Audit of the Inventory and Warehousing Cycle

Introduction

Inventory takes many different forms, depending on the nature of the business. For retail or
wholesale business, the most important inventory is merchandise on hand, available for sale. For
hospitals, it includes foods, drugs, and medical supplies. A manufacturing company has raw
materials, purchased parts, and supplies for use in production, goods in process of being
manufactured and finished goods available for sale.

The inventory and warehousing cycle is unique because of its close relationship to other
transaction cycles. Raw material and direct labor enter the inventory and warehousing cycle from
the acquisition and payment cycle and the payroll and personnel cycle, respectively. The
inventory and warehousing cycle ends with the sale of goods in the sales and collection cycle.

The audit of inventory, especially tests of the year-end inventory balance, is often the most
complex and time-consuming part of the audit. Factors affecting the complexity of the audit of
inventory include the following:

 Inventory is generally a major item on the balance sheet, and it is often the largest item
making up the accounts included in working capital.
 The inventory is in different locations, which makes physical control and counting
difficult. Companies must have their inventory accessible for the efficient manufacture
and sale of the product, but this dispersal creates significant auditing problems.
 The diversity of the items in inventories creates difficulties for the auditor. Such items as
jewels, chemicals, and electronic parts present problems of observation and valuation.
 The valuation of inventory is also difficult because of such factors as obsolescence and
the need to allocate manufacturing costs to inventory.
 There are several acceptable inventory valuation methods, but any given client must
apply a method consistently from year to year. More ever, an organization may prefer to
use different valuation methods for different parts of inventory, which is acceptable under
IFRS.
5.1 Business Functions in the Cycle and Related Documents and Records

The inventory and warehousing cycle can be thought of as comprising two separate but
closely related systems, one involving the actual physical flow of goods and the other the
related costs. As inventories move through the company, their must be adequate controls
over both their physical movement and their related costs. The physical flow of goods and
the flow of costs in inventory and warehousing cycle for manufacturing company are shown
below:

Raw Materials

Beginning
inventory

Raw
Purchases materials
used

Editing

inventory

Direct Labor

Actual Applied
manufacturi manufacturing
ng direct direct labor Work-in- Finished Cost of
labor
processgoodsgoods sold

Beginning
invitatory
Manufacturing
Cost of Beginning
Overhead
goods invitatory Cost of goods
Ending
Actual Applied manufacturing sold
inventory
overhead overhead
Ending

inventory

A brief examination of the six functions that makeup the inventory and ware housing cycle
will help students understand the controls in the physical movement and related costs and
the audit evidence needed to test their effectiveness.
₃ Process Purchase Orders: the inventory and warehousing cycle begins with the acquisition
of raw materials for production. Whether inventory purchases relate to raw materials for a
manufacturer or finished goods for retailer, it is essential that adequate controls over
purchasing are maintained. Purchase requisitions are used to request that the purchasing
department place orders for inventory items. Requisitions may be initiated by stockroom
personnel when inventory reaches a predetermined level, orders may be placed for the
materials required to produce a particular customer order, or orders may be initiated on the
basis of a periodic inventory count by a responsible person. Regardless of the method
followed, the controls over purchase requisitions and the related purchase orders are
evaluated and tested as part of the acquisition and payment cycle.

₃ Receive Raw Materials: receipt of the ordered materials is also part of the acquisition and
payment cycle. Material received should be inspected for quantity and quality. The receiving
department produces a receiving report that becomes a part of the necessary documentation
before payment is made. After inspection, the material is sent to the storeroom and the
receiving documents are typically sent to purchasing, the storeroom, and accounts payable.

₃ Store Raw Materials: when materials are received, they are stored in the stockroom until
needed for production. Materials are issued out of stock to production up on presentation of a
properly approved materials requisition, work order, or similar document that indicates the
type and quantity of materials needed. This requisition document is used to update the
perpetual inventory master files and to make book transfers from the raw materials to work-
in-process accounts. These updates occur automatically for organizations that have integrated
their inventory management and accounting.

