Auditing and Assurance Services A Systematic

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Auditing and Assurance Services A Systematic Approach Messier 8th Edition Solutions Manual

Chapter 13 - Auditing the Inventory Management Process

CHAPTER 13
AUDITING THE INVENTORY MANAGEMENT PROCESS

Answers to Review Questions

13-1 Inventory represents one of the most complex parts of the audit because the assignment
of values to inventory quantities is difficult. There are also issues such as obsolescence
and lower of cost or market that affect the valuation of inventory. The complexity of
auditing inventory may also be affected by the degree of processing required to
manufacture products.

13-2 The inventory process is affected by control activities in the revenue, purchasing, and
human resource management processes. The purchasing process controls the acquisition
and payment of raw materials and overhead costs. The cost of direct and indirect labor
assigned to inventory is controlled through the human resource management process.
Last, finished goods are sold and accounted for as part of the revenue process.

13-3 A production schedule is used to determine the quantity of goods needed and the time at
which they are required to meet the production scheduling. The materials requisition is
the document that authorizes the release of raw materials from the raw materials
department. The inventory master file contains all the important information related to
the entity's inventory, including the perpetual inventory records for raw material, work
in process, and finished goods. Production information is reported about the transfer of
goods and related cost accumulation at each stage of production. This information is
used to update the entity's perpetual inventory system and as input to generate the cost
accumulation and variance reports produced by the inventory system. The cost
accumulation report summarizes the various costs charged to departments and products
and presents the results of inventory processing in terms of actual costs versus standard
or budgeted costs.

13-4 The following duties are performed by the inventory management, stores, and cost
accounting functions:

Inventory management: Maintenance of inventory at appropriate levels;

issuance of purchase requisitions to the
purchasing department; managing inventory
through planning and scheduling manufacturing
activities.
Raw materials stores: Custody of raw materials and issuance of raw
materials to manufacturing departments.
Cost accounting: Responsible for ensuring that costs are properly
attached to inventory as goods are processed
through the manufacturing function. Cost
accounting reviews the cost accumulation and
variance reports after such data are processed into
the accounting records.

13-1

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Chapter 13 - Auditing the Inventory Management Process

13-5 The key segregation of duties in the inventory process and the errors or fraud that they
can prevent are:
Segregation of Duties Possible Errors or Fraud as a
Result of Conflicts in Duties

The inventory management function Production and inventory costs can be

should be segregated from the cost-
accounting function.
The inventory stores function should be
segregated from the cost-accounting
function.
The cost-accounting function should be
segregated from the general ledger
function.
The responsibility for supervising the
taking of physical inventory should be
separated from the inventory
management and inventory stores
functions.
manipulated, leading to an over- or
understatement of inventory and net income.
Unauthorized shipments can be made or the
theft of goods can be covered up.
Unauthorized shipments resulting in theft of
goods, leading to an overstatement of
inventory.
Inventory shortages can be covered up
through the adjustment of the inventory
records to the physical inventory resulting in
an overstatement of inventory.

13-6 Industry-related factors and operating and engagement inherent risk factors affect the
inventory process. Industry factors include industry competition and changes in
technology. Operating and engagement characteristics are (1) the susceptibility of the
products sold by the client to theft, (2) the difficulty in auditing and valuing inventory,
and (3) possible related-party transactions for the acquisition of raw materials and sale of
the finished product.

13-7 The three major steps in assessing control risk in the inventory process are:
1. Understand and document the inventory internal control system based on the planned
level of control risk.
2. Plan and perform tests of controls on inventory process transactions.
3. Assess and document control risk for the inventory process.

13-8 The following control activities can be used by the client to prevent unauthorized
inventory production:
• Preparation and review of an authorized production schedule.
• Use of material requirements planning and/or just-in-time inventory systems.
• Review of inventory levels by the inventory management department.

