CHAPTER 3

AUDIT OF INVENTORY AND

COST OF GOODS SOLD

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 Learning objectives
After studying this chapter, students can:
- Understand the characteristics of inventory and cost of goods sold;
- Determine the objectives of auditing for inventory items and cost of
goods sold;
- Risk analysis and design of internal controls over inventory and cost of
goods sold;
- Carry out procedures for auditing inventory and cost of goods sold

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 AUDIT OF INVENTORY AND COST OF GOODS SOLD

3.1
 Contents and characteristics of items

3.2  Internal control over Inventory and

Cost of Goods Sold

3.3
 Audit procedures

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 Learning Materials
•Textbook:

[1] Alvin A. Arens, Mark S Beasley, Randal J Elder (2020), Auditing

and Assurance services – an integrated approach, 17th edition.
•Other materials:
[2] Bộ môn Kiểm toán (2019), Kiểm toán. Đại học kinh tế TP.HCM,
NXB Lao Động Xã Hội.
[3] Trần Thị Hải Vân & cộng sự (2016), Tóm tắt lý thuyết và Bài tập
thực hành Kiểm toán doanh nghiệp, Đại học Ngân hàng TP.HCM
[4] Các website: www.mof.gov.vn; www.vacpa.org.vn;...

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 Preparatory questions

Question 1: What are the audit objectives of inventory on financial

statements?
Question 2: Describe the audit procedures used by auditors for
auditing inventory.
Question 3: What are the internal controls for inventory?
Question 4: Why is inventory often considered an important item on
financial statements?
Question 5: What are the audit procedures for inventory provision?

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 AUDIT OF INVENTORY AND COST OF GOODS SOLD

3.1
 Contents and characteristics of items

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 3.1.1. Contents

Inventories are assets:

Kept for sale in normal production and business periods;
In the process of unfinished business;
 Raw materials, materials, tools, tools for use in
production, business, or service provision.

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 3.1.1. Contents

Inventory is recorded at cost (the original price). In case the net

realizable value is lower than the cost, inventory must be
adjusted to the net realizable value.
Cost of inventory includes procurement costs, processing costs,
and other directly related costs incurred to obtain inventory in the
current location and state.
Realized net value is the estimated selling price of inventory in
the normal sales period minus (-) the estimated cost to complete
the product and the estimated cost required for their
consumption.

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 3.1.1. Contents

Cost of goods sold (COGS)

-COGS is an important indicator in the financial statements,

specifically in the report of business results of the enterprise.

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 3.1.2. Item characteristics

Presentation of Inventory and COGS on financial statements

Principles of Inventory evaluation: Inventory is evaluated
according to the original price;
Inventory value determination method: specific identification
method, weighted average, FIFO.
- Inventory accounting method: perpetual inventory or periodic
inventory;

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 3.1.1. Contents

Inventory often accounts for a large proportion of the total short-term assets;
Inventory is an item that is sensitive to fraud and has a high risk of loss especially if
inventory is of high value and easy to move.
Can be stored in many places making control and management difficult.
The valuation of Inventory contains many subjective factors that lead to the risk that
Inventory can be used to create fraud on financial statements;
Determination of the amount of Inventory usually requires specialized techniques;
Errors in Inventory data directly affect COGS and the net profit of the enterprise;
• Indicators related to Inventory are often widely used by many people inside and
outside enterprises to make decisions.

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 3.1.3. Audit objectives

Existence: Inventory reflected on the balance sheet actually exists;

Completeness: Inventory is recorded at the time of making the report, it

included a full range of materials, tools and goods,.. ;

Rights: Inventory reflects on the balance sheet owned by the business;

Evaluation and allocation: Inventory is reflected in its true value;

Presentation and disclosure: Inventory is properly presented and

classified on the financial statements

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 AUDIT OF INVENTORY AND COST OF GOODS SOLD

3.2  Internal control over Inventory and

Cost of Goods Sold

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 3.2.1. Control objectives

 Physical control: The use of separate warehouses and areas to restrict access
to warehouses of raw materials, goods, finished products, unfinished
products is a major and effective control procedure to protect assets.