₃ Process the Goods: the processing portion of the inventory and warehousing cycle varies
greatly from company to company. The determination of the items and quantities to be
produced is generally based on specific orders from customers, sales forecasts,
predetermined finished goods inventory levels, and economic production runs. Frequently, a
separate production control department often is responsible for the determination of the type
and quantities of production. Within the various production departments, provision must be
made to account for the quantities produced, control scrap, quality controls, and physical
protection of the material in process. The production department must generate production
 and scrap reports so that accounting can reflect the movement of materials in the books and
determine accurate costs of production. In any company involved in manufacturing, an
adequate cost accounting system is an important part of the processing of goods function.
The system is necessary to indicate the relative profitability of the various products for
management planning and control and to value inventories for financial statement purpose.
Two types of cost systems exist: job cost systems and process cost systems. The main
difference is whether costs are accumulated by individual jobs when material is issued and
labor costs incurred(job cost) or whether they are accumulated by process, with unit costs for
each process assigned to the products passing through the process(process cost). Cost
accounting records consists of master files, worksheets, and reports that accumulate
material, labor, and overhead costs by job or process as the costs are incurred. When jobs or
products are completed, the related costs are transferred from work-in-process to finished
goods on the basis of production department reports.

₃ Store Finished Goods: as finished goods are completed by the production department, they
are placed in the stockroom to await shipment. In companies with good internal controls,
finished goods are kept under physical control in a separate, limited-access area. The control
of finished goods is often considered part of the sales and collection cycle.

₃ Ship Finished Goods: shipping of completed goods is an integral part of the sales and
collection cycle. Any shipment or transfer of finished goods must be authorized by a properly
approved shipping document.

5.2 Parts of the Audit of Inventory

Now, you are familiar with the business functions and the related documents and records in
the inventory and warehousing cycle, we are ready to turn our attention to the audit of the
cycle. The overall objective in the audit of the inventory and warehousing cycle is to
determine that raw materials, work-in-process, finished goods inventory, and cost of goods
sold are fairly stated on the financial statements. The basic inventory and warehousing cycle
can be divided in to five distinct parts.

5.2.1 Acquire and Record Raw Materials and Overhead: this part of the audit of the
inventory and warehousing cycle includes the first three functions of the cycle: process
purchase orders, receive raw materials, and store raw materials. The internal control over
these three functions are first understood and then tested as part of performing tests of
controls and substantive testes of transactions in the acquisition and payment cycle and the
payroll and personnel cycle. At the completion of the acquisition and payment cycle, the
auditor is likely to be satisfied that acquisitions of raw materials and manufacturing costs are
correctly stated, and samples should be designed to ensure that these systems are adequately
tested. Similarly, when labor is a significant part of inventory, the payroll and personnel
cycle tests should verify the proper accounting for costs.

5.2.2 Transfer Assets and Costs: internal transfers include the fourth and the fifth functions
of the inventory and warehousing cycle: processing the goods and storing finished goods.
These two activities are not related to any other transaction cycles and therefore must be
studied and tested as part of the inventory and warehousing cycle. The accounting records
concerned with these functions are referred to as the cost accounting records.

5.2.3 Ship Goods and Record Revenue and Costs: the recording of shipments and related
costs, the last function in the inventory and warehousing function is part of the sales and
collection cycle. Thus, the internal controls over the functions are understood and tested as
part of auditing sales and collection cycle. Tests of controls and substantive tests of
transactions should include procedures to verify the accuracy of the perpetual inventory
master files.

5.2.4 Physically Observe Inventory: observing the client taking physical inventory count is
necessary to determine whether recorded inventory actually exists at the balance sheet date
and is properly counted by the client. Inventory is the first audit area for which physical
examination is an essential type of evidence used to verify the balance in an account.
Physical observation is studied in this chapter.

5.2.5 Price and compile inventory: costs used to value the physical inventory must be tested
to determine whether the client has correctly followed an inventory method that is in
accordance with IFRS and is consistent with the previous years. The audit procedures used to
verify these costs are called price tests. In addition, the auditor must verify whether the
physical counts were correctly summarized, the inventory quantities and prices were
correctly extended, and the extended inventory was correctly footed, these tests are called
compilation tests.

5.3 Audit of Cost Accounting

Cost accounting systems and controls of different company’s vary more than most other
areas because of the wide variety of items of inventory and the level of sophistication desired
by management. For example, a company that manufactures an entire line of farm machines
will have completely different kind of cost records and internal controls than a steel
fabricating shop that makes and installs custom-made metal cabinets. It should also not be
surprising that small companies with owners who are actively involved in manufacturing
process will need less sophisticated records than will large, multi product companies.

Cost accounting controls: are those related to the physical inventory and related costs from
the point at which raw materials are requisitioned to the point at which the manufactured
product is completed and transferred to storage. It is convenient to divide controls over cost
accounting in to two broad categories: (1) physical control over raw materials, work-in-
process, and finished goods inventory and (2) controls over the related costs.

