Chapter 21 Audit of the Inventory and Warehousing Cycle

21.1 Learning Objective 21-1

12) Separate perpetual records are likely to be kept only for raw materials inventory.

13) In process cost systems, costs are accumulated by individual jobs.

14) In job cost systems, costs are accumulated by individual jobs.

15) In some inventory systems, raw materials can be requisitioned by automated computer
software when raw materials reach a predetermined level.

16) The inventory and warehousing cycle is unique because of its close relationship to other
transaction cycles.

17) The inventory and warehousing cycle ends with the sale of goods in the sales and collection
cycle.

18) Inventory items such as jewels, chemicals, and electronic parts are easy for auditors to
observe and to value.

19) It is not allowed under accounting standards to use different inventory valuation methods for
different parts of the inventory.

20) Inventory valuation issues include the estimation of inventory obsolescence and the
allocation of manufacturing costs to inventory.

21) Purchase requisitions are often initiated by stockroom personnel as raw materials are needed.

22) The receiving department prepares a receiving report which often is electronic notification of
the receipt of goods that become part of the document before payment is made to the vendor.

23) An adequate cost accounting system is an important part of the processing of goods function
for all manufacturing companies.

1
Copyright © 2020 Pearson Education, Inc.
24) What are two factors affecting the complexity of the audit of inventory?

21.2 Learning Objective 21-2

1) The audit tests to verify that the client is using an inventory method which is generally
accepted and to verify that physical counts were correctly summarized are performed during the
audit of the
A) acquisition and payments cycle.
B) payroll and personnel cycle.
C) inventory and warehousing cycle.
D) sales and collection cycle.

Terms: Audit tests to verify client is using inventory method which is generally accepted
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

2) Handling the receipt of ordered goods is a part of the ________ cycle.

A) purchasing
B) acquisition and payment
C) inventory
D) inventory and warehousing

Terms: Handling receipt of ordered goods

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

3) Which of the following is not a function within the inventory and warehousing cycle?
A) process the goods
B) store raw materials
C) ship finished goods
D) process invoices for shipped goods

Terms: Functions within inventory and warehousing cycle

Difficulty: Easy
Objective: LO 21-2 and LO 21-1
AACSB: Reflective thinking

2
Copyright © 2020 Pearson Education, Inc.
4) Inventory is often a significant part of a company's current assets. Because of its importance,
A) auditors are required by auditing standards to observe the client taking a physical inventory
count.
B) price tests must be performed to verify whether the physical counts were correctly
summarized.
C) companies are required to use perpetual inventory systems.
D) auditors are required by auditing standards to take the physical inventory for the client.

Terms: Physical inventory

Difficulty: Moderate
Objective: LO 21-2
AACSB: Reflective thinking

5) Inventory compilation tests are used to verify that the inventory is recorded at the lower of
cost or market.

Terms: Inventory compilation tests

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

6) An approved purchase requisition form authorizes shipment of goods to customers.

Terms: Approved purchase requisition authorizes shipment of goods

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

7) The receipt of raw materials is a part of the acquisition and payment cycle.

Terms: Acquisition and payment cycle

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

8) The physical observation of the inventory and the acquisition of raw materials are part of the
inventory and warehousing cycle.

Terms: Inventory and warehousing cycles

Difficulty: Moderate
Objective: LO 21-2
AACSB: Reflective thinking

3
Copyright © 2020 Pearson Education, Inc.
9) Physical examination is an essential type of evidence used to verify the existence and count of
inventory.

Terms: Physical counting of inventory

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

10) Costs used to value inventory must be tested by the auditor only to determine whether the
client has followed an inventory method which is in accordance with generally accepted
accounting principles.

Terms: Inventory pricing and compilation tests

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

11) Audit procedures verifying the costs used to value inventories are called compilation tests.

Terms: Inventory pricing and compilation tests

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

12) The pricing and compilation of inventory are audited using substantive analytical procedures
and test of details of the balances.

Terms: Inventory pricing and compilation tests

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

13) As part of the risk assessment process, the auditor will consider whether any of the identified
risks of material misstatement found during the audit of the inventory and warehousing cycle are
considered a significant risk.

Terms: Inventory pricing and compilation tests

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

4
Copyright © 2020 Pearson Education, Inc.
14) It is acceptable practice for CPA firms to use drones to evaluate inventories and other assets
such as mineral deposits during audits.