 Recording process control: Documents must be numbered, and reviewed

before allowing goods to move. This will have the effect of protecting assets.
On the other hand, the inventory process needs to be separate from those
who protect and manage assets. General books and details of inventory
goods must be fully monitored in terms of quantity, quality, and quality of
end-of-period inventory, as well as separate from the responsibilities of
management departments to have a basis for investigation when
discrepancies arise between inventory and books.

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 3.2.1. Control activities

PURCHASING AND PRODUCTION CYCLE

Inventory Manufacturing Finished product

Warehouse process warehouse

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 AUDIT OF INVENTORY AND COST OF GOODS SOLD

3.3
Audit procedures

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 3.3.1. Risk assessment

Preliminary assessment of control risks:

Control procedure: Limit substantive tests

Low Control R
Effective Perform tests of control

Control procedure:
High Control R Perform tests of details
Weakness

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 3.3.1. Risk assessment

- No inventory stocktaking at 31/12 fiscal year;

- Record inventory without full invoices and valid documents: no
warehouse receipts, no delivery minutes, no inventory quality assessment
minutes;
- Identifying and incorrectly recording the original price of
inventory;
- Not go through the warehousing procedure for each entry, but
the warehouse voucher is pooled for a long period of time.
- No regular reconciliation between storekeepers and accountants.
- Actual inventory differences and accounting books, warehouse
cards, detailed book differences, ledgers, and balance sheets have not
identified the cause and handled promptly;

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 3.3.1. Risk assessment

- Regulations on management of materials and goods, norms of

material consumption, or inappropriate norms have not been formulated;
- Loss management and inventory preservation are not good. At
the end of the year, the unit does not consider and control the service life,
physicochemical characteristics that can lead to damage of each type of
inventory, does not consider the conditions of storage, storage and
arrangement at the warehouse to ensure compliance with technical
standards;
- Do not separate storekeepers, HTK accountants, and purchasing
and receiving departments.
- Making untimely import and export slips;
- Warehouse import and export slips are not in accordance with
regulations: no numbering, same numbering, lack of signatures,
inconsistent indicators ...;
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 3.3.1. Risk assessment

- The value of the inventory is different from the value on the invoice
and the costs incurred;
- Not made a summary table of import – export – inventory monthly
and quarterly; a summary table of the quantity of each type of raw materials
in stock to compare with the data on the accounting book;
- Exporting and importing warehouses but not actually exporting or
importing but recording short data;
- The method of calculating the export price, determining the value
of unfinished products is not suitable or inconsistent;
- Allocation of tools and instruments according to inappropriate and
inconsistent standards; there is no spreadsheet allocating instruments for
the period;

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 3.3.1. Risk assessment

- Not make provisions for inventory discounts or make

deductions, not on the basis of market prices, make provisions for
goods held by households not owned by the unit. Redundant
appropriations are not sufficient valid records;
- Goods and finished products are stagnant, with large
values but not been handled;
- Not compared, inventoried, or confirmed with customers
about inventory receiving custody;
- Not track goods sent for sale on inventory accounts or
deliver goods for sale but do not sign contracts, but only write
normal warehouse slips.

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 3.3.1. Risk assessment

Evaluate internal control

- Reassess
- Understand - Preliminary - Design and
control risks
the internal assessment implement
and perform
control of control tests of
substantive
system; risks; control;
tests.

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 INTERNAL CONTROL EVALUATION – INVENTORY
Answer Note
Question
Y N Weakness

Important Not
significant

Are the functions of ordering, receiving,

preserving and accounting inventory arranged
for independent individuals or departments in
charge?
Are orders always made based on an approved
offer of purchase?
Are orders numbered continuously in advance?
1. Does the unit set up an order approval
procedure?

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 INTERNAL CONTROL EVALUATION – INVENTORY

Answer Note
Question
Y N Weakness
Important Not
significant

Before warehousing, is it carefully verified for quantity,

specifications, and quality?
Does the unit organize warehouse arrangement 1
reasonably, avoiding losses and damage?
Does the unit organize periodic inventories?
HTK is poor, broken, outdated... is it recognized in a
timely manner?
Are exports based on PXK and sales invoices?
5. …

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 3.3.2. Tests of control

- Observing and inquiring about:

+ The division of responsibilities
+ The process of preparing, reviewing, and circulating
documents
- Test of purchasing and delivery operations
+ Check the continuity of documents
+ Check the authorization
+ Check the process of recording on the ledgers
+ Check the payment approval

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 3.3.2. Tests of control

 Testing purchase transactions: Select some purchasing operations as

a sample to check the approval, and receipt report, compare the
purchase order and the seller's invoice on the quantity and the
prices, and check the record on the books.

