‘APO — AUDIT OF INVENTORIES PART 1; CONTROLS OVER INVENTORIES AND TEST OF CONTROLS: Inventories are one of the significant current assets in the entity's balance sheet especially for the ‘manufacturing, merchandising and servicing industries. Hence, appropriate and effective intemal controls over its transactions should be in place. Inventory transactions are part of the production or conversion cycle and warehousing cycle. The production cycle involves the conversion of raw materials into finished goods while the warehousing cycle involves the warehousing or storage of such materials and goods. PRODUCTION CYCLE The main objective of this cycle is the proper valuation of inventories and cost of goods sold. This cycle focuses on the proper allocation of cost to determine the proper amount of inventories to be reported in the balance sheet and the proper amount of cost of goods sold to be reported in profit or loss. Remember that inventories become expense when the related revenues are recognized, that is at the point of sale. To achieve such objective, the production department uses inputs from the expenditure and disbursement department and provides outputs or information to the revenue and receipt cycle. There are three control objectives that should be addressed in the production cycle, namely: + Custody + Authorization + Recording ‘The following is the summary of control related procedures over shareholders’ equity: [Control (Control Measures ‘Audit Procedures (Objective \Physical custody of materials and labor documents, is normally held by the production department. |The following documents are held within the iproduction department: Production order — a prenumbered form used to instruct the production personnel to produce a {quantity of a particular product. Bills of materials — a list of raw material ‘components together with their required quantity, fecay peace srcared Auditor observes physical count and reconciles the result of such count to Materials requistton ~A prenumbored form used ently records. 11. Custody {to request and approve the issuance of materials from inventory. ‘Sond confirmation request if inventories are held by other parties.ee et gag f Hts cnt Sree aceon ees ec beats eter remaining in the production process. Se (2. normal production runs. In case of special [related documents supporting the |Authorization|production runs, authorization must come from the Jproduction runs made by the BOD or its representatives. production department to determine a a bs, (department. Daily summaries are then prepared and| Recording oMWarded to general accounting for recording and | Observe the reconciliation ofthe [posting in the general journal and ledger, jentries to the general ledger. ee o Observe the signature indicating tha’ looaseiirommned WAREHOUSING CYCLE ‘The transactions included in the warehousing cycle «+ The issuance of goods auditor's test of such controls: Include: + The receipt of the goods by the storeroom or warehouse The following is a summary of the control procedures implemented on the storeroom together with the Control Measures ‘Audit Procedures ‘A copy of the receiving report signed by a feceiving clerk is used to record receipt of goods. ‘Observe separation of duties and examine approval ignature on receiving report. “Amaterials requisition is prepared and signed by appropriate operating personnel. ‘Observe separation of duties and examine approval ignature on materials requisition. Receiving reports and materials requisition are renumbered and accounted for by a clerk in inventory accounting, (Observe procedure and account for a numerical sequence of receiving reports to determine that all have been recorded, ‘An inventory clerk signs a copy of the receiving foot tr counting aoe trnferred oh or Observe such procedure. Examine signature on Feceiving reports.PART 2: SUBSTANTIVE PROCEDURES ON AUDIT OF INVENTORIES ‘Audit of inventories presents the auditors with significant risks because: ‘+ They often represent a very substantial portion of current assets. + Numerous valuation methods are used for inventories. ‘+ The valuation of inventories affects directly cost of goods sold and other expense. ++ The determination of inventory quality, condition and value is inherently complex. «= Lack of information held on inventory holdings resulting in poor decision and inability to meet the demands and objectives of the business. ‘+ There is a possible omission from the accounting records of inventory owned by the business by held externally by third parties. += Lack of appropriate security over inventory may result to significant losses due to theft and misappropriation. ‘The following are the substantive audit procedures performed for inventories and cost of sales. 