accounting department So that the decrease in value of goods in process
inventories may be recorded. Scrapped materials may have substantial salvage value, and this
calls for segregation and control of scrap inventories.

The shipping function

Shipments of goods should be made only after proper authorization has been received. This
authorization will normally be a sales order approved by the credit department; although the
shipping function also includes the returning of defective goods to suppliers. In this latter case,
the authorization may take the form of a shipping advice from a purchasing department
executive.

The cost accounting system

To account for the usage of raw materials and supplies, to determine the content and value of
goods in process inventories, and to compute the finished goods inventory, an adequate cost
accounting system is necessary. This system comprises all the records, orders, requisitions, time
tickets, and the like needed in a proper accounting for the disposition of materials as they enter
the flow of production and as they continue through the factory in the process of becoming
finished goods. The cost accounting system also serves to accumulate labor costs and indirect
costs that contribute to the goods in process and the finished goods inventories. The cost
accounting system thus forms an integral part of the internal control for inventories.

The perpetual inventory system

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Perpetual inventory records constitute a most important part of internal control. These records,
by showing at all times the quantity of goods on hand, provide information essential to intelligent
purchasing, sales, and production-planning policies. With such a record it is possible to guide
procurement by establishing points of minimum and maximum quantities for each standard item
stocked.

The use of a perpetual inventory system allows companies to control the high costs of holding
excessive inventory, while minimizing the risk of running out of stock. The company can
control inventories through reorder points and economic order quantities, including just-in-time
systems in which inventory levels are kept to a minimum.

4.4 Audit procedures for inventories and cost of goods sold:

The following audit procedures for the verification of inventories and cost of goods sold are
appropriate for a manufacturing company.
A) Consider internal control for inventories and cost of goods sold
1 Obtain an understanding of internal control.
As previously indicated, the consideration of internal controls may involve the filling out of a
questionnaire, the writing of descriptive memoranda, or the preparation of flowcharts depicting
organizational structure and the flow of materials and documents. All these approaches utilize
the same basic investigative techniques of interview and the conduct of a walk-through of the
system to determine that the system is accurately described.

During the review of internal controls over inventory, the auditors should become thoroughly
conversant with the procedures for purchasing, receiving, storing, and issuing goods and for
controlling production, as well as acquiring an understanding of the cost accounting system and
the perpetual inventory records. The auditors should also give consideration to the physical
protection for inventories.

2. Assess control risk and design additional tests of controls.

Control risk for a financial statement assertion may be assessed below the maximum only when
tests indicate that related controls are designed and operating effectively. The auditors must
decide which additional tests of controls will likely result in cost justified restrictions of
substantive tests.

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3. Perform additional tests of controls
a) Examine significant aspects of a sample of purchase transactions.
The proper recording of purchase transactions and of cash disbursements is essential to reliable
accounting records. Therefore, the auditors test the key control procedures in the client’s
purchasing transaction cycle. Tests of this cycle may include the following steps:
1) Select a sample of purchase transactions.
2) Examine the purchase requisition or other authorization for each purchase transaction in the
sample.
3) Examine the related vendor’s invoice, receiving report, and paid check for each purchase
order in the sample. Trace transactions to the voucher register and check register.
4) Review invoices for approval of prices, extensions, footings, freight, and credit terms.
5) Compare quantities and prices in the invoice, purchase order, and receiving report.
6) Trace postings from voucher register to general ledger and any applicable subsidiary
ledgers.

b) Test the cost accounting system

For a client in the manufacturing field, the auditors must become familiar with the cost
accounting system in use as a part of their consideration of internal control.

In any cost accounting system, the three elements of manufacturing cost are direct materials
costs, direct labor costs, and manufacturing overhead. Cost accounting systems may accumulate
either actual costs or standard costs according to processes or jobs. The auditors’ tests of the
client’s cost accounting system are designed to determine that costs allocated to specific jobs or
processes are appropriately compiled.

To achieve this objective, the auditors test the appropriateness of direct materials quantities and
unit costs, direct labor hours and hourly rates, and overhead rates and allocation bases.

4. Reassess control risk and design substantive tests.

The description and tests of controls of the client’s internal control for inventories and cost of
goods sold provide the auditors with evidence as to weaknesses and strengths of the system.

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Based on this information, the auditors reassess control risk and design their substantive testing
of inventories and cost of sales accordingly.

B) Substantive tests
5. Obtain listings of inventory and reconcile to ledgers.
The auditor will obtain a schedule of listings of inventory which will be reconciled to both the
general ledger and appropriate subsidiary ledgers. The auditors’ goal in performing this step is
to make sure the inventory records agree with what is recorded in the accounting system.

6. Evaluate the client’s planning of physical inventory.

Efficient and effective inventory taking requires careful planning in advance. Once the plan has
been developed, it must be documented and communicated in the form of written instructions to
the personnel taking the physical inventory. These instructions normally will be drafted by the
client and reviewed by the auditors, who will judge their adequacy.

If the instructions for taking inventory are adequate, then the auditors’ responsibility during the
count is largely a matter of seeing that the instructions are followed conscientiously.