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Chapter 13 - Auditing the Inventory Management Process

13-9 Substantive analytical procedures that can be used to test inventory and related account
balances include:
• Compare raw material, finished goods, and total inventory turnover to previous
periods’ and industry averages.
• Compare days outstanding in inventory to previous periods and industry data.
• Compare gross profit percentage by product line with previous periods' and industry
data.
• Compare actual cost of goods sold to budgeted amounts.
• Compare current-year standard costs with prior periods' after considering current
conditions.
• Compare actual manufacturing overhead costs with budgeted or standard
manufacturing overhead costs.

13-10 To audit standard costs, the auditor should first review the client's policies and
procedures for constructing standard costs. Once the policies and procedures are
understood, the auditor normally tests the component cost buildup for materials, labor,
and overhead for a representative sample of standard product costs. The material
component requires testing of the quantity and type of materials included in the product
and the price of the materials. The quantity and type of materials are tested by
reviewing the engineering specifications for the product. Labor costs require evidence
about the type and amount of labor needed for production and the labor rate. The
amount of labor necessary to assemble a product can be tested by reviewing engineering
estimates, which may be based on time-and-motion studies or historical information.
The labor rates for each type of labor necessary to assemble a product can be tested by
examining a schedule of authorized wages. Overhead costs are tested by reviewing the
client's method of overhead allocation for reasonableness, compliance with GAAP, and
consistency. The auditor examines the costs included in overhead to ensure that such
costs are appropriate costs assignable to the product and that the inclusion or exclusion
of such costs is consistent from one period to the next.

13-11 During the observation of the physical inventory count, the auditor should perform the
following procedures:
• Ensure that no production is scheduled. Or, if production is scheduled, ensure that
proper controls are established for movement between departments in order to
prevent double counting.
• Ensure that there is no movement of goods during the inventory count. If movement
is necessary, the auditor and client personnel must ensure that the goods are not
double counted and that all goods are counted.
• Make sure that the client's count teams are following the inventory count instructions.
• Ensure that inventory tags are issued sequentially to individual departments. If the
client uses another method of counting inventory, such as detailed inventory listings,
the auditor should obtain copies of the listings prior to the start of the inventory
count.
• Perform test counts and record a sample of counts in the working papers.

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Chapter 13 - Auditing the Inventory Management Process

• Obtain tag control information for testing the client's inventory compilation. Tag
control information includes documentation of the numerical sequence of all
inventory tags and accounting for all used and unused inventory tags.
• Obtain cutoff information, including the number of the last shipping and receiving
documents issued on the date of the physical inventory count.
• Observe the condition of the inventory for items that may be obsolete, slow moving,
or carried in excess quantities.
• Inquire about goods held on consignment for others or held on a "bill-and-hold" basis.
The auditor must also inquire about goods held on consignment for the client.

13-12 Possible causes of book-to-physical differences include:

• Inventory cutoff errors.
• Unreported scrap or spoilage.
• Pilferage or theft.

13-13 Example disclosure items for inventory and related accounts include:
• Cost method (FIFO, LIFO, retail method).
• Components of inventory.
• Long-term purchase contracts.
• Consigned inventory.
• Purchases from related parties.
• LIFO liquidations.
• Pledged or assigned inventory.
• Disclosure of unusual losses from write-downs of inventory or losses on long-term
purchase commitments.
• Warranty obligations.

Answers to Multiple-Choice Questions

13-14 d 13-21 b
13-15 a 13-22 d
13-16 c 13-23 d
13-17 b 13-24 b
13-18 d 13-25 a
13-19 c 13-26 d
13-20 d

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Chapter 13 - Auditing the Inventory Management Process