1. Observation during inventory count and test counts Assertions addressed: Existence, Completeness, Accuracy, Rights, Valuation and Cut-off Nature of inventory counts ‘One of the main procedures to verity existence of inventories is by observation of inventory counts. Also, ‘observing inventory counts can enhance the auditor's understanding of the entity's business process and intemal controls regarding inventories (if they are properly carried out). NOTE: Aucitors’ responsibilty is to observe the count and not to administer it. Administration, conduct land supervision of inventory counts are of management's responsibilities. What to do during observation of inventory counts? (a) Obtain and review copy of the company’s lst of procedures in taking inventory and determine appropriateness of procedures. (6) Scrutinize the care with which client's employees are following the inventory count procedures. (c) See that al merchandise are tagged and no items are double tagged. (4) Determine that pre-numbered inventory tags and compilation sheets are properly controlled (e) Make some test counts and trace quantities to compilation sheets (f) Be alert for empty containers and hollow squares, and for damaged and obsolete inventories (@) Appraise general condition of inventories (h) Determine the last receiving and shipping documents used and determine that goods received during the count are properly segregated. These cut-off decuments will play an important role in the final analysis of cut-off procedures. (Inquire about or observe existence of slow moving items. 2. Confirmation of inventories held by others Assertions addressed: Existence, Rights and Completeness Some of the inventories owned by the cliont held by third parties include: (@) Inventory stored in public warehouse {b) Inventories aut an eonsianment(6) Inventory held by suppliers (Le. title over inventories has passed to the entity prior delivery. If the inventories held by third partios is significant and the confirmation can be relied upon, a confirmation letter is sent to the custodian requesting: (a) details (b) details of the last receipt or shipment as at the count date and for several days prior and after the count date, inventory on hand at the count date. ‘The auditor may consider visiting the third party and observing physical counts if tis considered material 3. Review the year-end cut-off purchases and sales transactions: (a) Asales cut-off is performed to obtain evidence that all goods delivered by the client as at the: balance sheet date are excluded from the inventory and the related receivable has been recorded (it must constitute a valid sale). NOTE: This requires examination of journal entries on sales journal days before and after the balance sheet date and tracing them to the source document (delivery receipt) (b) A purchase cut-off is performed to obtain evidence that all goods owned by the client at the balance sheet date are included and payable account has been recorded. NOTE: This requires examination of purchases days before and after the balance sheet date and tracing them to the source document (suppliers’ invoice, delivery receipt and client's receiving reports) (6) Test inventory items between physical inventory date and balance sheet date if observation is other than balance sheet date. 4, Lower of Cost of Net Realizable Value (LCNRV) Test Assortions addressed: Valuation and Presentation and Disclosure NRV is the estimated selling price of an inventory less its estimated cost to complete and estimated cost of disposal. To verify the NRV of inventories, the following should be observed: + Finished goods — the NRV of finished goods generally is based on the selling prices evidenced by sales subsequent to reporting date less any estimated cost to dispose them. + Work in process — the NRV is based on the selling prices evidenced by sales subsequent to reporting date less any estimated cost to dispose them and their estimated cost of completion. + Raw materials — the NRV of raw materials is generally based on the replacement cost less any estimated cost to complete and dispose the item. 5. Test of Proper Valuation Assertions addressed: Valuation and Presentation and Disclosure ‘The auditor should test the valuation of inventory to verify that itis performed in accordance with the client's accounting policies or applicable PFRS. ‘Test of proper valuation of inventories includes determination of existence obsolete and slow moving inventories. Itis performed by doing the following procedures: + Inquire for any obsolete and slow moving items in the inventory. + Obsolete inventories may be discovered during the physical count. + Slow moving inventories may be discovered by employing analytical ratios. + Reviewing the perpetual records may also help uncover any slow moving items,PART 3: FINANCIAL ACCOUNTING REVIEW Definition According to PAS 2, Inventories are assets: 2. Held for sale in the ordinary course of business. ». In the process of production for such sale «. In the form of materials or supplies to be consumed in the production process or in the rendering of services, Classes of Inventories 1. Classes of inventories vary in accordance with the entity's nature of business. 