7. Observe the taking of physical inventory and make test counts.

It is not the auditors’ function to take the inventory or to control or supervise the taking; this is
the responsibility of management. The auditors observe the inventory taking in order to obtain
sufficient competent evidence as to the existence and completeness of audit objectives.

Observation by the auditors also includes determining that all usable inventory owned by the
client is included in the count and that the client’s employees comply with the written inventory
instructions. As part of the process of observing the physical inventory, the auditors will be alert
to detect any obsolete or damaged merchandise included in inventory. Such merchandise should
be segregated by the client and written down to net realizable value. During their inventory
observation, the auditors will make test counts of selected inventory items.

8. Review the year-end cut off of purchases and sales transactions

An accurate cut off of purchases is one of the most important factors in verifying the accuracy
and completeness of the year-end inventory. Assume that a shipment of goods costing Br.
10,000 is received from a supplier on December 31, but the purchase invoice does not arrive

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until January 2 and is entered as a January transaction. If the goods are included in the December
31 Physical inventory but there is no December entry to record the purchase and the liability, the
result will be an overstatement of both net incomes for the year and retained earnings and an
understatement of accounts payable, each error being in the full amount of Br. 10, 000 (ignoring
income taxes).

An opposite situation may arise if a purchase invoice is received and recorded on December 31,
but the merchandise covered by the invoice is not received until several days later and is not
included in the physical inventory taken at the year-end. How can the auditors determine that the
liability to suppliers has been recorded for all goods included in inventory? Their approach is to
examine on a test basis the purchase invoices and receiving reports for several days before and
after the inventory date.

The sales cutoff is mentioned at this point to emphasize its importance in determining the
fairness of the client’s inventory and cost of goods sold as well as accounts receivable and sales.

9. Obtain a copy of the completed physical inventory, determine its clerical accuracy, and
trace test counts.
The testing of extensions and footings on the final inventory listing may disclose misstatements
of physical inventories. In testing extensions, the auditors should be alert for two sources of
substantial errors- misplaced decimal points and incorrect extension of count units by price units.
For example, an inventory listing that extends 1,000 units times Br.1C (Per hundred) as Br.1,000
will be overstated by Br.990. An inventory extension of 1,000 sheets of steel times Br. 1 per
pound will be substantially understated if each sheet of steel weighs more than one pound.

The auditors also should trace to the completed physical inventory their test counts made during
the observation of physical inventory. Another test of the clerical accuracy of the completed
physical inventory is the reconciliation of the physical counts to inventory records. Both the
quantities and the values of the items should be compared to the company’s perpetual records.

10. Review inventory quality and condition

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The auditors should also be alert during the course of their inventory observation for any
inventory of questionable quality or condition. Excessive dust or rust on raw materials inventory
items may be indicative of obsolescence or infrequent use.

The auditors should also review perpetual inventory records for indications of slow-moving
inventory items. Then, during the course of observing inventory taking, the auditor should
examine these slow-moving items and determine that the client has identified the items as
obsolete if appropriate.

11. Evaluate the bases and methods of inventory pricing.

The auditors are responsible for determining that bases and methods of pricing inventory are in
accordance with generally accepted accounting principles. The investigation of inventory
pricing often will emphasize the following three questions:
1) What method of pricing does the client use?
2) Is the method of pricing the same as that used in prior years?
3) Has the method officially selected by the client been applied consistently and accurately in
practice?

For the first question a long list of alternatives is possible, including such methods as cost; cost
or market, whichever is lower; the retail method; and quoted market price. The cost method, of
course, includes many diverse systems, such as last-in, first-out (LIFO); first-in, first-out (FIFO);
specific identification; weighted average.

For the second question the nature and justification of the change in method of valuing inventory
and its effect on income should be disclosed. To answer the third question the auditors must test
the pricing of a representative number of inventory items.

12. Test the pricing of inventories.

To determine whether the inventory valuation method used by the client has been properly
applied, the auditors must make tests of the pricing of selected items of finished goods, goods in
process and raw materials.

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As a general rule, inventories should not be carried at an amount in excess of net realizable
value. The lower-of-cost-or-market rule is a common means of measuring any loss of utility in
the inventories. If the inventory includes any discontinued lines or obsolete or damaged goods,
the client should reduce these items to net realizable value, which is often scrap value.

13. Perform analytical procedures

Material errors in counting, pricing, and calculating the physical inventory, as well as fictitious
or obsolete inventory, may be disclosed by analytical procedures designed to establish the
general reasonableness of the inventory figures.
A comparative summary of inventories classified by major types, such as raw materials, goods in
process, finished goods, and supplies, should be obtained or prepared. Explanations should be
obtained for all major increases or decreases from the prior year’s amounts.
14. Determine whether any inventories have been pledged and review purchase and sales
commitments.
The verification of inventories includes a determination by the auditors as to whether any goods
have been pledged. In some lines of business, it is customary to enter into firm contracts for the
purchase of merchandise or materials well in advance of the scheduled delivery dates.
Comparison by the auditors of the prices quoted in such commitments with the vendors’ prices
prevailing at the balance sheet date may indicate substantial losses if firm purchase commitments
are not protected by firm sales contracts. Such losses should be reflected in the financial
statements.
15. Evaluate financial statement presentation of inventories and cost of goods sold,
including the adequacy of disclosure.

