Auditing and Assurance Services

Seventeenth Edition, Global Edition

Chapter 20
Audit of the Inventory and
Warehousing Cycle

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Learning Objectives (1 of 2)
20.1 Describe the business functions and the related
documents and records in the inventory and
warehousing cycle
20.2 Explain the five parts of the audit of the inventory and
warehousing cycle
20.3 Design and perform audit tests of cost accounting
20.4 Apply substantive analytical procedures to the
accounts in the inventory and warehousing cycle

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Learning Objectives (2 of 2)
20.5 Design and perform physical observation audit tests for
inventory
20.6 Design and perform audit tests of pricing and
compilation for inventory
20.7 Integrate the various parts of the audit of the inventory and
warehousing cycle

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Learning Objective 20.1
Describe the business functions and the related documents
and records in the inventory and warehousing cycle

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Business Functions in the Cycle
and Related Documents and
Records (1 of 3)
• The inventory and warehousing cycle can be thought of as
comprising two separate but closely related systems:
– The physical flow of goods
– The related costs

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Business Functions in the Cycle
and Related Documents and
Records (2 of 3)
• There are six functions that make up the inventory and
warehousing cycle:
– Process purchase orders
– Receive raw materials
– Store raw materials
– Process the goods
– Store finished goods
– Ship finished goods

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Business Functions in the Cycle
and Related Documents and
Records (3 of 3)
• A perpetual inventory master file is a type of record used for
inventory which typically includes information about the units
of inventory acquired, sold, and on hand
• Separate computerized perpetual records are likely to be kept
for raw materials, work-in-process, and finished goods

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Figure 20.1 Flow of Inventory and Costs

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Learning Objective 20.2
Explain the five parts of the audit of the inventory and
warehousing cycle

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Parts of the Audit of Inventory
• The audit of the inventory and warehousing cycle can be
divided into five activities within the cycle:
– Acquire and record raw materials, labor, and overhead
– Internally transfer assets and costs
– Ship goods and record revenue and costs
– Physically observe inventory
– Price and compile inventory

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Figure 20.2 Functions in the
Inventory and Warehousing Cycle

*
Inventory counts are taken and compared with perpetual and book amounts at any stage of the cycle. The auditor
compares the documentation related to the receipt, movement, and sale of inventory with the physical location of the
items to ensure proper cut off and classification of inventory as raw material, work in process, or finished goods. A
count must ordinarily be taken once a year. If the perpetual inventory system is operating well, this can be done on a
cycle basis throughout the year.

†
Includes cost information for materials, direct labor, and overhead.

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Figure 20.3 Audit of Inventory

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Learning Objective 20.3
Design and perform audit tests of cost accounting

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Audit of Cost Accounting (1 of 3)
Cost accounting systems and controls of different
companies vary more than most other audit areas because
of the wide variety of items of inventory and the level of
sophistication desired by management

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Audit of Cost Accounting (2 of 3)
• Cost accounting controls are those related to processes affecting
physical inventory and the tracking of related costs
• There are two broad categories of controls:
– Physical controls over raw materials, work-in-process, and
finished goods inventory
– Controls over the related costs

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Audit of Cost Accounting (3 of 3)
• The concepts in auditing inventory cost accounting are no
different from those discussed for other transaction cycles
• The auditor is concerned with four aspects of cost
accounting:
– Physical controls over inventory
– Documents and records for transferring inventory
– Perpetual inventory master files
– Unit cost records

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Let’s Discuss (1 of 7)
• Give the reasons why inventory is often the most difficult and
time-consuming part of many audits.
• State what is meant by cost accounting records and explain their
importance in the conduct of an audit.

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Let’s Discuss (2 of 7)
• Many auditors assert that certain audit tests can be significantly
reduced for clients with adequate perpetual records that include
both unit and cost data.
– What are the most important tests of the perpetual records
that the auditor must make before reducing assessed control
risk?
– Assuming the perpetuals are determined to be accurate,
which tests can be reduced?

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Learning Objective 20.4
Apply substantive analytical procedures to the accounts in
the inventory and warehousing cycle

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Substantive Analytical Procedures (1 of 2)
• Substantive analytical procedures are important for auditors to
examine the relationship of inventory account balances with
other financial statement accounts
• Auditors often use nonfinancial information to assess the
reasonableness of inventory-related balances

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Substantive Analytical Procedures (2 of 2)
• Inventory is often the largest asset on the balance sheet for
many companies
• Significant improvements in audit effectiveness and efficiency
may be achieved by use of audit data analytics
• Auditors may be able to use audit software to test entire
populations for certain audit tests, eliminating the need for
more costly tests involving sampling

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Table 20.1 Substantive Analytical Procedures
for the Inventory and Warehousing Cycle