Terms: Inventory drone revolution

Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

15) The audit of the inventory and warehousing cycle will be affected by the results from other
business processes. Identify the "other" business cycles and how they impact the audit of
inventory.
cquisition and payment, and payroll and personnel: Acquire and record raw materials, labor, and
overhead.
Sale and collection: Ship goods and record revenue and costs.
Terms: Audit of inventory and warehousing cycle affected by other business cycles
Difficulty: Moderate
Objective: LO 21-2
AACSB: Reflective thinking

16) The audit of the inventory and warehousing cycle consists of five parts. State the five parts
and, for each part, identify the cycle in which that part is tested by the auditor.
Terms: Parts of inventory and warehousing cycle and cycle in which tested by auditor
Difficulty: Challenging
Objective: LO 21-2
AACSB: Reflective thinking

5
Copyright © 2020 Pearson Education, Inc.
17) State the six functions that make up the inventory and warehousing cycle and, for each
function, identify the related documents that would be used by a manufacturing company.
Terms: Functions that make up the inventory and warehousing cycle and related
documents/records
Difficulty: Challenging
Objective: LO 21-2
AACSB: Reflective thinking

21.3 Learning Objective 21-3

1) Auditor tests of the physical controls over raw materials, work in process, and finished goods
are generally limited to
A) observation and confirmation.
B) observation and inquiry.
C) inquiry and reconciliation.
D) observation and reconciliation.

Terms: Auditor tests of physical controls over inventory limited

Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

2) Almost all companies need physical controls over their assets to prevent loss. Which of the
following is not an example of such a control?
A) perpetual inventory master files
B) segregated, limited-access storage areas
C) custody of assets assigned to specific responsible individuals
D) approved prenumbered documents for authorizing movement of inventory

Terms: Physical controls over assets to prevent loss

Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

6
Copyright © 2020 Pearson Education, Inc.
3) The reliability of perpetual inventory master files affects the timing and ________ of the
auditor's physical examination of inventory.
A) cutoff
B) accuracy
C) nature
D) extent

Terms: Perpetual inventory master file

Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

4) When auditing inventory cost accounting, the auditor is concerned with all of the following
except for
A) net realizable value.
B) unit cost records.
C) physical controls over inventory.
D) documents and records for transferring inventory.

Terms: Tests of inventory cost accounting

Difficulty: Easy
Objective: LO 21-3
AACSB: Analytic thinking

5) Auditors usually test cost accounting records as part of the

A) acquisition tests.
B) payroll tests.
C) sales tests.
D) All of the above are correct.

Terms: Cost accounting controls related to physical inventory and costs

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

6) To ensure proper segregation of duties, who should maintain the perpetual inventory master
files?
A) production personnel
B) inventory storeroom personnel
C) inventory receiving personnel
D) accounting department personnel

Terms: Segregation of duties; Maintain perpetual inventory master files

Difficulty: Challenging
Objective: LO 21-3
AACSB: Reflective thinking

7
Copyright © 2020 Pearson Education, Inc.
7) Which of the following statements is correct regarding the audit of inventory cost accounting?
A) Cost accounting systems and controls are the same for all manufacturing companies.
B) All companies that have work-in-process must use a perpetual inventory system.
C) Auditors test perpetual inventory master files by examining documentation that supports
additions and reductions of inventory amounts in the master files.
D) Manufacturing companies keep their cost accounting records separate from the production
and other accounting records.

Terms: Audit of cost accounting for inventory

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

8) Which of the following is an accurate statement regarding perpetual inventory master files?
A) When perpetual inventory master files are accurate, auditors can test the physical inventory
after the balance sheet date.
B) It is a difficult procedure for the auditor to test the accuracy of the perpetual inventory master
files.
C) Auditors test the perpetual records for reductions in finished goods for sale as part of the sales
and collection cycle.
D) All of the above are accurate statements.

Terms: Perpetual inventory master file

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

9) Which of the following is a significant audit concern related to the transfer of inventory from
one location to another?
A) Recorded transfers occurred.
B) Transfers were properly transported.
C) Transfers were properly planned.
D) Transfers represent efficient movement of assets.

Terms: Significant audit concern related to transfer of inventory

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

8
Copyright © 2020 Pearson Education, Inc.
10) When auditing manufacturing overhead costs assigned to inventory, auditors should keep in
mind that
A) GAAP has strict procedures that must be followed when assigning overhead to work-in-
process inventory.
B) overhead costs must be allocated to raw materials, work-in-process, and finished goods
inventory.
C) management typically allocates overhead using total direct labor dollars as the basis for the
allocation.
D) determining the reasonableness of the allocation method is relatively simple for work-in-
process inventory.

Terms: Audit of cost accounting for inventory

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

11) A major difficulty in the verification of inventory cost records for the purpose of inventory
valuation is in determining the reasonableness of the
A) direct labor costs.
B) raw material costs.
C) manufacturing overhead costs.
D) period costs.

Terms: Difficulty in verification of inventory cost records for valuation

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

9
Copyright © 2020 Pearson Education, Inc.
12) Auditor tests of physical controls over raw materials, work-in-process, and finished goods
are performed by
A)
Examination Observation Inquiry
Yes No Yes

B)
Examination Observation Inquiry
No Yes No

C)
Examination Observation Inquiry
Yes Yes No

D)
Examination Observation Inquiry
No Yes Yes

Terms: Auditor tests of physical controls over inventory

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

13) If the perpetual inventory master files show lower quantities of inventory than the physical
count, an explanation of the difference might be unrecorded
A) sales.
B) sales discounts.
C) purchases.
D) purchase discounts.

