Auditing and Assurance Services

A Systematic Approach
Eleventh Edition

Chapter 13

Auditing the
Inventory
Management Process

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 Learning Objective 13-1

FIGURE 13-1 The Relationship of the Inventory

Management Process to Other Accounting
Processes

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 Learning Objective 13-2

Types of Documents and Records

(1 of 2)
1. Production Schedule – Based on the expected
demand for the entity’s products.

2. Receiving Report – Records the receipt of goods from

vendors.

3. Materials Requisition – Used to track materials during

the production process.

4. Inventory Master File – Contains all the important

information related to the entity’s inventory, including
the perpetual inventory records.

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 Learning Objective 13-2

Types of Documents and Records

(2 of 2)
5. Production Data Information – Contains information
about the transfer of goods and related cost
accumulation at each stage of production.

6. Cost Accumulation and Variance Report – Material,

labor, and overhead costs are charged to inventory as
part of the manufacturing process. The variance report
compares actual costs to standard or budgeted costs.

7. Inventory Status Report – Shows the type and

amount of products on hand.

8. Shipping Order – Used to remove goods from the

perpetual inventory records.

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 Learning Objective 13-3

The Major Functions

Functions in the Inventory Management Process

Authorization of production activity and maintenance of
Inventory management inventory at appropriate levels; issuance of purchase
requisitions to the purchasing department.

Custody of raw materials and issuance of raw materials to

Raw materials stores
manufacturing departments.

Manufacturing Production of goods.

Custody of finished goods and issuance of goods to the
Finished goods stores
shipping department.
Maintenance of the costs of manufacturing and inventory in
Cost accounting
cost records.

Proper accumulation, classification, and summarization of

General ledger
inventory and related costs in the general ledger.

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Key Segregation of Duties (1 of 2)
Segregation of Duties
The inventory management function should be
segregated from the cost-accounting function.
The inventory stores function should be
segregated from the cost-accounting function.
The cost-accounting function should be
segregated from the general ledger function.
The responsibility for supervising physical
inventory should be separated from the
inventory management and inventory stores
functions.
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Learning Objective 13-4
Possible Errors or Fraud
If the individual responsible for inventory
management also has access to the cost-
accounting records, production and inventory
costs can be manipulated. This may lead to an
over- or understatement of inventory and net
income.
If one individual is responsible for both controlling
and accounting for inventory, unauthorized
shipments can be made or theft of goods can be
covered up.
If one individual is responsible for the inventory
records and also for the general ledger, it is
possible for that individual to conceal unauthorized
shipments. This can result in the theft of goods,
leading to an overstatement of inventory.
If the individual responsible for production
management or inventory stores functions is also
responsible for the physical inventory, it is
possible that inventory shortages can be covered
up through the adjustment of the inventory
records to the physical inventory, resulting in an
overstatement of inventory.
13-6
 Learning Objective 13-4

Key Segregation of Duties (2 of 2)

Segregation of duties is a particularly important control in the inventory
management process because of the potential for theft and fraud.
Department

Raw
Inventory Finished Cost
Inventory Function Materials IT
Management Goods Stores Accounting
Stores
Preparation of production
schedules X
Issuance of Materials
requisitions that accompany
goods to the manufacturing X
department
Updating of cost records
with materials, labor, and X X
overhead usage
Updating of inventory
records X X
Release of goods to the
shipping department X
Approval and issuance of
purchase requisitions X
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 Learning Objective 13-5

Inherent Risk Assessment

The auditor should consider industry-related factors
and operating and engagement characteristics when
assessing the possibility of a material misstatement.

Products that are small and of

high value are more susceptible
If industry competition is intense,
to theft. The auditor must be alert
there may be problems with the
to related-party transactions
proper valuation of inventory.
for acquiring raw materials and
Technology changes in certain
selling finished products. Prior-
industries may also promote
year misstatements are good
material misstatement due to
indicators of potential
obsolescence.
misstatements in the current
year.

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 Learning Objective 13-6

Control Risk Assessment

Major steps in setting the control risk in the
inventory management process.

Understand and document the inventory

management process based on a reliance strategy.

Plan and perform tests of controls on inventory

transactions.

Set and document the control risk for the inventory

management process.

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 Learning Objective 13-7

Control Activities and Tests of Controls – Inventory Transactions (1 of 8)

Assertion Test of Controls

Observe and evaluate proper segregation of duties. Review and test procedures for
transfer of inventory. Review and test procedures for issuing materials to manufacturing
Occurrence
departments. Review and test entity procedures for account for numerical sequence of
materials requisitions. Observe the physical safeguards over inventory.

Completeness Review and test entity's procedures for consignment goods.

Review authorized production schedules. Review and test procedures for developing
Authorization
inventory levels and procedures used to control them.