 Checking the detailed ledger system: In case the entity applies the
perpetual inventory method, it is necessary to check the inventory
detail ledger system to ensure that the recording is accurate and
complete on these ledgers.

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 3.3.3. Substantive tests
Reassess control risk and redesign substantive tests:
identify weaknesses and strengths of the internal control
system and adjust the audit plan accordingly.

Control risk LOW Minimize substantive tests

Control risk HIGH Expand substantive tests

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 3.3.3. Substantive tests

General procedures

- Compare inventory balances and inventory structure of this

year and those in the previous year, and explain the unusual
fluctuations.
- Compare inventory's turnaround and those in the previous
year and plan, determine the causes of fluctuations, and the
need to make provisions (if any).

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 3.3.3. Substantive tests
General procedures

- Compare the ratio of inventory with total short-term assets this year
compared to the previous year, and assess the reasonableness of the
fluctuations.
- Compare the cost structure (raw materials, labor, general production)
this year with the previous year, and assess the rationality of
fluctuations.
- …

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 3.3.3. Substantive tests
Tests of details
Physical observation of the inventory stocktaking at the end of the
accounting period
Identify all warehouses (of enterprises or rented), consignments ..., and
value warehouses and assess the risks of each warehouse to
determine where auditors will participate in witnessing inventory.
Participate in the inventory stocktake under the Inventory Stocktake
Program.
For rented warehouses: Send a confirmation letter asking the
warehouse holder to confirm the number of goods sent (if
material).

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 3.3.3. Substantive tests
Tests of details
In case of witnessing inventory stocktake before or after the end of the
accounting period:
Selecting samples to check warehouse entry/export operations
arising after or before the time of inventory, performing
down/reverse reconciliation to the actual inventory balance on the
accounting book/warehouse card at the closing date by adjusting
the corresponding import/exit operations. Find out the cause of the
discrepancy (if any).

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 3.3.3. Substantive tests
Tests of details
Check the purchasing transactions in the period:
Select samples of warehousing transactions in the period and
compare the transactions recorded on the Ledger with related
documents.
Check and calculate export prices for raw materials, tools, finished
products, goods, and goods sent for sale:
Check the sample selection to ensure that the enterprise correctly
and consistently implements the selected export price calculation method.

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 3.3.3. Substantive tests
Tests of details

Check the balance of goods sent for sale, goods being held by 3rd parties,
purchases are on the way:
Compare or send a confirmation letter to the inventory receiving
party (if necessary) or check shipping documents, contracts, or delivery
minutes after the end of the accounting period to ensure the
reasonableness of the recording.

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 QUESTIONS AND EXERCISES
Are the statements below True or False? Explain?

Inventory is presented in the short-term assets section and is recorded at

the original price on the balance sheet. The original price of the end-of-
period inventory is the actual inbound price of the goods that remain in
stock at the time of inventory.
In any case, an inventory audit carries a high risk because inventory is
always a critical item.
Witnessing an end-of-period inventory is mandatory for every audit. When it
is not possible to witness an end-of-period inventory, the auditor may
withdraw from the audit contract to reduce liability.
1.

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 QUESTIONS AND EXERCISES
You are performing an audit for Hanna Company, which is a unit
specializing in the production of children's toys. This is your company's
multi-year audit client but your first-time client in charge.
The company currently uses the inventory accounting system according to
the perpetual inventory method. In the process of researching, you found in
the audit records of previous years recorded a lot of adjusted entries related
to inventory, especially errors in the division of purchasing operations.
Required:
1. Indicate why year separations are important for inventory audits.
2. When CC uses a perpetual inventory system, indicate the audit
procedures the auditor uses to ensure inventory figures are truthful and
reasonable.

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 Requirements

• Do other questions and exercises on the

textbook and provided documents in Chapter 3

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