Terms: Perpetual inventory master file shows lower quantities of inventory than physical count
Difficulty: Challenging
Objective: LO 21-3
AACSB: Analytic thinking

14) Cost accounting controls are those related to the physical inventory and the consequent costs
from the point at which
A) materials are ordered for purchase until the finished product is sold.
B) the customer's order is received until the finished product is shipped.
C) raw materials are requisitioned until the finished product is sent to storage.
D) raw materials are requisitioned until the finished product is completely manufactured.

Terms: Cost accounting controls related to physical inventory and costs

Difficulty: Challenging
Objective: LO 21-3
AACSB: Reflective thinking

10
Copyright © 2020 Pearson Education, Inc.
15) In order to strengthen controls over cost accounting information, a company should consider
implementing
A) perpetual inventory master files.
B) a job order cost accounting system.
C) an accounting system that keeps separate the records of the accounting department from the
records of the production department.
D) an economic quantity order system.

Terms: Strengthen internal controls over accounting for materials used in production
Difficulty: Challenging
Objective: LO 21-3
AACSB: Reflective thinking

16) The auditor is concerned with four aspects of cost accounting, including
A) documents and records for transferring inventory.
B) perpetual inventory master files.
C) unit cost records.
D) all of the above.

Terms: Tests of cost accounting

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

17) One of the auditor's primary concerns in verifying the transfer of inventory from one location
to another is that
A) recorded transfers exist.
B) all actual transfers are recorded.
C) the quantity, date, and description of all recorded transfers are accurate.
D) all of the above.

Terms: Audit tests of cost accounting system

Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

11
Copyright © 2020 Pearson Education, Inc.
18) The audit of cost accounting begins with the internal transfer of assets from raw materials to
work-in-process to
A) manufacturing overhead.
B) finished goods inventory.
C) the perpetual inventory master files.
D) retail sales.

Terms: Audit of cost accounting for inventory

Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

19) Management typically allocates overhead using total raw materials as the basis for the
allocation.

Terms: Audit of cost accounting for inventory

Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

20) When verifying the transfer of inventory from one location to another, the audit objectives
with which the auditor is primarily concerned are occurrence of recorded transfers, completeness
of recorded transfers, and accuracy of recorded transfers.

Terms: Transfer of inventory; Occurrence, completeness, and accuracy

Difficulty: Challenging
Objective: LO 21-3
AACSB: Reflective thinking

21) Cost accounting systems and controls are the same for all manufacturing companies.

Terms: Cost accounting controls related to physical inventory and costs

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

22) The extent and timing of an auditor's physical examination of inventory is significantly
influenced by the adequacy of the client's perpetual inventory records.

Terms: Extent and timing of auditor's physical examination of inventory

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

12
Copyright © 2020 Pearson Education, Inc.
23) In evaluating management's overhead cost allocations, the auditor must simply consider the
reasonableness of the allocation method and determine if the valuation method complies with
generally accepted accounting principles.

Terms: Tests of cost accounting

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

24) Management may decide to allocate manufacturing overhead based upon machine hours. In
this situation, the auditor must test and verify the reasonableness of the use of machine hours to
allocate overhead.

Terms: Tests of cost accounting

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

25) Internal controls over cost accounting records are very similar among companies.

Terms: Tests of cost accounting

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

26) Auditors should design appropriate tests of internal controls over cost accounting records
based upon their understanding of those records and the extent they will be relied upon for
reducing substantive tests.

Terms: Tests of cost accounting

Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

13
Copyright © 2020 Pearson Education, Inc.
27) Discuss the four aspects of the audit of cost accounting with which the auditor is most
concerned.
Terms: Four aspects of audit of cost accounting
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

28) What are the auditor's primary concerns in verifying the transfer of inventory from one
location to another?
Terms: Methodology for designing tests of details of balances for inventory
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

21.4 Learning Objective 21-4

1) Which one of the following substantive analytical procedures would be most useful in alerting
the auditor to the possibility of obsolete inventory?
A) Compare gross margin percentage with that of previous years.
B) Compare unit costs of inventory with previous years.
C) Compare inventory turnover ratio with previous years.
D) Compare current year manufacturing costs with previous years.

Terms: Analytical procedure useful in alerting for obsolete inventory

Difficulty: Moderate
Objective: LO 21-4
AACSB: Reflective thinking

14
Copyright © 2020 Pearson Education, Inc.
2) Which one of the following substantive analytical procedures would be most useful in alerting
the auditor to the possibility inventory and cost of goods sold being overstated or understated?
A) Compare extended inventory value with that of previous years.
B) Compare unit costs of inventory with previous years.
C) Compare inventory turnover ratio with previous years.
D) Compare current year manufacturing costs with previous years.