Review and test procedures for taking physical inventory. Review and test procedures
used to develop standard costs. Review and test cost accumulation and variance
Accuracy reports. Review and test procedures for identifying obsolete, slow-moving, and excess
quantities. Review the reconciliation of perpetual inventory to general ledger control
account.
Review and test procedures for processing inventory included on receiving reports into
Cutoff the perpetual records. Review and test procedures for removing inventory from
perpetual records based on shipments of goods.
Classification Review the procedures and forms used to classify inventory.
Review inventory reports, general ledger and chart of accounts for proper aggregation
or disaggregation. Review procedures and forms used to develop inventory disclosures;
Presentation
if IT application, testing of application controls for proper codes. Review disclosure
checklist and related disclosures for relevance and completeness.

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 Learning Objective 13-7

Control Activities and Tests of Controls – Inventory Transactions (2 of 8)

Occurrence of Inventory Transactions

The auditor’s main concern is that all recorded

inventory transactions actually occurred. The auditor
should also be concerned that goods may be stolen.
Review and observation are the main tests of controls
used by the auditor to test the control procedures.

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 Learning Objective 13-7

Control Activities and Tests of Controls – Inventory Transactions (3 of 8)

Completeness of Inventory Transactions

The primary control procedures for completeness

relates to recording inventory that has been received.
Controls are closely related to the purchasing process.

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 Learning Objective 13-7

Control Activities and Tests of Controls – Inventory Transactions (4 of 8)

Authorization of Inventory Transactions

The auditor’s concern with authorization in the

inventory system is with unauthorized purchase or
production activity that may lead to excess levels of
certain types of finished goods.

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 Learning Objective 13-7

Control Activities and Tests of Controls – Inventory Transactions (5 of 8)

Accuracy of Inventory Transactions

Inventory transactions that are not properly recorded
result in misstatements that directly affect the
amounts reported in the financial statements.
Inventory purchases must be recorded at the correct
price and actual quantity received. Inventory shipped
must be properly recorded in cost of goods sold and
the related revenue recognized.

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 Learning Objective 13-7

Control Activities and Tests of Controls – Inventory Transactions (6 of 8)

Cutoff of Inventory Transactions

Inventory transactions recorded in the improper
period could affect a number of accounts, including
inventory, purchases and cost of goods sold.

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 Learning Objective 13-7

Control Activities and Tests of Controls – Inventory Transactions (7 of 8)

Classification of Inventory Transactions

The entity must have control procedures to ensure

that inventory is properly classified as raw materials,
work in process, or finished goods. By knowing which
manufacturing department holds the inventory, the
auditor is able to classify it by type.

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 Learning Objective 13-7

Control Activities and Tests of Controls – Inventory Transactions (8 of 8)

Presentation of Inventory Transactions

Auditor’s tests of controls around management’s use
of a chart of accounts, proper codes for recording
inventory transactions, and the financial reporting
process, including the use of a disclosure checklist,
should provide adequate assurance for the
presentation assertion.
Controls over the aggregation or disaggregation of
transactions are important to properly allocate costs
to appropriate classes of inventory.

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 Learning Objective 13-8

Auditing Inventory (1 of 4)
Assertions about Classes of Transactions and Events:

Occurrence All inventory transactions and events that

have been recorded or disclosed have
occurred and are valid, and such
transactions and events pertain to the
entity.
Completeness All inventory transactions and events that
should have been recorded have been
recorded, and all related disclosures that
should have been included in the financial
statements have been included.
Authorization All inventory transactions and events have
been properly authorized.
Classification All inventory transactions and events have
been recorded in the proper accounts.

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 Learning Objective 13-8

Auditing Inventory (2 of 4)
Accuracy Amounts and other data relating to
inventory transactions and events have
been recorded appropriately, and related
disclosures have been appropriately
measured and described.
Cutoff All inventory transactions and events have
been recorded in the correct accounting
period.

Presentation All inventory transactions and events are

appropriately aggregated or disaggregated
and clearly described, and related
disclosures are relevant and
understandable in the context of the
requirements of the applicable financial
reporting framework.

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 Learning Objective 13-8

Auditing Inventory (3 of 4)
Assertions about Account Balances at the Period End:

Occurrence Inventory recorded on the books and

records actually exists.

Completeness All inventory related accounts that should

have been recorded have been recorded,
and all related disclosures that should have
been included in the financial statements
have been included.

Accuracy, Inventory accounts are included in the

Valuation, financial statements at appropriate
amounts, any resulting valuation or
and
allocation adjustments are appropriately
Allocation recorded, and related disclosures have
been appropriately measured and
described.

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 Learning Objective 13-8

Auditing Inventory (4 of 4)
Classification All inventory is recorded in the proper
accounts.

Completeness Inventory accounts are appropriately

aggregated or disaggregated and clearly
described, and related disclosures are
relevant and understandable in the context
of the requirements of the applicable
financial reporting framework.

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 Learning Objective 13-9

Substantive Analytical Procedures

Substantive Analytical Procedures Possible Misstatement Detected
Inventory turnover to previous years' and Obsolete, slow-moving, or excess
industry averages. inventory

Compare days outstanding in inventory to Obsolete, slow-moving, or excess

previous years' and industry average. inventory

Compare quarterly gross profit percentage

by product line with quarterly values in Unrecorded or fictitious inventory
previous years and industry
Compare actual cost of goods sold to
Over- or understated inventory
budgeted amounts.
Compare current-year standard costs with
prior years' after considering current Over- or understated inventory
conditions.
Compare quarterly actual manufacturing Inclusion or exclusion of overhead costs
overhead costs with quarterly budgeted or
standard overhead costs.