2. Merchandising business ~ Merchandise Inventories (definition (a) above). 3. Manufacturing business — Finished Goods Inventories (definition (a) above); Work in Process Inventories (definition (b) above); Raw Materials Inventories and Factory Supplies (definition (c) above). 4. Service business ~ Work in Progress Inventories (definition (b) above). ‘SCOPE PAS 2 applies to all inventories except for the following: (1) Assets accounted for by other standards STANDARDS (a) Financial Instruments PAS 32, PFRS 9 (0) Biological assets and agricultural produce athe point of harvest PAS 41 (2) Assets not measured under PAS 2 MEASUREMENT Inventories of producers of agricultural, forest and mineral products Net Realizabe Value (NRV) Inventories of commodity broker-reders Fair Value less Cost to Sell (FV.CTS) RECOGNITION Inventories are recorded as assets and are reported on the balance sheet when the following conditions are met: «Its probable that the future economic benefits associated with the inventories will flow to the enterprise. », The inventories have cost or value that can be measured reliably, But the real question is what goods shall be included inventory? “All goods to which the entity has title shall be included in inventory, regardless of location.”GENERAL RULE: The one who has POSSESSION has LEGAL TITLE. EXCEPTIONS: 0 eon Point of Transfer of nner Sree ing roe sanbpig ant (6) Free Alongside (FAS) Upon delivering the goods up to the dock next to hen the goad ae unloaded at he other see (@ co @ & NOTE: As rule, the entity who owns the goods should pay its related costs. ownen? (2) Consignment Goods Gerctanor {@) tnvertonabe costs (©) Heninventonabie Coat Pratt ar Fite onstage are retard th conor 1 Reksgecs end other reimburse costco’ consignee (6) Inventory Financing agreements (2) Sale wth a Repurehace Agreement selee (8) Prdge of vertores Pedgor or Borrower (6) Coan inventory Borrower (4). Sale or Return Buyer GS) Seis cnc Approval Sele (6) Instaiment 5 Buyer ) stand vata suyer (6). Layaway sae Seler (8), Speci! Order Sale ‘yer upen completion NOTES REGARDING EXCEPTIONS: (a) Ina sale or return agreement, if the goods are unsalable or the buyer has the intention of returning it, the goods are not recognized on the books of the buyer. (b) Ina sale on trial or approval, the goods are not recognized on the books of the seller ifthe buyer signified approval or if the goods are not returned within a reasonable time after the allowed period elapse; it Is recorded on the books of the buyer. FREQUENTLY ASKED QUESTION ON RECOGNITION: INVENTORY CUT-OFF The following steps are undertaken in applying inventory cut-off (1) Determine whether the inventory should be included or excluded (use the above concepts). (2) Determine whether sales or purchases is recorded The recording of sales or accounts receivable is generally manifested by the issuance or recording of sales invoice. On the other hand, the recording of purchases or accounts payable is usually manifested by the receipt or recording of purchase invoice. (3) Determine whether the inventories are actually excluded or included If the problem did not indicate whether the goods have been actually included or excluded, the following assumptions are used:(a) All sale DELIVERIES made ON OR BEFORE COUNT DATE are EXCLUDED from the count. All deliveries made AFTER COUNT DATE are INCLUDED in the count. (b) All RECEIPTS of goods ON OR BEFORE COUNT DATE are INCLUDED in the count, All receipts AFTER COUNT DATE are EXCLUDED from the count. ‘The above rule is subject to contradicting evidence stated in the problem, MEASUREMENT COST OF PURCHASE, INCLUSIONS: (1) Purchase Price Means of Acouisition Purchase Price (a) Regular Purchase voice Price (6) Deferred Settioment Cash Price Equivalent (¢}_Limp-sum Purenase Allocated Purchace Price using Relative Flr V (2) Import duties 3) Imecoverable taxes NOTE: VAT, being recoverable is generally NOT CAPITALIZED as cost of inventories UNLESS the entity is NON-VAT REGISTERED. (4) Freight and handling costs (5) Insurance while the inventories are in transit (6) Broker's commission EXCLUSIONS: (1) Trade discounts, rebates and other similar items (deducted to arrive at invoice price) (2) Foreign exchange differences {@) Interest expense (unless inventories are categorized as qualifying assets) COST OF CONVERSION (1) Direct Labor (2) Factory Overhead Allocation Basie (a) Variable FOH ‘Actual Capacity (©) Fixed FOH Normal Capacity NOTE: Unallocated fixed FOH are expensed and not capitalized. OTHER costs ‘These