Terms: Analytical procedure useful in alerting for obsolete inventory

Difficulty: Moderate
Objective: LO 21-4
AACSB: Reflective thinking

3) A comparison of the current year's inventory turnover ratio with previous years' may indicate
the presence of obsolete inventory.

Terms: Comparison of inventory turnover ratios

Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

4) Ratios such as the gross margin percentage calculated as part of risk assessment procedures
may be performed using aggregate data.

Terms: Comparison of inventory turnover ratios

Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

5) Significant improvements in audit effectiveness and efficiency may be achieved by the use of
audit data analytics in the inventory and warehousing cycle.

Terms: Use of audit data analytics in audit of inventory

Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

6) It is permissible for an auditor to test the entire inventory population for certain types of audit
tests in order to eliminate the need for more costly tests involving sampling.

Terms: Use of audit data analytics in audit of inventory

Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

15
Copyright © 2020 Pearson Education, Inc.
7) Many of the internal controls over inventory and the details of the entire inventory population
can be tested using audit software.

Terms: Use of audit data analytics in audit of inventory

Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

8) In addition to performing analytical procedures that examine the relationship of inventory

account balances with related financial statement accounts, auditor's will often use nonfinancial
measures in determining the reasonableness of inventory balances. List below at least two
nonfinancial measures that may be useful to auditors.
Terms: Nonfinancial measures to determine reasonableness of inventory
Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

9) Given the following information about your audit client, perform analytical procedures and
comment on your findings.

2015 2016 Industry Average

Inventory $20,000 $32,000 $25,000
Cost of Sales $240,000 $320,000 $400,000

Terms: Analytical procedures

Difficulty: Challenging
Objective: LO 21-4
AACSB: Analytic thinking

16
Copyright © 2020 Pearson Education, Inc.
21.5 Learning Objective 21-5

1) You are auditing the inventory account and are concerned about the possibility of an inventory
overstatement. What is the best audit procedure to detect damaged inventory?
A) Observe the condition of inventory during the client's physical count.
B) Compare the condition of inventory from the previous year's count to the current year.
C) Compare inventory turnover from the previous year's inventory to the current year's
inventory.
D) Reconcile the inventory counts to the cost accounting records.

Terms: Best audit procedure to detect damaged inventory

Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

2) When determining the sample size for the number of items the auditor should count during the
physical inventory,
A) it is easy to quantify the number of items based on a formula developed by the AICPA.
B) one of the key determinants that must be considered is internal control over the physical
count.
C) one of the key determinants that must be considered is the cost involved.
D) generally accepted auditing standards require that at least 80% of the dollar value of the
inventory should be included in the sample.

Terms: Audit procedure observe client taking physical inventory count

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

3) There must be a periodic physical count by the client of the inventory items on hand
A) only if the client uses the LIFO method.
B) only if the client uses a lower-of-cost-or-market method.
C) regardless of the client's inventory valuation method.
D) only if the client uses either the LIFO or FIFO method.

Terms: Periodic physical count on inventory on hand

Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

17
Copyright © 2020 Pearson Education, Inc.
4) If the auditor concludes that physical controls over inventory are so inadequate that the
inventory will be difficult to count, the auditor should ordinarily
A) withdraw from the engagement.
B) issue a qualified audit report.
C) conduct expanded observation tests of physical inventory.
D) hire a specialist to assist the auditor.

Terms: Auditor concludes physical controls over inventory are so inadequate

Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

5) From which of the following evidence-gathering audit procedures would an auditor obtain
most assurance concerning the existence of inventories?
A) observation of physical inventory counts
B) written inventory representations from management
C) confirmation of inventories in a public warehouse
D) auditor's recomputation of inventory extensions

Terms: Evidence-gathering audit procedures for auditor to obtain most assurance concerning
existence of inventories
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

6) When auditors observe the client counting inventory, they should be careful to do all of the
following except
A) inquire about items that are likely to be obsolete or damaged.
B) calculate the unit cost of the inventory items.
C) discuss with management the reasons for excluding any material items.
D) observe the counting of the most significant items.

Terms: Physical counting of inventory

Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

7) It is frequently possible to test the physical inventory prior to the balance sheet date when
A) the perpetual inventory records are accurate and related controls operate effectively.
B) year-end sales are small.
C) the internal control system is no better at year-end than at an earlier point in time.
D) the client counts inventory at interim dates.

Terms: Test of physical inventory prior to balance sheet date

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking
18
Copyright © 2020 Pearson Education, Inc.
8) Comparing the physical counts with the perpetual inventory master files satisfies the balance-
related audit objective of
A) classification.
B) observation.
C) completeness.
D) accuracy.

