CHAPTER 21

AUDIT OF THE INVENTORY

AND WAREHOUSING CYCLE
Performed by Group 2 & 6

1
LEARNING OBJECTIVES

Describe the business functions and the related

21.1
documents and records in the inventory and
warehousing cycle
Explain the five parts of the audit of the
21.2
inventory and warehousing cycle

21.3 Design and perform audit tests of cost

accounting

Apply substantive analytical procedures to the

21.4
accounts in the inventory and warehousing cycle

2
LEARNING OBJECTIVES

Design and perform physical observation

21.5
audit tests for inventory

Design and perform audit tests of pricing

21.6
and compilation for inventory

Integrate the various parts of the audit of the

21.7
inventory and warehousing cycle

3
GENERAL INTRODUCTION

The inventory and warehousing cycle is unique because of its close

relationship to other transaction cycles (such as sales and
acquisition cycles)
Auditing this cycle is often the most complex and
time-consuming part of the audit for these reasons:

Inventory is often in Diverse inventory items

Inventory is often the
different locations, are often difficult for
largest account on the
making physical control auditors to observe and
balance sheet
and counting difficult value

Valuation is also difficult when

estimation of inventory There are different inventory valuation
obsolescence is necessary and methods for different types of inventory
when manufacturing costs must be within their business
allocated to inventory
4
OBJECTIVE 21-1

Describe the business functions and

the related documents and records
in the inventory and warehousing cycle

5
OBJECTIVE 21-1
Describe the business functions and the related
documents and records in the inventory and
warehousing cycle

I Flow of inventory and costs

Business Functions in the cycle

II
and Related documents and
Records

III Perpetual Inventory Master Files

6
I. Flow of Inventory and
Costs

Raw materials, purchased parts and

supplies for use in production

To study the inventory

and warehousing cycle,
we will use the example
Goods in the process of being
of a manufacturing manufactured
company, whose
inventory may include:
Finished goods available for sale

7
I. Flow of Inventory and Costs
The physical flow of goods and the flow of costs in the inventory and
warehousing cycle for a typical manufacturing company are illustrated in
Figure 21-1:

Figure 21-1: Flow of Inventory and Costs

8
II. Business Functions in the cycle and
Related documents and Records

There are six functions that make up the inventory and

warehousing cycle
The inventory and
warehousing cycle
comprises two
separate but closely
related systems

the physical flow of goods

the related costs

Figure 21-2: Functions in the Inventory and Warehousing
Cycle 9
II. Business Functions in the cycle and
Related documents and Records

1. Process purchase orders

• Acquisition of raw materials for production

• Adequate controls over purchasing must be
maintained
Documents that may be involved

Purchase requisition
request the purchasing Purchase order
department to order
inventory
10
II. Business Functions in the cycle and
Related documents and Records

2. Receive raw materials

Receipt of the ordered materials, involves the inspection

of material received for quantity and quality

After inspection, the material is sent to the storeroom, copies of

the receiving documents, or electronic notifications of the receipt
of goods, are sent to purchasing, the storeroom, and accounts
payable

Control and accountability are necessary for all

transfers
11
II. Business Functions in the cycle and
Related documents and Records

2. Receive raw materials

Vendor’s invoice
Receiving report
Documents that Document from the
prepared by the
may be involved vendor that shows the
receiving
amount owed for an
department
acquisition

12
II. Business Functions in the cycle and
Related documents and Records

3. Store raw materials

Once received, materials are normally stored in a

stockroom

Personnel submit a properly approved materials requisition, work

order or similar document that indicates the type and quantity of
materials needed

Documents that may be involved

Approved materials requisition
indicates the type and quantity of
Raw materials perpetual inventory materials needed
master file

Update the perpetual inventory master files and record transfers from raw materials to work-in-
process accounts 13
 II. Business Functions in the cycle and
Related documents and Records

4. Process the goods

• A separate production control department is often responsible for determining the types and
quantities to produce
• An adequate cost accounting system is an important part of the processing of goods for all
manufacturing company Two primary types of cost systems exist

Job cost systems Process cost systems

costs are accumulated by costs are accumulated by processes,

individual jobs when material with unit costs for each process
is issued and labor costs assigned to the products passing
incurred through the process 14
II. Business Functions in the cycle and
Related documents and Records

4. Process the goods

Cost accounting records

Raw Documents that consist of master files, spreadsheets, and
materials may be involved reports that accumulate material, labor,
requisition and overhead costs by job or process as
those costs are incurred

15
II. Business Functions in the cycle and
Related documents and Records

5. Store finished goods

Documents that may be involved

When finished goods are completed, Finished goods perpetual

they are placed in the stockroom to inventory master file
await shipment

The control of finished goods is often

Cost accounting records
considered part of the sales and collection
cycle

16
II. Business Functions in the cycle and
Related documents and Records

6. Ship finished goods

Part of the sales and collection Shipments of finished goods must be authorized by a
cycle properly approved shipping document