Substantive Analytical Procedure Possible Misstatement

Compare gross margin percentage with that Overstatement or understatement of
of previous years. inventory and cost of goods sold.
Compare inventory turnover (cost of goods Obsolete inventory, which affects inventory
sold divided by average inventory) with and cost of goods sold.
that of previous years. Overstatement or understatement of
inventory.
Compare unit costs of inventory with those Overstatement or understatement of unit
of previous years. costs, which affects inventory and cost of
goods sold.
Compare extended inventory value with that Misstatements in compilation, unit costs, or
of previous years. extensions, which affect inventory and
cost of goods sold.
Compare current-year manufacturing costs Misstatements of unit costs of inventory,
with those of previous years (variable especially direct labor and manufacturing
costs should be adjusted for changes in overhead, which affect inventory and
volume). cost of goods sold.

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Let’s Discuss (3 of 7)
• List the major substantive analytical procedures for testing the
overall reasonableness of inventory.
– For each test, explain the type of misstatement that could be
identified.

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Learning Objective 20.5
Design and perform physical observation audit tests for inventory

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Physical Observation of Inventory
(1 of 3)

• Obtaining an understanding of the client’s industry and business

is more important for both physical inventory observation and
inventory pricing and compilation than for most audit areas
• Auditors often first familiarize themselves with the client’s
inventory by conducting a tour of the client’s inventory
facilities, including receiving, storage, production, planning,
and record-keeping areas

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Physical Observation of Inventory
(2 of 3)

• Auditing standards require auditors to meet following

inventory observation requirements:
– Be present at the time the client counts its inventory
– Observe the client’s counting procedures
– Make inquiries of client personnel about their counting
procedures
– Make their own independent tests of the physical count

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Physical Observation of Inventory
(3 of 3)

• Adequate controls over the client’s physical count of

inventory include:
– Proper client instructions for the physical count
– Supervision by responsible company personnel
– Independent internal verification
– Independent reconciliations of the physical counts with
perpetual inventory master files

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Let’s Discuss (4 of 7)
• What major audit procedures are involved in testing for the
ownership of inventory during the observation of the physical
counts and as a part of subsequent valuation tests?
• Assuming that the auditor properly documents receiving report
numbers as a part of the physical inventory observation
procedures.
– Explain how the proper cutoff of purchases, including tests
for the possibility of raw materials in transit, should be
verified later in the audit.

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Learning Objective 20.6
Design and perform audit tests of pricing and compilation for
inventory

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Audit of Pricing and Compilation
(1 of 3)

• Auditors must verify that the physical counts or perpetual

record quantities are correctly priced and compiled
• Inventory price tests include all the tests of the client’s unit
prices to determine whether they are correct
• Inventory compilation tests include testing the client’s
summarization of the inventory counts, recalculating price times
quantity, footing the inventory summary, and tracing the totals
to the general ledger

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Audit of Pricing and Compilation
(2 of 3)

Adequate internal controls surrounding the tracking of unit costs

that are integrated with production and other accounting records
provide assurance that clients use reasonable costs for valuing
ending inventory

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Audit of Pricing and Compilation
(3 of 3)

• In performing inventory valuation tests, the auditor has

three concerns:
– The method must be in accordance with accounting
standards
– The application of the method must be consistent from year
to year
– Inventory cost versus market value must be considered

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Let’s Discuss (5 of 7)
• Explain why a proper cutoff of purchases and sales is heavily
dependent on the physical inventory observation.
– What information should be obtained during the physical
count to ensure that cutoff is accurate?
• Explain the importance of documenting used, unused, and
voided tags at the end of the physical inventory observation.
– How will the auditor use this information in follow-up
inventory testing?

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Let’s Discuss (6 of 7)
• A client applies manufacturing overhead to inventory on the
basis of $3.47 per direct labor hour.
– Explain how the auditor will evaluate the reasonableness of
total direct labor hours and manufacturing overhead in the
ending inventory of finished goods.
• Define what is meant by compilation tests.
– List several examples of audit procedures to verify
compilation.

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Learning Objective 20.7
Integrate the various parts of the audit of the inventory and
warehousing cycle

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Integration of the Tests
• The audit of the inventory and warehousing cycle consists of
the following series of integrated tests:
– Tests of the acquisition and payment cycle
– Tests of the payroll and personnel cycle
– Tests of the sales and collection cycle
– Tests of cost accounting
– Physical inventory, pricing, and compilation

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Let’s Discuss (7 of 7)
• Each employee of the Gedding Manufacturing Co., a firm using
a job cost inventory costing method, must reconcile his or her
total hours worked with the hours worked on individual jobs
using a job time record when the weekly payroll records are
submitted. The total hours worked on the job time record must
agree to the total on the time record.
– Explain how you could test the direct labor dollars included
in inventory as a part of the payroll and personnel tests.

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