Terms: Tests of perpetual inventory master files

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

19
Copyright © 2020 Pearson Education, Inc.
9) Which of the following statements is correct regarding the auditor's responsibility with respect
to the year-end inventory procedures of an audit client?
A)
The auditor is responsible The auditor is responsible The auditor is responsible
for setting up the for taking and compiling for observing the physical
procedures for taking an the inventory. counting of inventory.
accurate physical
inventory.
Yes No No

B)
The auditor is responsible The auditor is responsible The auditor is responsible
for setting up the for taking and compiling for observing the physical
procedures for taking an the inventory. counting of inventory.
accurate physical
inventory.
No No Yes

C)
The auditor is responsible The auditor is responsible The auditor is responsible
for setting up the for taking and compiling for observing the physical
procedures for taking an the inventory. counting of inventory.
accurate physical
inventory.
Yes No Yes

D)
The auditor is responsible The auditor is responsible The auditor is responsible
for setting up the for taking and compiling for observing the physical
procedures for taking an the inventory. counting of inventory.
accurate physical
inventory.
No Yes No

Terms: Auditor's responsibility for year-end inventory procedures

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

20
Copyright © 2020 Pearson Education, Inc.
10) McKesson & Robbins Company is a well-known audit case involving auditor responsibility.
What occurred at the McKesson & Robbins Company to change the way in which auditors audit
inventory?
A) The company recorded nonexistent inventory.
B) The auditor did not perform any audit tests of the inventory.
C) The auditor and company colluded to overstate inventory balances.
D) The company counted inventory three months prior to year-end.

Terms: McKesson & Robbins Company audit case; Auditor responsibility in auditing inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

11) When a physical count of inventory is performed at an interim date, the auditor observes it at
that time and tests the perpetual records for transactions
A) throughout the year.
B) which are a representative sample of the period under audit.
C) from the date of the count to year-end.
D) from the date of the count to the end of the audit field work.

Terms: Count of inventory performed at interim date

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

12) When there are no perpetual inventory files and inventory is material,
A) an audit cannot be performed, so the auditor must issue a disclaimer.
B) a physical inventory should be taken by the client near the end of the accounting period.
C) the auditor will have to perform the inventory count and determine valuation.
D) the auditor need not observe inventory counts but must do test counts.

Terms: No perpetual inventory files and inventory is material

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

13) The most important part of the observation of inventory is to determine whether
A) all counts are accurate.
B) the inventory-takers are qualified.
C) obsolete inventory has been identified.
D) the physical count is being taken in accordance with the client's instructions.

Terms: Most important part of observation of inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

21
Copyright © 2020 Pearson Education, Inc.
14) A useful starting point for becoming familiar with the client's inventory is for the auditor to
A) read the AICPA's Industry Audit Guide.
B) review accounting theory covering special inventory problems.
C) read the client's accounting manual.
D) tour the client's facility.

Terms: Starting point for becoming familiar with client's inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

15) A common inventory observation procedure is to select a random sample of tag numbers and
identify the tag with that number attached to the actual inventory item. The audit objective being
achieved by this procedure is
A) inventory as recorded on tags actually exists (existence).
B) existing inventory is counted and tagged (completeness).
C) inventory is counted accurately (accuracy).
D) inventory is classified correctly (classification).

Terms: Audit objective of procedure to select random sample

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

16) If a client intends to count inventory at an interim date, the auditor should expect there to be
all of the following except
A) controls over the preparation and maintenance of perpetual inventory records.
B) competent personnel assigned to count the inventory.
C) third-party inventory counting specialists.
D) an adequately designed plan to count the inventory.

Terms: Inventory count at interim date

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

22
Copyright © 2020 Pearson Education, Inc.
17) A common inventory observation procedure is to be alert for items that are damaged, rust- or
dust-covered, or located in inappropriate places. The balance-related audit objective being
achieved by this procedure is
A) classification.
B) cutoff.
C) realizable value.
D) rights.

Terms: Balance-related audit objective for alert for items that are damaged
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

18) The test of details of balance procedure which requires the auditor to account for unused
inventory tag numbers to make sure none have been deleted is associated with the audit objective
of
A) accuracy.
B) existence.
C) detail tie-in.
D) completeness.

Terms: Audit objective related to test of details of balances procedure to account for unused
inventory tag numbers
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

19) Which of the following is an accurate statement regarding inventory and risk?
A) Inventory with a high business risk includes products with potential obsolescence.
B) Auditors often have a greater concern for misstatements when inventory is stored in one
warehouse.
C) Inherent risk is generally set at low for manufacturing companies.
D) Performance materiality for inventory is determined before assessing client business risk.

Terms: Inventory and risk

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

23
Copyright © 2020 Pearson Education, Inc.
20) The auditor's tour of the client's inventory facilities should be led by
A) a member of the audit committee.
B) the CFO.
C) a plant supervisor.
D) the company president.