are costs necessary in bringing inventories to their present location and condition. (e.g. cost of design for specific customers. EXCLUSION FROM COSTS: (2) Abnormal Los oma asses G) Adrinatative Expenses Traceable (6) Storage costs of Finished Goods Related to Rew Materials or WIP (@)_ Seting costs N/A, always expensedACCOUNTING FOR INVENTORIES Inventories are accounted for either through (a) periodic inventory system or (b) perpetual inventory system. Let us elaborate them by comparing the two inventory systems: Paints of Comparison Patio Pecpatual (2) wen to update iventares? Upon physical count Each mov through stock cards (2) Treatment on inventory counts Necessary procedure fer recorde scurecy {G)_Wehrunning balance or cous? No ves {4) Inventory account treatment Residual acount Fantsined eccount {When to use When iventories are nen inventsres are Summary tourna ane (2) Purchase of fae ae 2) Pymetotienot Pn tment 5 (2) Retard purchased onde a =o w * (4). 50 goeds on acount » mom = (6) sales etme Seles rata ce Pst in Fst out (F1rO} Mathod ‘Coat Formulas [1 Faverage method] Specie ‘SUBSEQUENT, dentition MEASUREMENT. (LOWER OF COST OR nev) [concept of nav] Nel Resi aren Weert inventory ire ‘sown ‘ecounting for I eee ete “lowance Method NOTES: (1) FIFO Method and Average Method are used for homogenous or interchangeable inventories while ‘specific identification is used for heterogeneous or non-interchangeable inventories. (2) Last in, First out is NOT ALLOWED anymore by PAS 2. COST FORMULAS (1) First in, First out Method ~ this method assume that the items of inventory which are purchased first are sold first and the ending inventory are represented by the most recent purchases. FIFO costing method may be used with PERPETUAL or PERIODIC system and regardless of the system used, the cost of the ending inventory and cost of goods sold are the same.‘SOLUTION GUIDE: (a) Ending inventory — (inventory, end quantity x cost of latest purchases) If the quantity purchased based on the most recent transaction is not enough, the cost of the next latest purchase is used unti the entire ending inventory quantity has been assigned cost to. (0) Cost of Goods Sold — (inventory sold in quantity x cost of oldest purchases) If the quantity purchased based on the oldest transaction is not enough, the cost of the next oldest purchase is used unti the entire quantity sold has been assigned cost to. (2) Average Method — under this method, the cost of each item is determined from the average of the cost Of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. ‘Average method may be used with PERIODIC SYSTEM and most commoniy known as WEIGHTED AVERAGE METHOD SOLUTION GUIDE (a) Ending inventory — (inventory, end quantity x weighted average unit cost) (0) Cost of Goods Sold ~ (inventory sold in quantity x weighted average unit cost) NOTE: Weighted average cost is RECOMPUTED ONCE EVERY YEAR and computed as TGAS in total / TGAS in units ‘Average method may be used with PERPETUAL SYSTEM and most commonly known as MOVING AVERAGE METHOD SOLUTION GUIDI (a) Ending inventory — (inventory, end quantity x latest moving average unit cost) (0) Cost of Goods Sold — (inventory sold in quantity x latest moving average unit cost) NOTE: Under this costing method, the average unit cost is RECOMPUTED after EVERY PURCHASE TRANSACTION (it includes purchase retums transactions), so that whatever the last moving average unit cost (after the last purchase transaction) shall be assigned as cost of ending inventory and cost of goods sold. NET REALIZABLE VALUE (NRV) Concept of NRV Measuring inventories at the lower of cost or NRV is inline with the basic accounting concept that an ‘asset shall not be carried at an amount in excess of amounts itis expected to be realized (recoverable amount). So if Cost > NRV = There is inventory write-down Cost < NRV = There is reversal of inventory write-down if there is a previous inventory write-down How to compute NRV? Net Rolla Value NV) (2) Fined Goods / Merchandive Inventorien ESP ECTS (2) Worcin Proceed tnventones esp ECTS ECIC (9. Raw Materials and Factory Supplies Current Replacement CostEsk Determination of LONRV Lower of Cost or NRV (LCNRV) is applied on an ITEM BY ITEM BASIS. This is applied to all types of inventories except for RAW MATERIALS AND FACTORY SUPPLIES. These items of inventories are tested for possible write-down only ifthe related finished goods are to be written down. Estimated Selling Price; ECTS = Estimated Cost to Sell; ECTC = Estimated Cost to Complete Accounting for Inventory Write-down Direct method ‘The inventory is recorded at the lower of cost or net realizable value. This method is also known as "cos! of goods sold” method because any loss on inventory write-down is not accounted for separately but “buried! in the cost of goods sold. Allowance method ‘The