Solutions to Problems

13-27 The identification and explanation of the systems and control weaknesses are as follows:
• The purchase requisition is not approved. A responsible person in the stores
department should approve the purchase requisition. The approval should be
indicated on the purchase requisition after the approver is satisfied that it was
properly prepared based on a need to replace stores or the proper request from a user
department.
• Purchase requisition number 2 is not required. Purchase requisitions are
unnecessarily sent from the stores department to the receiving room. The receiving
room does not make any use of the purchase requisitions, and no purpose seems to
exist for the receiving room to obtain a copy. A copy of the requisition might be sent
from the stores department directly to the accounts payable department, where it can
be compared to the purchase order to verify that merchandise requisitioned by an
authorized employee has been properly ordered.
• Purchase requisitions and purchase orders are not compared in the stores department.
Although purchase orders are attached to purchase requisitions in the stores
department, there is no indication that any comparison is made of the two documents.
Prior to attaching the purchase order to the purchase requisition, the requisitioner's
functions should include a check that (1) prices are reasonable, (2) the quality of the
materials ordered is acceptable, (3) delivery dates are in accordance with company
needs, and (4) all pertinent data on the purchase order and purchase requisition (e.g.,
quantities, specifications, delivery dates, etc.) are in agreement. Since the
requisitioner will be charged for the materials ordered, the requisitioner is the logical
person to perform these steps.
• Purchase orders and purchase requisitions should not be combined and filed with the
unmatched purchase requisitions in the stores department. A separate file should be
maintained for the combined and matched documents. The unmatched purchase
requisitions file can serve as a control over merchandise requisitioned but not yet
ordered.
• Preliminary review should be made before preparing purchase orders. Prior to
preparation of the purchase order, the purchase office should review the company's
need for the specific materials requisitioned and approve the request.
• The purchase office should attempt to obtain the highest-quality merchandise at the
lowest possible price, and the procedures that are followed to achieve this should be
included on the flowchart. There is no indication that the purchase office submits
purchase orders to competitive bidding when appropriate. That office should be
directly involved with vendors in determining the cost of materials ordered and
should be primarily responsible for deciding at what price materials should be
ordered and which vendors should be used.

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Chapter 13 - Auditing the Inventory Management Process

• The purchase office does not review the invoice prior to processing approval. The
purchase office should review the vendor's invoice for overall accuracy and
completeness, verifying quantity, prices, specifications, terms, dates, etc., and if the
invoice is in agreement with the purchase order, receiving report, and purchase
requisition, the purchase office should clearly indicate on the invoice that it is
approved for payment processing. The approved invoice should be sent to the
accounts payable department.
• The copy of the purchase order sent to the receiving room generally should not show
quantities ordered, thus forcing the department to count goods received. In addition
to counting the merchandise received from the vendor, receiving department
personnel should examine the condition and quality of the merchandise upon receipt.
• There is no indication of the procedures in effect when the quantity of merchandise
received differs from what was ordered. Procedures for handling overshipments
should be clearly outlined and included on the flowchart.
• The receiving report is not sent to the stores department. A copy of the receiving
report should be sent from the receiving room directly to the stores department with
the materials received. The stores department, after verifying the accuracy of the
receiving report, should indicate approval on that copy and send it to the accounts
payable department. The copy sent to the accounts payable department will serve as
proof that the company received the materials ordered and are in the user department.
• There is no indication of control over vouchers in the accounts payable department.
In the accounts payable department a record of all vouchers submitted to the cashier
should be maintained, and a copy of the vouchers should be filed in an alphabetical
vendor reference file.
• There is no indication of control over dollar amounts on vouchers. Accounts payable
personnel should prepare and maintain control sheets on the dollar amounts of
vouchers. Such sheets should be sent to departments posting transactions to general
and subsidiary ledgers.
• There is no examination of documents prior to voucher preparation. In addition to the
matching procedure, the mathematical accuracy of all documents should be verified
prior to preparation of vouchers.
• The controller should not be responsible for cash disbursements. The cash
disbursement function should be the responsibility of the treasurer, not the controller,
so as to provide proper division of responsibility between the custody of assets and
the recording of transactions.
• There is no indication of the company's procedures for handling purchase returns.
Although separate return procedures may be in effect and included on a separate
flowchart, some indications of this should be included as part of the purchases
flowchart.
• Discrepancy procedures are not indicated. The flowchart should indicate what
procedures are followed whenever matching reveals a difference between the
information on the documents compared.
• There is no indication of any control over prenumbered forms. All prenumbered
documents should be accounted for.