Documents that may be involved

Finished goods perpetual

Shipping document Cost accounting records
inventory master file

17
III. Perpetual Inventory Master Files

Include information about the units of inventory acquired, sold, and on hands and often
include information about unit costs

Separate perpetual records are likely to be kept for

Raw materials Work-in-process Finished goods

18
OBJECTIVE 21-2

Explain the five parts of the audit of

the inventory and warehousing cycle

19
OBJECTIVE 21-2

The overall objective in the audit of the inventory and warehousing cycle is to provide assurance
that the financial statements fairly account for raw materials, work-in-process, finished goods
inventory, and cost of goods sold

The audit of the inventory Acquire and record raw

Internally transfer
and warehousing cycle materials, labor, and
assets and costs
overhead

Ship goods and record Physically observe Price and

revenue and costs inventory compile inventory

20
OBJECTIVE 21-2

Figure 21-3 summarizes the

five parts of the audit of the
inventory and warehousing
cycle

Figure 21-3: Audit of Inventory

21
OBJECTIVE 21-2

1. Acquire and record raw materials, labor, and overhead

Include processing purchase Performs TOC and STT in both

orders, receiving raw the acquisition and payment
materials, and storing raw cycle and the payroll and
materials functions personnel cycle

The auditor obtains an understanding

of internal controls over these three
functions

22
OBJECTIVE 21-2

2. Transfer assets and costs

Include processing the goods and storing

finished goods

Clients account for these activities in the cost accounting

records, which are independent of other cycles and are
tested as part of the audit of the inventory and
warehousing cycle

23
OBJECTIVE 21-2

3. Ship goods and record revenue and costs

Auditors obtain an understanding and test internal controls

over recording shipments as a part of auditing sales and
collection cycle

Including procedures to verify the accuracy of the credits to

inventory recorded in perpetual inventory master files

24
OBJECTIVE 21-2

4. Physically observe inventory

Auditors are required to observe the client taking a physical

inventory count,
to determine whether recorded inventory actually exists at the
balance sheet date and is correctly counted by the client

Verify the existence and count of inventory

25
OBJECTIVE 21-2
Inventory compilation tests

5. Price and compile inventory

Costs used to value inventory must be

tested to determine whether the client
has correctly followed an inventory Verify whether the physical
method that is both in accordance with counts were correctly
accounting standards and consistent summarized, the inventory
with previous years quantities and prices were
correctly extended, and the
extended inventory correctly
footed to equal the general
ledger inventory balance

Price tests
26
OBJECTIVE 21-3

Design and perform audit

tests of cost accounting

27
OBJECTIVE 21-3
Design and perform audit tests of cost
accounting

Cost Accounting Controls Tests of Cost Accounting

28
 I. Cost Accounting Controls

Processes affecting physical inventory and tracking of related cost from the time
raw material are requisitioned to the completion of manufactured product and its
transfer to storage

There are two broad categories of controls

Physical controls over raw materials,

Controls over the related costs
work-in-process, and finished goods inventory

29
I. Cost Accounting Controls

1. Physical controls over RM, WIP and FG inventory

Prevent loss from misuse and theft

2. Controls over the related costs

Perpetual inventory master maintained by persons who do not

have custody of or access to assets are a useful control

30
II. Tests of Cost Accounting

The auditor is concerned with four aspects of cost

accounting

Physical controls over Documents and records for

inventory transferring inventory

1 2

3 4

Perpetual inventory master

Unit cost records
files

31
II. Tests of Cost Accounting

1. Physical controls over inventory

Generally limited to observation and inquiry

Audit tests

Examine raw material

Ask custodians - explain If auditors conclude that
storage area - whether the
their duties related to their the physical controls are so
inventory is protected from
oversight of inventory inadequate, they should
theft and
monitored by expand observation of
misuse by locks or other
them physical inventory tests
security measures

32
 II. Tests of Cost Accounting

2. Documents and records for transferring inventory

Auditor’s Recorded transfers exist, all actual transfers are recorded, and the quantity,
primary description,
concern and date of all recorded transfers are accurate

Understand the client’s internal controls for recording transfers

After they understand the internal controls, they can easily perform tests of
controls or
substantive tests of transactions by examining documents and records to test
Audit tests the
occurrence and accuracy objectives
Compare completed production records with perpetual inventory
master files to be sure that all manufactured goods were physically
delivered to the finished goods storeroom
33
II. Tests of Cost Accounting

3. Perpetual inventory master files

Reliability of perpetual inventory master files effect timing and extent of the auditor’s
physical examination of inventory