Almost all companies need physical controls over their assets to prevent loss from misuse
and theft. The use of physically segregated, limited-access storage areas for raw material,
work-in-process, and finished goods is one major control to protect assets. In some
instances, the assignment of custody of inventory to specific responsible individuals may be
necessary to protect assets. Approved pre-numbered documents for authorizing movement of
inventory also protects the assets from improper use. Copies of these documents should be
sent directly to accounting by the persons issuing them, by passing people with custodial
responsibilities. Example, approved materials requisition for obtaining raw materials from
the storeroom.

Perpetual inventory master files maintained by persons who do not have custody of or access
to assets are another useful cost accounting control. Perpetual inventory master files are
important for a number of reasons: (a) they provide a record of items on hand, which is used
to initiate production or acquisition of additional materials or goods; (b) they provide a
record of the use of raw materials and the sale of finished goods, which can be reviewed for
obsolete or low-moving items; and (c) they provide a record that can be used to pinpoint
responsibility for custody as a part of the investigation of differences between physical
counts and the amount shown on the records.

Another important consideration in cost accounting is the existence of adequate internal

controls that integrate production and accounting records for the purpose of obtaining
accurate costs for all products. The existence of adequate cost records is important to
management as an aid in pricing, controlling costs, and costing inventory.

Tests of Cost Accountingin auditing cost accounting, the auditor is concerned with four
aspects: (1) physical controls over inventory, (2) documents and records for transferring
inventory, (3) perpetual inventory master files, and (4) unit cost records. The concepts in
auditing cost accounting are no different from those for any other transaction cycle. And the
methodology the auditor should follow in deciding which tests to perform is shown in the
figure below:

Understand general controls-cost accounting system

Understand internal controls-cost accounting system

Assess planed control risk-cost accounting systems

 Evaluating cost-benefit of testing controls

Design tests of Audit procedures

controls for the cost
accounting systems Sample size
to meet transaction-
related audit
Items to select
objectives

Timing

1. Physical controls: an auditor’s test of the adequacy of the physical controls over raw
materials, work-in-process, and finished goods must be restricted to observation and inquiry.
Fore example, the auditor can examine the raw materials storage area to determine whether
the inventory is protected from theft and misuse by the existence of a locked storeroom. The
existence of an adequate storeroom with a competent custodian in charge also ordinarily
results in the orderly storage of inventory. If the auditor concludes that the physical controls
are so inadequate that the inventory will be difficult to count, the auditor should expand his
or her observation of physical inventory tests to make sure that an adequate count is carried
out.

2. Documents and Records for Transferring Inventory: the auditors primary concerns in
verifying the transfer of inventory from one location to another are that the recorded transfers
exist, the transfers that have actually taken place are recorded, and the quantity, description,
and date of all recorded transfer are accurate. First, it is necessary to understand the client’s
internal controls for recording transfers before relevant tests can be performed. Once the
internal controls are understood, the tests can easily be performed by examining documents
and records. Fore example, a procedure to test the existence and accuracy of the transfer of
goods from the raw material storeroom to the manufacturing assembly line is to account for a
sequence of raw material requisitions, examine the requisitions for proper approval, and
compare the quantity, description, and date with the information on the raw material
perpetual master files. Similarly, completed production records can be compared with
perpetual inventory master files to be sure that all manufactured goods were physically
delivered to the finished goods storeroom.

3. Perpetual Inventory Master Files: The existences of adequate perpetual inventory

master files have a major effect on the timing and extent of the auditor’s physical
examination of inventory. When there are accurate perpetual inventory master files, it is
often possible to test the physical inventory before the balance sheet date. An interim
physical inventory can result in significant cost savings for both the client and the auditor,
and it enables the client to get the audited statement earlier. Perpetual inventory files also
enable the auditor to produce the extent of the tests of physical inventory when assessed
control risk is related to physical observation of inventory is low.

Tests of the perpetual inventory master files for the purpose of reducing the tests of physical
inventory or changing their timing are done through the use of documentation. Documents to
verify the acquisition of raw materials can be examined when the auditor is verifying
acquisition as part of the test of acquisition and payment cycle. documents supporting the
reduction of raw material inventory for use in production and the increase in the quantity of
finished goods inventory when goods have been manufactured are examined as part of the
tests of the cost accounting documents and records in the manner discussed in the preceding
section. Documents supporting the reduction in finished goods inventory through sale of
goods to customers is ordinarily tested as part of sales and collection cycle. It is relatively
easy to test the accuracy of the perpetual after the auditor determines how the internal
controls are designed and decides to what degree assessed control risk should be reduced.