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Chapter 13 - Auditing the Inventory Management Process

13-28 a. Evidence found in the working papers to support the fact that the audit was
adequately planned and assistants were properly supervised would be:
• Documentation indicating discussions with client personnel concerning
developments affecting the entity that require recognition in the audit plan.
• Documentation of a preaudit planning conference among audit firm personnel to
develop an audit strategy by considering matters noted in the review of prior
years' working papers, changes in accounting and auditing standards, etc.
• An internal control write-up documenting that the internal control system had
been reviewed.
• Audit programs tailored to the strengths and weaknesses of the internal control
system (i.e., tested the relevant assertions).
• Audit programs indicating steps that were assigned to and completed by
individual assistants.
• A budget indicating the time to be spent in each audit area.
• Individual working papers signed by reviewers to document review, approval, and
responsibility.
• Confirmations that all questions raised by assistants were answered.

b. Substantive tests that would document management’s completeness assertion as it

relates to inventory quantities would be:
• Observation of physical inventory counts.
• Analytical procedures for the relationship of inventory balances to purchase,
production, and sales activities.
• Inspection of shipping and receiving documentation for proper amounts and dates
to verify proper cutoff procedures.
• Obtaining of confirmation of inventories at locations outside the entity.
• Tracing of test counts recorded during the physical inventory observation to the
inventory listing.
• Accounting for all inventory tags and count sheets used in recording the physical
inventory counts.
• Recomputation of the inventory calculations for clerical accuracy.
• Reconciliation of physical counts to perpetual records and general ledger balances
and investigation of significant differences.

13-29 a. When a client uses statistical sampling to estimate inventories, the auditor should
perform procedures similar to the following:
• The auditor should review the client's procedures and methods for determining
inventories to ascertain that they are sufficiently reliable to produce results
substantially the same as those that would be obtained by a 100 percent inventory
count.
• The auditor should be satisfied that the statistical sampling plan to be used by the
client has statistical validity, that it will be properly applied, and that the planned
tolerable and expected misstatement and risk of incorrect acceptance will be
reasonable in the circumstances.
• The auditor should ascertain that proper steps have been taken to ensure that all

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Chapter 13 - Auditing the Inventory Management Process

• parts and supplies in the warehouse are included in the perpetual inventory
records. This would normally be checked in advance of the physical count.
• The auditor should be present when the sample is drawn to make sure that the
requirements for random selection are properly observed and that all items in the
inventory have an equal or determinable probability of selection.
• The auditor must be present to observe counts and must be satisfied with the
client's counting procedures. The inventory observation can be made either
during or after the year-end of the period under audit if well-kept perpetual
records are maintained and the client makes periodic comparisons of physical
counts with such records.
• The auditor should review the statistical evaluation and be satisfied that the
estimated value of the precision at a given level of reliability meets the materiality
requirements set for the audit.

b. In addition to the above, the following standard audit procedures for verification of
physical quantities should be performed whether the client conducts a periodic
physical count for all or part of its inventory:
• Review and be satisfied with the client's physical inventory-taking procedures.
• Observe the physical count.
• Make test counts where appropriate.
• Trace selected count data to the inventory compilation.
• Select items from compilation and trace them to original count data.
• Select items from the warehouse at random and trace these items to the perpetual
inventory records.
• Verify footings.
• Compare inventory compilation amounts to the subsidiary ledger control and
investigate significant differences.
• Ascertain that there was a proper purchases and sales cutoff.
• Review the treatment of merchandise in transit and consigned merchandise.
• Confirm merchandise in warehouses.
• Perform analytical procedures for inventories.
• Account for all client inventory count sheets.
• Be sure inventory items are properly classified, in good condition, and of proper
quality.