If accurate

Auditors can test Assessed control

the physical Reduce tests of physical risk related to
inventory before inventory counts physical
the balance observation of
sheet date inventory is low

34
II. Tests of Cost Accounting

3. Perpetual inventory master files

Test perpetual inventory master files by examining

documentation to support additions and reductions of
inventory amounts

Audit Test the perpetual records for acquisitions of RM in

tests the acquisition and payment cycle, while reductions
in FG for sale are tested in the sales and collection
cycle

If perpetual inventory is computerized and integrated then

auditors will test computer control to support reduction in
control risk
35
II. Tests of Cost Accounting

4. Unit cost records

Accounting for RM, DL, MOH must be accurate for the fair presentation of RM, WIP, & FG inventories

Auditors must understand Material costs: Trace units and

internal control in the cost unit costs to additions recorded in
accounting system, which is the perpetual inventory master
part of acquisition, files and the total cost to cost
payroll/personnel and sales accounting records
Audit
tests
Manufacturing overhead
Payroll costs: Trace payroll costs: Consider the
summary directly to job order reasonableness of the allocation
cost sheet method and whether it is
consistently applied
36
OBJECTIVE 21-4

Apply substantive analytical procedures to the

accounts in the inventory and warehousing
cycle

37
OBJECTIVE 21-4

Apply substantive analytical procedures to the accounts in the

inventory and warehousing cycle

After performing the

appropriate tests of the
Auditors often use
cost accounting records
nonfinancial
and SAP, auditors have a
information to assess
basis for designing and
the reasonableness of
performing tests of details
inventory-related
of the ending inventory
balances
balance

38
OBJECTIVE 21-4
Table 21-1 shows several common analytical procedures and possible
misstatements that may be indicated when fluctuations occur

Table 21-1: Substantive AP for the Inventory and

Warehousing Cycle 39
OBJECTIVE 21-5

Design and perform physical

observation audit tests for inventory

40
OBJECTIVE 21-5

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

Valuation method selected by management

Key
consideratio The potential for inventory obsolescence
ns

The risk that consignment inventory might be

intermingled with own inventory
41
OBJECTIVE 21-5

1 Inventory observation Requirements

Controls over Physical Count 2

3 Audit Decisions

Physical Observation Tests 4

42
1. Inventory observation requirements

The client is responsible for:

• Setting up the procedures for taking
an accurate physical inventory
• Actually making and recording the
counts

The auditor is responsible for evaluating

and observing the client’s procedures,
including:
• Doing test counts
• Drawing conclusions about the
adequacy of the physical inventory

43
1. Inventory observation requirements
Auditing standards require auditors to satisfy themselves about the effectiveness of the client’s
methods of counting inventory and the reliance they can place on the client’s
representation of the inventories

Be present at the time the client counts its inventory

for determining year end balances

Procedures to Observe the counting procedures

meet the
requirements
Make inquiries of client personnel about
their accounting procedures

Make own independent tests of the physical count

44
2. Controls over physical count

The client must make a periodic physical count, but not necessarily every year

The physical count may be performed

At or near the balance sheet date

At an interim date
Appropriate only if there are adequate
controls over the perpetual inventory
master files
On a cycle basis throughout the year

45
2. Controls over physical count
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 of the counts by other client

personnel

Independent reconciliations of the physical counts with

perpetual inventory master files

Adequate client control over count sheets or tags used to record

inventory counts

46
 3. Audit decisions
a. Timing

Observe the inventory count at that time

When a client does an
interim physical count (only
when internal controls are Test transactions recorded in the perpetual
effective) inventory records from the date of the count to
year-end

When the perpetual

Compare the perpetuals with the actual inventory
records are accurate
on a sample basis at convenient times throughout
and related controls
the year
operate effectively

When there are no The client must take a complete physical

perpetuals and the inventory near the end of the accounting
inventory is material period
47
3. Audit decisions
b. Sample size

Auditors concentrate on observing the client’s procedures rather than on selecting items
for testing
Sample size in physical observation may be considered in terms of the total number
of hours spent rather than the number of inventory items counted

Key considerations to determine the amount of time needed:

• The adequacy of internal controls over the physical counts

• Accuracy of the perpetual inventory master files
• Total dollar amount and type of inventory
• Number of different significant inventory locations
• Nature and extent of misstatements discovered in
previous years
• Other inherent risks 48
3. Audit decisions
c. Selection of items

When auditors observe the client counting inventory, they should be

careful to

Observe the counting of Discuss with

Inquire about
the most significant items management the
items that are
and a representative reasons for
likely to be
sample of typical excluding any
obsolete or
inventory items material items
damaged

49
 Physical observation
4 tests

When the client’s employees are not following the inventory

instructions, the auditor must either contact the supervisor to
correct the problem or modify the physical observation procedures