For many companies, traditional documents exist only in electronic form. Also, the perpetual
inventory system is often integrated with other accounting cycles and is automatically
updated with activity in those cycles. As a result, there may be opportunities to test
computer-performed controls to support a reduction in control risk, which reduces the extent
of substantive testing. This in turn may lead to audit efficiencies in testing of the inventory
and warehousing cycle.
4. Unit cost records: obtaining adequate cost data for raw materials, direct labor, and
manufacturing overhead is an essential part of cost accounting. Adequate cost accounting
records must be integrated with production and other accounting records to produce accurate
costs of all products. Cost accounting records are pertinent to the auditor in that the valuation
of ending inventory depends on the proper design and use of these records.

In testing the inventory cost records, the auditor must first develop an understanding of
internal control structure. This is frequently somewhat time-consuming because the flow of
costs is usually integrated with other accounting records, and it may not be obvious how the
internal controls provide for the internal transfers of raw materials and for direct labor and
manufacturing overhead as production is carried out.

A major difficulty in the verification of inventory cost records is determining the

reasonableness of cost allocations. For example, the assignment of manufacturing overhead
costs to individual products entails certain assumptions that can significantly affect the unit
costs of inventory and therefore the fairness of the inventory valuation. In evaluating these
allocations, the auditor must consider the reasonableness of both the numerator and the
denominator that result in the unit costs. Fore example, in testing overhead applied to
inventory on the basis of direct labor dollars, the overhead rate should approximate total
actual manufacturing overhead divided by total actual direct labor dollars. Because total
manufacturing overhead is tested as part of test of the test of the acquisition and payment
cycle, and direct labor is tested as part of the payroll and personnel cycle, determining he
reasonableness of the test is not difficult. However if manufacturing overhead is applied on
the basis of machine hours, the auditor must verify the reasonableness of the machine hours
by separate tests of the clients machine records. The major considerations in evaluating the
reasonableness of all cost allocations, including manufacturing overhead, are compliance
with IFRS and consistency with previous years.

Because internal controls over cost accounting records vary significantly among
organizations, specific tests of controls are not presented in this module. The auditor should
design appropriate tests based on the understanding of the nature of the cost accounting
records and the extent to which they will be relied on to reduce substantive tests. The quality
of the cost accounting records also affects the use of analytical procedures, which is to be
discussed in next section:

Review inventory quality & condition: the auditor should also be alert during the course of
their inventory observation for inventory of questionable quality for condition. Excessive
dust or rust on raw materials inventory items may be indicative of obsolescence or infrequent
use.

The auditor should also review perpetual inventory records for indicative of slow-moving
inventory items. Then, during the course of observation of inventory taking, the auditors
should examine these slow-moving items and determine that the client has identified the
items as obsolete if appropriate. To discharge their responsibility for inventory quality and
condition, the auditors may also have to rely upon the advice of a specialist. Eg, the auditors
of a retail jeweler might request the client to hire an independent expert in jewelry to assist
the auditors in identifying the precious stones and metals included in the client’s inventory.

5.4 Analytical Procedures

Analytical procedures are as important in auditing inventory and warehousing as any other
cycle. Material errors in counting, pricing, and calculating the physical inventory, swell as
fictitious or obsolete inventory, may be disclosed by analytical procedures designed to
establish the general reasonableness of the inventory figures.

A comparative summary of inventories classified by major types, such as raw materials,

goods in process, finished goods, and supplies, should be obtained or prepared. Explanations
should be obtained for all major increases or decreases from the prior year’s amounts.

In certain line of business, particularly retail and wholesale companies, gross profit margin
may be quite uniform from year to year. Any major deference between the ending inventory
estimated by the gross profit percentage method and the count of inventory at year-end
should be investigated fully. The discrepancy may reflect theft of merchandise, or unrecorded
or fictitious purchases or sales. It may be the result of sharp changes in sales prices.

Another useful test is the computation of rates of inventory turnover, based on the
relationship between the cost of goods sold for the year and the average inventory as shown
 on the monthly financial statements. These turnover rates should be compared with the rates
prevailing in prior years. A decreasing rate of turnover suggests the possibility of
obsolescence or of unnecessary large inventories. Deliberate stockpiling in anticipation of
higher prices or shortages of certain strategic materials will, of course, be reflected by a
declining inventory turnover rate. Rates of turnover are most significant when computed for
individual products or by departments; if compared on a company- wide basis, substantial
declines in turnover in certain sections of the client company’s operations may be obscured
by compensating increases in turnover rates for other units of the organization.

The auditors should also make certain that aggregate or unit inventories do not exceed the
capacity of the client’s production or storage facilities.