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Chapter 13 - Auditing the Inventory Management Process

13-30 The substantive auditing procedures Kachelmeier may consider performing include:

(a) Using the perpetual inventory file

• Recalculate the beginning and ending balances (prices x quantities), foot, and print out a
report to be used to reconcile the totals with the general ledger or agree beginning
balance with the prior year's working papers.
• Calculate the quantity balances as of the physical inventory date for comparison to the
physical inventory file. Alternatively, update the physical inventory file for purchases
and sales from January 6 to January 31, 2011, for comparison to the perpetual inventory
at January 31, 2011.
• Select and print out a sample of items received and shipped for the periods (1) before and
after January 5 and 31, 2011, for cutoff testing, (2) between January 5 and January 31,
2011, for vouching or analytical procedures, and (3) prior to January 5, 2011, for tests of
details or analytical procedures.
• Compare quantities sold during the year to quantities on hand at year-end. Print out a
report of items for which turnover is less than expected. Alternatively, calculate the
number of days' sales in inventory for selected items.
• Select items noted as possibly unsalable or obsolete during the physical inventory
observation and print out information about purchases and sales for further consideration.
• Recalculate the prices used to value the year-end FIFO inventory by matching prices and
quantities to the most recent purchases.
• Select a sample of items for comparison to current sales prices.
• Identify and print out unusual transactions. These are transactions other than purchases
or sales for the year, or physical inventory adjustments as of January 5, 2011.
• Recalculate the ending inventory by taking the beginning balances plus purchases, less
sales, and print out the differences.
• Recalculate the cost of sales for selected items sold during the year.

(b) Using the physical inventory and test count files

• Account for all inventory tag numbers used and print out a report of missing or duplicate
numbers for follow-up.
• Search for tag numbers noted during the physical inventory observation as being voided
or not used.
• Compare the physical inventory file to the file of test counts and print out a report of
differences for auditor follow-up.
• Combine the quantities for each item appearing on more than one inventory tag number
for comparison to the perpetual file.
• Compare the quantities on the file to the calculated quantity balances on the perpetual
inventory file as of January 5, 2011. Alternatively, compare the physical inventory file
updated to year end to the perpetual inventory file.
• Calculate the quantities and dollar amounts of the book-to-physical adjustments for each
item and the total adjustment. Print out a report to reconcile the total adjustment to the
adjustment recorded in the general ledger before year-end.
• Using the calculated book-to-physical adjustments for each item, compare the quantities
and dollar amounts of each adjustment to the perpetual inventory file as of January 5,
2011, and print out a report of differences for follow-up.

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Chapter 13 - Auditing the Inventory Management Process
13-31
Basic Inventory-Auditing Procedures
1. Observation of the physical count,
making and recording test counts
where applicable.
2. Testing of the mathematical
accuracy of the inventory
compilation.
3. Comparison of the auditor's test
counts to the inventory records.
4. Comparison of physical count data
to inventory records.
5. Testing of the inventory pricing by
obtaining a list of costs per item
from buyers, vendors, or other
sources.
6. Examination of purchases and
sales cutoff.
7. Ascertainment of the propriety of
items of inventory located in
public warehouses.
8. Analysis of inventory for evidence
of possible obsolescence.
13-10
How a Generalized Audit Software
Package and Tape of the Inventory File
Data Might Be Helpful
1. By determining which items are to be
test counted by selecting a random
sample of a representative number of
items from the inventory file as of the
date of the physical count.
2. By mathematically computing the
dollar value of each inventory item
counted by multiplying the quantity on
hand by the cost per unit and verifying
the addition of the extended dollar
values.
3. By arranging test counts in an
electronic file format identical to the
inventory file and matching the data
files.
4. By comparing the total extended
values of all inventory items counted
and the extended values of each
inventory item counted to the
inventory records.
5. By preparing an electronic data file in
a format identical to the inventory file
and matching the data files.
6. By listing a sample of items on the
inventory file for which the date of last
purchase and date of last sale are on or
immediately prior to the date of the
physical count.
7. By listing items located in public
warehouses.
8. By listing items on the inventory file
for which the quantity on hand is
excessive in relation to the quantity
sold during the year.
Chapter 13 - Auditing the Inventory Management Process

9. Analysis of inventory for evidence 9. By listing items on the inventory file

of possible overstocking or slow-
moving items.
10. Performance of an overall test for
accuracy of inventory master file.
for which the quantity on hand is
excessive in relation to the quantity
sold during the year.
10. By listing items, if any, with negative
quantities or costs.