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 Learning Objective 13-10

Auditing Standard Costs

Materials Labor
Test the quantity Gather evidence
and type of about the type and
materials included amount of labor
in the product and needed for
the price of the production and the
materials. Overhead labor rate.
Review the entity’s
method of
overhead allocation
for reasonableness,
compliance with
GAAP, and
consistency.

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 Learning Objective 13-11

Observing Physical Inventory

(1 of 2)
During the observation of the physical inventory
count, the auditor should do the following:
1. Ensure that no production is scheduled. If production is
scheduled proper controls must be established for
movement between departments in order to prevent double
counting.
2. Ensure that there is no movement of goods during the
inventory count.
3. Make sure that the entity’s count teams are following the
inventory count instructions.
4. Ensure that inventory tags are issued sequentially to
individual departments.

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 Learning Objective 13-11

Observing Physical Inventory

(2 of 2)
5. Perform test counts and record a sample of counts in the
working papers.
6. Obtain tag control information for testing the entity’s
inventory compilation.
7. Obtain cutoff information, including the number of the last
shipping and receiving documents issued.
8. Observe the condition of the inventory for items that may
be obsolete, slow moving, or carried in excess quantities.
9. Inquire about goods held on consignment for others or held
on a “bill-and-hold” basis.

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 Learning Objective 13-12

Tests of Details of Transactions

Substantive Tests of Transactions
Vouch a sample of inventory additions to receiving reports
Occurrence
and purchase requisitions.

Completeness Trace a sample of receiving reports to the inventory records.

Test a sample of inventory shipments to ensure there is an

Authorization
approved shipping ticket and customer sale.

Recompute the mathematical accuracy of a sample of

Accuracy inventory transactions. Audit standard costs or other methods
used to price inventory.

Trace a sample of time cards before and after period end to

Cutoff
the appropriate weekly inventory report.

Examine a sample of inventory checks for proper classification

Classification
into expense accounts.

Review disclosure checklist and related disclosures for

Presentation
relevance and completeness.

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 Learning Objective 13-12

Tests of Details of Account

Balances (1 of 2)
Test of Details of Account Balances

Existence Observe count of physical inventory.

Trace test counts and tag control information to the inventory

Completeness
compilation.
Verify that inventory held on consignment for others or “bill-
and-hold” goods are not included in inventory. Inquire of
Rights and management about issues related to warranty obligations.
Obligations Inquire of management and review any loan agreements and
board of directors’ minutes for any indication that inventory
has been pledge or assigned.
Obtain a copy of the inventory compilation and agree totals to
general ledger. Test mathematical accuracy of extensions and
Valuation and foot the inventory compilation. Inquire of management
Allocation concerning obsolete, slow-moving, or excess inventory.
Review book-to-physical adjustment for possible
misstatements.

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 Learning Objective 13-12

Tests of Details of Account

Balances (2 of 2)
Review inventory compilation for proper classification among
Classification
raw materials, work in process, and finished goods.

Review disclosure checklist and related disclosures for

relevance and completeness. Review inventory purchase
contracts for proper disclosure of long-term contracts, related
party transactions, and assigned and consigned inventory.
Presentation
Determine if cost method is accurately disclosed (e.g., LIFO).
Inquire of management about issues related to LIFO
liquidations. Read the financial statements and evaluate that
disclosures are relevant and understandable.

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 Learning Objective 13-12

Tests of Details of Transactions, Account

Balances, and Disclosures (1 of 2)

The auditor should investigate any large adjustments

between the amount of inventory shown in the
general ledger account and the amount determined
from the physical inventory count (book-to-physical
adjustments) for possible misstatements.

Possible causes of book-to-physical differences:

1. Inventory cutoff errors
2. Unreported scrap or spoilage
3. Pilferage or theft

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 Learning Objective 13-12

Tests of Details of Transactions, Account

Balances, and Disclosures (2 of 2)
Examples of Disclosure Items:
1. Cost method (FIFO, LIFO, retail method)
2. Components of inventory
3. Long-term purchase contracts
4. Consigned inventory
5. Purchases from related parties
6. LIFO liquidations
7. Pledged or assigned inventory
8. Disclosure of unusual losses from write-downs or losses on
long-term purchase commitments
9. Warranty obligations

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 Learning Objective 13-13

Evaluating the Audit Findings –

Inventory
At the conclusion of testing, the auditor should
aggregate all identified misstatements. The likely
misstatement is compared to the tolerable
misstatement allocated to the inventory account.

Likely misstatement < Tolerable misstatement

The auditor may accept the inventory account as
fairly presented.

Likely misstatement > Tolerable misstatement

The auditor must conclude the inventory is not fairly
presented.

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