50
 Physical
4 observation
tests
Table 21-2 lists common
tests of details of balances
audit procedures for
physical inventory
observation

51
OBJECTIVE 21-6

Design and perform audit tests of

pricing and compilation for inventory

52
OBJECTIVE 21-6
Design and perform audit tests of pricing and compilation for inventory

1 Pricing and Compilation procedures

2 Pricing and Compilation Controls

3 Valuation of Inventory

53
1. Pricing and Compilation
procedures
Pricing procedures

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

Standard cost records that indicate variances in material, labor, and

overhead costs are helpful to evaluate the reasonableness of production
records

To prevent including or overstating the value of obsolete inventory, clients should

have a
formal review and reporting of obsolete, slow-moving, damaged, and overstated
inventory items 54
1. Pricing and Compilation
procedures
Compilation procedures

Clients need inventory compilation internal controls to ensure that the

physical counts are

included in the
priced at the
correctly perpetual inventory
correctly same amount
extended master file and
summarize as the unit
and related general ledger
d records
totaled inventory accounts at
the proper amount

55
 Pricing and
2 Compilation
Controls
Table 21-3 lists the audit
objectives and related
tests for inventory pricing
and compilation, except
for the cutoff objective

56
3. Valuation of Inventory

a. 3 concerns in performing inventory valuation tests (price tests)

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

57
3. Valuation of Inventory

b. Identify the cost of inventory

Pricing purchased inventory

• The auditor must determine the client’s valuation method (FIFO, LIFO, weighted
average…) and which costs should be included in the valuation of an item of
inventory
• In selecting specific inventory items for pricing, auditors should focus on larger
dollar amounts and on products that are known to have wide fluctuations in
price
• The auditor must examine sufficient invoices to account for the entire quantity
of inventory for the item being tested

• When the client has perpetual inventory master files that include unit costs of
acquisitions: vouching the unit costs to the perpetuals rather than to vendors’
invoices
58
3. Valuation of Inventory
b. Identify the cost of inventory

Pricing manufactured inventory: in pricing work-in-process and finished goods, the

auditor
must consider the cost of raw materials, direct labor, and manufacturing overhead

• The auditor must consider both the unit cost of the raw materials and the number of
units required to manufacture a unit of output

• Auditors must also verify the hourly costs of direct labor and the number of hours
it takes to manufacture a unit of output

• Auditors must evaluate for consistency and reasonableness the manufacturing overhead
allocation method being used and recompute the costs to determine whether the
overhead is correct
• When the client has standard cost records, an efficient and useful method of
determining valuation is to review and analyze variances

59
3. Valuation of Inventory

c. Identify the lower of Cost or Market value

Manufactured goods (both WIP and

Purchased goods and materials
FG)

Test for replacement cost by

Consider the sales value of
examining vendor invoices of
inventory items and the
the subsequent period or
possible effect of rapid
recent invoices if no purchases
fluctuation of prices to
of an inventory item were made
determine net realizable value
after year-end

60
OBJECTIVE 21-7

Integrate the various parts of the audit of

the inventory and warehousing cycle

61
OBJECTIVE 21-7

Figure 21-4 summarizes and

illustrate the audit of the
inventory and warehousing
cycle as a series of integrated
tests

62
 Objective 21-7

The auditor obtains evidence about the accuracy of raw materials acquired and all
Test of the manufacturing overhead costs incurred except labor
Acquisition
and Payment
Cycle Auditors commonly test these as a part of tests of controls and substantive tests of
transaction procedures performed in the acquisition and payment cycle

Test of the
The cost accounting records for direct and indirect labor costs can be tested as
Payroll and
part of the
Personnel
audit of the payroll and personnel cycle
Cycle

Test of the
Most of the audit testing in the storage of finished goods, as well as the shipment
Sale and
and
Collection
recording of sales, takes place when the sales and collection cycle is tested
Cycle
63
 Objective 21-7

Auditors test the physical controls, transfers of raw material costs to work-in-process,
Test of Cost
transfers of costs of completed goods to finished goods,
Accounting
perpetual inventory master files, and unit cost records

In testing physical inventory, auditors may rely heavily on the

perpetual inventory master files if they have been tested as a part of
one or more of the cycles we’ve discussed and are considered reliable

Physical Auditors can observe and test the physical count at a time other than year-end
Inventory, and rely on the perpetuals
Pricing, and
Compilation When testing the unit costs, auditors may also rely, to some degree, on the
tests of the cost records made during the substantive tests of transactions

The auditor should obtain an understanding of client controls related to inventory

disclosures
and perform tests of those controls and other substantive tests.
64
THANKS
FOR YOUR
ATTENTION

65