Inventory is recorded at cost and any loss on inventory write-down is accounted for separately. This method is also known as “loss method" because a loss account, “loss on inventory write-down" is debitec and a valuation account “allowance for inventory write-down" is credited for the inventory write-down, Allowance for Inve Fy Write-down, ‘Beginning Balance me Reversal of Inventory Write- Loss on Inventory Write- down down Pa Ending Balance x NOTES: (1) The ending balance of allowance for inventory write-down is the difference between cost and NRV of the current end of accounting period. (2) Loss on inventory write-down is presented as addition to COGS or other losses if immaterial (3) Gain on reversal of inventory write-down is up to the extent of allowance balance only and presented ‘as deduction against COGS. OTHER RELATED TOPICS PURCHASE COMMITTMENTS Purchase commitments are obligations of an entity to acquire certain goods sometime in the future at a fixed price and fixed quantity. ‘Actually, a purchase order has already been made for future delivery of goods fixed in price and fixed in ‘quantity contracting party under a purchase commitment cannot cancel the contract without suffering a penalty. ‘Thus, the buyer has to accept future delivery even if the goods promised to be purchased become impaired (there is a decrease in price). In such case, the buyer recognized loss on purchase ‘commitments. Entry to recognize the loss is: Loss on purchase commitments xx Estimated Liability on Purchase Commitments x When prices subsequently increase, the buyer recognizes gain on purchase commitment but up to the extent only of the loss previously recognized.INVENTORY ESTIMATION Why thore is a need for inventory estimation? (1) Impossibility of Physical Count (2) Cost-benefit Constraint (3) Proof ofthe reasonable accuracy of a physical count Frequently Asked Questions in Inventory Estimation (1) Estimated ending inventory (there is a solution guide on how to compute these below and it varies. depending on the method used), (2) Loss on casualty (fre, storm or earthquake) Estimated ending Inventory xx Less: Undamaged inventories @ cost (e.9. goods in transit) (x) Damaged inventories @ LCNRV (ad, Total inventory loss ox (3) Inventory shortage Estimated ending inventory xx Inventory based on count od Inventory shortage xx Methods used in Inventory Estimation GROSS PROFIT METHOD - This method is based on the major assumption that the rate of gross profit remains approximately the same from period to period and therefore the ratio of cost of goods sold to net sales is relatively constant from period to period. SOLUTION GUIDE: ‘The ultimate purpose of this topic is to compute estimated ending inventory. Cost of Goods Available for Sale xx Less: Ending Inventory (SQUEEZE) x Cost of Goods Sold me NOTES: (1) COGS is computed as Net sales x Cost Ratio (if GP is based on sales) Net sales / Sales Ratio (if GP is based on cost) (2) To arrive at net sales, sales returns are the only item to be deducted for inventory estimation purposes only. (3) Gross profit method may be used to estimate inventories for INTERIM REPORTING purposes but NOT ACCEPTABLE for ANNUAL REPORTING, RETAIL INVENTORY METHOD - The retail inventory method came to its name because the selling price or retail price is tagged to each item and therefore the ending inventory is stated at selling price. Actually, the gross profit method is a variation of retail method except that in retail method: (2) The cost ratio is computed directly without regard to the gross profit rate. (b) Net mark-ups and net mark-downs are consideredSOLUTION GUIDE: cost etal Beainnina Inventory co x Purchases wx mx Freight in wx Purchase Discounts (0, Purchase Returns and Allowances (oo) 00) Departmental Transfer in (debi) co = el Transter-out (ered) (a a) Losses to, ben, Net Maric downs pa) ‘TOTAL GOODS AVAILABLE FOR SALE (TGAS) 7% x ENDING INVENTORY (SQUEEZE) x = COST OF GOODS SOLD. ~ NOTES: (1) COGS at retail is computed as: Gross sales less sales returns add employees discount and normal losses. As we can see, only sales returns are deducted. (2) COGS at cost is computed as TGAS at cost less ending inventory at cost 3) Estimated ending inventory at cost is computed as (Ending inventory at retail x cost ratio) (4) Cost ratio varies depending on the retail inventory method used: Under Average Method: (TGAS @ COST / TGAS @ RETAIL) Undor FIFO Method: (TGAS @ COST - BEG. INVENTORY @ COST) / (TGAS @ RETAIL - BEG. INVENTORY @ RETAIL) Under Conservative Method: (TGAS @ COST / TGAS @ RETAIL + NET MARKDOWNS) (6) Retail inventory method may be used to estimate inventories for INTERIM REPORTING purposes and ACCEPTABLE for ANNUAL REPORTING. FS PRESENTATION OF INVENTORIES Inventories are reported in the Statement of Financial Position under CURRENT ASSETS section,