One of the most important factors in proper presentation of inventories in the financial
statements is disclosure of the inventory pricing method or methods in use. Other important
points in presenting inventories in the financial statements include the following:
1) Changes in methods of valuing inventory should be disclosed and the dollar effect and
justification for the change reported.
2) A separate listing is desirable for the various classifications of inventory, such as finished
goods, goods in process, and raw materials.

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3) If any portion of the inventory has been pledged to secure liabilities, full disclosure of the
arrangement should be made.
4) Deduction of valuation allowance for inventory losses from the related inventory.
5) Disclosure of the existence and the terms of inventory purchase commitments.

Table 2.8: Assertions, Objectives and Procedures for Purchases and Inventory
Financial report Specific audit objective Common audit procedures to achieve
assertions objectives
Existence Inventories included in the .inspection of physical inventory
statement of financial position (checking from inventory records to
physically exist and represent physical stock)
items held for sale in the ordinary .analytical procedures
course of business. .Confirm stock held at other location
Occurrence Transaction of purchase and cash .Select transactions from purchases
payments occurred during the journal and agree to supporting
period. documentation ( i.e. goods received note)
.select transaction from cash payments
journal and agree to supporting
documents (e.g. supplier’s invoices)
Completeness Inventory quantities include all .inspection of physical inventory
items on hand or in transit. (checking from physical stock to records)
Inventory listings are accurately .analytical procedures
compiled and properly included .inquire about stock held at other
in the inventory accounts. locations
Rights and The entity has legal title or Check legal ownership or goods being
obligations ownership rights to inventory shipped and goods on consignment
items, and inventories exclude
items billed to customers or
owned by others.
Measurement Inventory transactions are .check dollar value of purchases to
recorded in the correct amount inventory price list.
and period .agree dollar value of cash payments to
supporting documents (e.g. supplier’s
invoice)
.check last purchase and sales recorded
before balance date and first purchases
recorded after balance date are recorded
in correct period (cut-off)
.test clerical accuracy of inventory listing

Valuation Inventories are properly stated .test of pricing and summarization

with respect to: .analytical procedures

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 .cost determined by an acceptable
method consistently applied
.slow-moving, excess, defective,
and obsolete items identified
.reduced to net realizable value if
lower than cost
Disclosure Inventories are properly described
and classified in the statement of
financial position and related
disclosures are adequate.
.observation of physical inventory (look
for obsolete or damaged items)
.Inquire and scanning
.check subsequent sales price and
compare with cost
.inquiry and scanning
.general procedures

There are 4 internal control objectives and associated potential errors or frauds and their related
audit procedures for inventory. These objectives are:
• Authorization
• Execution/implementation
• Recording
• Access to assets
Table 2.9: Authorization: Inventory Objective, Error, And Procedure
Objective Error Procedure
Production should be authorized in Unauthorized quantities, or Prepare
accordance with management’s products may be statements of
criteria produced; potentially Criteria for
resulting in obsolete, determining
excess, or otherwise which products
unusable inventory and are to be
excess carrying cost produced & in
what quantities.
Execution: Inventory Objective, Error, Procedure
Objective Error Procedure
Procedures for using and Unauthorized personnel may Prepare Inventory processing manuals
physically transferring avoid existing procedures, including procedures for controlling
inventory should be potentially resulting in stolen, inventory movement.
established in accordance with or misused inventory Restrict access to inventory to
management’s authorization authorized personnel.
Inventory may be misplaced,
potentially resulting in unused
assets

Recording: Inventory Objectives, Errors, Procedures

Objectives Errors Procedures

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Inventory used or transferred Inventory placed in production Establish processing and recording
should be recorded at proper may not be recorded, procedures;
amounts, period, and potentially resulting in
classification misstated inventory and CGS. Pre-number, and control materials release
forms and production orders

Inventory-related Adjustments Unauthorized adjustments Establish policies for approving and

should be authorized in may be recorded to conceal recording adjustments;
accordance with management’s physical storages, potentially
criteria resulting in misused and , Pre-number, and control inventory adjustment
misstated inventory forms

Access: Inventory Objectives, Errors, Procedures

Objectives Errors Procedures
Access to inventory should be Inventory could be stolen, lost, Establish Physical controls over inventory;
restricted personnel authorized by or diverted, potentially resulting
management in misapplied and misstated Maintain insurance and fidelity bonds for
assets personnel handling valuable inventory

Maintain adequate insurance coverage for assets

Segregate responsibility for handling inventory

from inventory recording.
Access to production, cost Inventory Records could be Establish Physical controls over unused forms and
accounting and perpetual inventory misused, destroyed, or lost, records; Maintain files of authorized signatures,
records should be, records potentially resulting in misstated
restricted to personnel authorized inventory.
by management.

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