Terms: Physical counting of inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Analytic thinking

21) The physical counting of inventory may be performed at which of the following times?
A)
Interim dates On a cycle basis during the year
Yes Yes

B)
Interim dates On a cycle basis during the year
No No

C)
Interim dates On a cycle basis during the year
Yes No

D)
Interim dates On a cycle basis during the year
No Yes

Terms: Physical counting of inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

22) When an auditor observes that personnel who are responsible for physically counting
inventory are not following the inventory instructions, the auditor should
A) contact a client's supervisor to correct the problem.
B) modify the client's physical inventory instructions.
C) not discuss the problem with client's supervisor in order to maintain independence.
D) assign audit staff to the inventory count.

Terms: Observation of personnel taking inventory not following instructions

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

24
Copyright © 2020 Pearson Education, Inc.
23) Auditors need to understand the client's physical inventory count controls before the count of
the inventory begins so that
A) the auditors can accurately count and tag the inventory for the client.
B) the auditors can make constructive suggestions as to the adequacy of the procedures.
C) the client will be informed on exactly what items the auditor intends to test count.
D) the auditor can communicate any weaknesses directly to the audit committee.

Terms: Auditor's objective during observation of physical inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

24) The audit of year-end physical inventories should include steps to verify that the client's
purchases and sales cutoffs were adequate. The audit steps should be designed to detect whether
merchandise included in the physical count at year-end was not recorded as a
A) sale in the current period.
B) sale in the subsequent period.
C) purchase in the current period.
D) purchase return in the subsequent period.

Terms: Audit of year-end physical inventories

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

25) Which one of the following procedures would not be appropriate for an auditor in
discharging his responsibilities concerning the client's physical inventories?
A) confirmation of goods in the hands of public warehouses
B) supervising the taking of the annual physical inventory
C) carrying out physical inventory procedures at an interim date
D) obtaining written representation from the client as to the existence, quality, and dollar amount
of the inventory

Terms: Procedures not appropriate for auditor in discharging responsibilities concerning

physical inventories
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

25
Copyright © 2020 Pearson Education, Inc.
26) The auditor generally decides whether the inventory count can be taken before year-end
primarily on the basis of
A) audit efficiency.
B) accuracy of the perpetual inventory master files.
C) client convenience.
D) audit staff availability.

Terms: Basis that auditor decides whether inventory count can be taken before year-end
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

27) An auditor selects a random sampling of tag numbers and identifies the tag with that number
attached to the actual inventory. The purpose of the procedure is to
A) obtain proper cutoff information.
B) uncover the inclusion of nonexistent items as inventory.
C) determine if the client has adequately priced the inventory item.
D) verify that the client has not changed the recorded counts after the auditor left the premises.

Terms: Physical counting of inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

28) An auditor must inquire about consigned or customer inventory included on the client's
premises to satisfy the balance-related audit objective of
A) cutoff.
B) classification.
C) rights.
D) completeness.

Terms: Audit of year-end physical inventories

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

29) To best ascertain that a company has properly included merchandise that it owns in its
ending inventory, the auditor should review and test the
A) terms of the open purchase orders.
B) purchase cutoff procedures.
C) contractual commitments made by the purchasing department.
D) purchase invoices received on or around year-end.

Terms: Auditor should review and test for proper inclusion of merchandise in ending inventory
Difficulty: Challenging
Objective: LO 21-5
AACSB: Reflective thinking
26
Copyright © 2020 Pearson Education, Inc.
30) Boxes or other containers holding inventory should also be opened during test counts to
determine the ________ of the inventory.
A) classification
B) detail tie-in
C) existence
D) realizable value

Terms: Audit of inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

31) When may auditors observe the physical inventory count?

A)
At an interim date At year-end
Yes Yes

B)
At an interim date At year-end
No No

C)
At an interim date At year-end
Yes No

D)
At an interim date At year-end
No Yes

Terms: Auditors observe physical inventory count

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

32) Auditing standards recommend that auditors observe physical inventory counts by the client.

Terms: Audit standards; Auditors observe physical inventory

Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

27
Copyright © 2020 Pearson Education, Inc.
33) In the audit of inventory, the auditor and client are jointly responsible for making and
recording the count of physical inventory, while the auditor is responsible for drawing
conclusions about the adequacy of the physical inventory.

Terms: Responsibility for making and recording count of physical inventory count
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

34) A common source of business risk for inventory is the reliance on a few key suppliers.

Terms: Inventory and risk

Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

35) To test for proper sales cutoff, an auditor would obtain the number of the last bill of lading
issued during the period under audit and verify that the item shipped had been excluded from the
inventory listing.

Terms: Test for proper sales cutoff

Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

36) When the client's perpetual inventory master files are inadequate, the auditor will probably
choose to test the physical inventory prior to the balance sheet date.

Terms: Client's perpetual inventory master files are inadequate

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

37) When part of the client's inventory is in a public warehouse or in the possession of other
outside custodians, the auditor does not need to observe a physical count of the inventory if a
written confirmation is obtained directly from the inventory custodians.