13-32 a. 6
b. 3
c. 1
d. 4
e. 2

Solution to Discussion Case

13-33 a. The auditors did not follow the following audit procedures in a satisfactory manner:
• Control of count sheets during and after the inventory. There may not have been
adequate supervision and instruction of the inventory observation teams by the
auditors. There is no evidence that there was adequate preplanning of the
inventory count. Even though it is difficult to spend continuous time in the upper
decks, there must be a careful control over their contents and planned counting
must still be observed.
• Although the late addition of such sheets is highly irregular, the auditors did very
little to satisfy themselves of their accuracy. The altering of count sheets after
the auditors left could have been prevented by "lining out" unused portions of the
count sheet prior to leaving the inventory observation. Test counts of lines on
sheets could also have detected the changes.
• Physically examining inventory represented on additional count sheets with
specific assurances that the items did not represent duplications in the count.
Tracing the items to purchase invoices does not prove existence at the inventory
date, only that the items were at one time bona fide.
• Questions about inventory turnover and similar comparisons should have been
raised and addressed.
• If the additional items listed on the four additional sheets, the changing of unit
designations, or the fictitious amounts added to completed sheets created unusual
balances in specific inventory items, a review of the inventory balances and
comparison with previous years’ would have indicated unusual increases.
Because of the weaknesses in inventory control, audit procedures should have
been expanded.

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Chapter 13 - Auditing the Inventory Management Process

b. Failure to obtain adequate evidence to support management's assertions can result in

legal liability from injured third parties and in fines and sanctions by the PCAOB and
the SEC. Possible PCAOB and SEC sanctions are discussed in Chapter 20. For
example, SEC sanctions can involve prohibition of appearing before the commission,
prohibition from accepting new SEC clients, and/or required peer reviews.

c. The following auditing standards require that the auditor communicate specific
information to the audit committee. AU 265, "Communicating Internal Control-
Related Matters Identified in an Audit,” requires that the auditor report to the audit
committee, or to a similar level of authority when the entity does not have an audit
committee, matters which are referred to as reportable conditions. AU 240,
"Consideration of Fraud in a Financial Statement Audit,” and AU 250,
"Consideration of Laws and Regulations in an Audit of Financial Statements,” state
that the auditor should inform the audit committee or board of directors of material
fraud that is identified. AU 260, "The Auditor’s Communication with Those Charged
with Governance,” requires that the auditor communicate certain matters related to
the conduct of the audit to those individuals responsible for oversight of the financial
reporting process. The communication should address the following matters:
• The auditor's responsibility under GAAS.
• Significant accounting policies.
• Management judgments and accounting estimates.
• Significant audit adjustments.
• Disagreements with management.
• Consultation with other accountants.
• Major issues discussed with management prior to retention.
• Difficulties encountered during the audit.

Solutions to Internet Assignments

13-34 A search of the Internet showed a number of sites that contained financial information
on the retail industry. Unfortunately, many of these sites are for industry organizations
and the user must be a member to obtain information. One site, the National Retail
Federation contains information on its National Retail Institute (NRI). NRI provides
knowledge about consumer needs, industry trends and strategies that are shaping the
retail industry, and demographic information. NRI also publishes reports and books on
financial and merchandising issues, information technology’s effect on retailing, and a
retail salary survey.
Another site is Lebhar-Friedman which is a leading independent publisher and
provider of information for the retail and foodservices communities. Lebhar-Friedman
also owns Corporate Intelligence on Retailing which maintains a site that has links to
over 100 retailing companies.
There is also the International Mass Retail Association’s (IMRA) site which contains
general economic trends analysis, but no direct information on inventory turnover and
merchandise liquidations.

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Auditing and Assurance Services A Systematic Approach Messier 8th Edition Solutions Manual

Chapter 13 - Auditing the Inventory Management Process

A number of the major public accounting firms’ home pages contained information
on the retail industry, as do consulting firms such as Accenture. Finally, financial
services companies; such as Standard & Poors have sites that contain links to the retail
industry. However, these services are available by subscription only.

13-35 A search of the SEC’s website should identify a recent company that has been cited by
the SEC for financial reporting problems related to inventory.

13-13

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