Terms: Client's inventory in pubic warehouse

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

28
Copyright © 2020 Pearson Education, Inc.
38) The adequacy of internal controls over the physical count of inventory is one of the key
determinants of the amount of time needed to test inventory.

Terms: Audit of inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

39) Inherent risk is typically assessed at a low level for inventory due to the nature of the asset.

Terms: Inherent risk for inventory

Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

40) Discuss the auditor's responsibilities for inventory maintained in public warehouses or with
other outside custodians.
n auditor's physical examination of inventory is not required if inventory is housed in a public
warehouse or overseen by outside custodians. In these situations, auditors verify inventory by
confirmation with the custodian. However, the auditor may perform additional procedures if the
amounts involved are significant. These additional procedures may include: an investigation of
the custodian's inventory procedures, obtaining an independent accountant's report on the
custodian's control procedures over the custody of goods, or observing the physical count of
goods held by the custodian, if practical.
Terms: Auditor responsibilities for inventory maintained in public warehouses
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

41) Discuss the key control procedures relating to the client's physical count of inventory.
Terms: Control procedures related to physical count of inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

29
Copyright © 2020 Pearson Education, Inc.
42) Auditing standards require that auditors satisfy themselves about the effectiveness of the
client's methods of counting inventory and the reliance they can place on the client's
representations about the quantities and physical condition of the inventories. To meet this
requirement, auditors must perform four activities. List them below.
Terms: Effectiveness of client's method of counting inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

43) When auditors observe the client counting inventory, the auditor should take special care in
three areas with regards to selection of inventory items. What action should be taken in these
areas?
Terms: Selection of inventory items for the auditor to audit
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

21.6 Learning Objective 21-6

1) If an auditor were concerned with obtaining evidence about the appropriateness of the value of
inventory, which of the following tests would be most appropriate?
A) compilation tests
B) price tests
C) confirmation of inventory held by outside parties
D) physical examination of the inventory

Terms: Tests of evidence about appropriateness of value of inventory

Difficulty: Easy
Objective: LO 21-6
AACSB: Reflective thinking

30
Copyright © 2020 Pearson Education, Inc.
2) The first step in verifying the valuation of purchased inventory is in determining the valuation
method used by the client. The next step is
A) determining that all inventory that is purchased is expensed through cost of goods sold.
B) determining which costs should be included in the valuation of an item of inventory.
C) determining that all inventory on hand reconciles to the perpetual inventory records.
D) determining that cut-off procedures have been adhered to prior to counting inventory.

Terms: Second step in verifying the valuation of purchased inventory

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

3) You are gathering evidence for the audit objective that existing inventory items are included
in the inventory listing schedule. The audit procedure that would provide you with the best
evidence to confirm this objective is
A) trace from inventory tags to the inventory listing schedule and make sure the inventory on the
tags is included.
B) trace the inventory totals to the general ledger.
C) perform tests of lower-of-cost-or-market.
D) account for unused tags shown in the auditor's documentation to make sure no tags have been
added.

Terms: Audit procedure that provides evidence to confirm audit objective of existence of
inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

4) The test of details of balance procedure which requires the auditor to perform tests of lower of
cost or market, selling price, and obsolescence is an attempt to satisfy the objective of
A) existence.
B) completeness.
C) accuracy.
D) realizable value.

Terms: Objective for tests of details of balance procedure to perform lower-of-cost-or-market,

selling price, and obsolescence
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

31
Copyright © 2020 Pearson Education, Inc.
5) A major source of cutoff information for sales and purchases of inventory is
A) confirmations from outside parties.
B) the test of details of balances.
C) physical observation.
D) the performance of analytical procedures.

Terms: Audit of inventory

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

6) Pricing manufactured inventory is difficult. Auditors must evaluate the method of allocating
manufacturing overhead for all but which of the following?
A) reasonableness
B) computational correctness
C) compliance with generally accepted auditing standards
D) consistency

Terms: Auditors must evaluate method of allocating manufacturing overhead

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

7) Controls which provide a means of ensuring that the physical counts are properly summarized,
priced at the same amount as the unit records, correctly extended and totaled, and included in the
general ledger at the proper amount are known as
A) standard cost controls.
B) pricing internal controls.
C) compilation internal controls.
D) count quantity internal controls.

Terms: Controls which provide means of ensuring physical counts are properly summarized
Difficulty: Challenging
Objective: LO 21-6
AACSB: Reflective thinking

32
Copyright © 2020 Pearson Education, Inc.
8) Assume that the client's valuation of an inventory item is $10 per unit for 1,000 units, using
first-in, first-out (FIFO). If the most recent acquisition of inventory was for 600 units at $10 per
unit and the immediately preceding acquisition was for 700 units at $9 per unit, the inventory
item is in error and it is
A) understated $400.
B) understated $300.
C) overstated $400.
D) overstated $700.

Terms: Inventory errors—First-in, first-out (FIFO)

Difficulty: Challenging
Objective: LO 21-6
AACSB: Analytic thinking

9) The auditor traces inventory tags identified as non-owned during the physical observation to
the inventory listing schedule to make sure these have not been included. This test satisfies the
balance-related audit objective of
A) cutoff.
B) rights.
C) accuracy.
D) existence.

Terms: Audit of inventory

Difficulty: Moderate
Objective: LO 21-6
AACSB: Analytic thinking

10) Which of the following is an accurate statement regarding the audit of pricing and
compilation of inventory?
A) Inventory compilation tests include all of the tests of the client's unit prices to determine
whether they are correct.
B) The review for obsolete inventory should be performed by the accounting department.
C) The most important internal control for accurate unit costs is external verification by an
outside consultant.
D) Inventory compilation internal controls are needed to ensure that the physical counts are
correctly summarized and priced.

Terms: Audit of inventory

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

33
Copyright © 2020 Pearson Education, Inc.
11) In valuing inventory, the auditor must consider all but which of the following factors?
A) The valuation method must be in accordance with GAAP.
B) The valuation method must be applied on a consistent basis.
C) The inventory must be valued at the lower of cost or market.
D) LIFO must be used for work-in-process inventory.

Terms: Factors considered in valuing inventory

Difficulty: Challenging
Objective: LO 21-6
AACSB: Reflective thinking

12) In pricing raw materials in manufactured products, auditors must consider both the unit cost
of the raw materials and the number of units required to manufacture a unit of output.

Terms: Pricing manufactured inventory

Difficulty: Easy
Objective: LO 21-6
AACSB: Reflective thinking

13) The audit procedure "Perform tests of lower-of-cost-or-market, selling price, and
obsolescence" provides assurance mainly for the realizable value objective for inventory pricing
and compilation.

Terms: Assurance for realizable value objective for inventory pricing and compilation
Difficulty: Easy
Objective: LO 21-6
AACSB: Reflective thinking

14) When performing price tests for purchased inventory, the auditor would not be concerned
with the most recent vendors' invoices if the client uses the FIFO valuation method.

Terms: Performing price tests for purchased inventory; FIFO valuation method
Difficulty: Easy
Objective: LO 21-6
AACSB: Reflective thinking

15) When a client has standard cost records, an efficient and useful method of determining
valuation is to review and analyze variances.

Terms: Audit of inventory

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

34
Copyright © 2020 Pearson Education, Inc.
16) Inventory price tests include testing the client's summarization of the inventory counts.

Terms: Inventory price tests and inventory compilation tests

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

17) The audit procedure "Foot the inventory listing schedules for raw materials, work-in-process,
and finished goods" provides assurance mainly for the accuracy objective for inventory pricing
and compilation.

Terms: Accuracy objective for inventory pricing and compilation

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

18) The auditor need not be concerned about inventory being classified and disclosed, properly,
into finished goods, work-in-process and raw materials (separately) in the financial statements;
this is management's responsibility, only.

Terms: Balance-related audit objective

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

19) When performing inventory valuation tests, the auditor must be concerned that the method is
in accordance with accounting standards.

Terms: Valuation of inventory

Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

20) Explain why the audit of work in process and finished goods inventory is generally more
complex than the audit of purchased inventory.
Terms: Audit of work-in-process and finished goods inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

35
Copyright © 2020 Pearson Education, Inc.
21.7 Learning Objective 21-7

1) When labor is a significant part of inventory, verifying the proper accounting of these costs
should be tested in the
A) inventory and warehousing cycle.
B) payroll and personnel cycle.
C) acquisitions and payments cycle.
D) cash cycle.

Terms: Labor a significant part of inventory

Difficulty: Easy
Objective: LO 21-7
AACSB: Reflective thinking

2) Accounting standards require disclosure of inventory valuation methods.

Terms: Disclosures for inventory

Difficulty: Easy
Objective: LO 21-7
AACSB: Reflective thinking

3) Cost of goods sold is generally a residual of beginning inventory less acquisitions plus ending
inventory.

Terms: Cost of goods sold as a residual

Difficulty: Easy
Objective: LO 21-7
AACSB: Reflective thinking

4) Cost of goods sold is generally one of the largest accounts on the income statement.

Terms: Cost of goods sold as a residual

Difficulty: Easy
Objective: LO 21-7
AACSB: Reflective thinking

5) The design of tests of details of balances for inventory is affected by audit results from
multiple cycles. Identify the cycles, other than the inventory and warehousing cycle that affect
the audit of inventory.
Terms: Cycles that affect inventory
Difficulty: Moderate
Objective: LO 21-7
AACSB: Reflective thinking

36
Copyright © 2020 Pearson Education, Inc.