The following table includes common analytical procedures and possible miss- statement that
may be indicated when fluctuations exist. Several of those analytical procedures like gross
margin percentage have also been included in other cycles.

Analytical procedures for the inventory and warehousing cycle

Analytical procedures possible misstatement

Compare gross margin percentage with that Overstatement or understatement of

Of previous years inventory and cost of goods sold

Compare inventory turnover (cost of goods sold Obsolete inventory, which affects.

Divided by average inventory) with that of previous inventory and cost of goods sold.

Years. Overstatement or understatement of inventory

Compare unit costs of inventory with those of Overstatement or under statement of unit costs,

Previous years. which affect inventory and cost of goods sold.

Compare extended inventory value with that of Misstatements in compilation, unit costs, or extensions,
Previous years. which affect inventory and cost of goods sold.

Compare current year manufacturing costs with those Misstatements of unit costs of inventory, espec

Of previous years(variable costs should be adjusted for ially direct labor and manufacturing overhead,

Changes in volume) which affect inventory and cost of goods sold.

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

account balances with other financial statement accounts, auditors often use non-financial
information to assess the reasonableness of inventory-related balances. Fore example,
knowledge about the size and weight of inventory products, their methods of storage (stacks,
tanks etc), and the capacity of storage facilities (such as available square footage) can be used
to determine whether recorded inventory is consistent with available inventory storage.

After performing the appropriate tests of the cost accounting records and analytical
procedures, the auditor is prepared to design and perform tests of details of the ending
inventory balance.

5.5 Methodology for Designing Tests of Details of Balances

The methodology for deciding which tests of details of balances to perform for inventory and
warehousing is essentially the same as that discussed for accounts receivable, accounts payable,
and all other balance sheet accounts.

Table 5.2: Methodology for designing tests of details of balance for inventory

Set materiality and assess acceptable audit risk and inherent risk for inventory

Assess control risk for several cycles

Design and perform tests of controls for several cycles

 Design and perform analytical procedures for the inventory and warehousing cycles

Design tests Audit procedures

of inventory
to satisfy
Sample size
balance-
related audit
objectives Items to select

Timing

Obtaining an understanding of the client’s business is even more important for inventory than
for most aspects of the audit because inventory varies so significantly for different
companies. A proper understanding of the client’s business and its industry enables the
auditor to ask about and discuss such problems as inventory valuation, potential
obsolescence, and the existence of consignment inventory intermingled with owned
inventory. A useful starting point for becoming familiar with client’s inventory is for the
auditor to tour the client’s facilities, including receiving, storage, production, planning, and
record keeping areas. And the tour should be led by a supervisor who can answer questions
about production, especially about any changes in the past year.

As part of gaining an understanding of the effect of the clients business and industry on
inventory in the beginning phase of the audit, the auditor assesses client business risk. There
may be significant sources of business risk related to inventory because of such factors as
short product cycles and the risk of obsolescence, use of just-in-time inventory and other
supply-chain management techniques, reliance on a few key suppliers, and use of
sophisticated inventory management technology.

After assessing client business risk, the auditor then sets tolerable misstatement and assesses
inherent risk for inventory. Inherent risk is often assessed at a relatively high level for
companies with significant inventory. Inventory may be stored in multiple locations,
increasing concerns about the existence of inventory, including potential theft. The pricing of
inventory is often complex, increasing the risk of misstatement for accuracy objective. There
may also be concerns about inventory obsolescence, which relates to the net realizable value
objective.

In assessing control risk, the auditor is primarily concerned about internal controls over
perpetual records, physical controls, inventory counts, and inventory pricing. The nature and
extent of controls vary widely from company to company. Note that the test results from
several cycles other than inventory and warehousing also affect tests of details of balances
for inventory.

Because of the complexity of auditing inventory, two aspects of tests of details of balances
are discussed separately: (1) physical observation and (2) pricing and compilation.

5.5.1 Physical Observation of Inventory

Evaluate the clients planning of physical inventory:

Auditors have been required to perform physical observation tests of inventory. However,
auditors should first evaluate the client’s planning of physical inventory before observation
of inventory. Efficient and effective inventory-taking requires careful planning in advance.
Cooperation between the auditors and client personnel in formulating the procedures to be
followed will prevent unnecessary confusion and will aid in securing a complete and well-
controlled count. A first step is the designation by the client management of an individual
employee, often representative of the controller, to assume responsibility for the physical
inventory. This responsibility will begin with the drafting of procedures and will carry
through to the final determination of the dollar value of inventories.

In planning the physical inventory, the client should consider many factors, such as (1)
selection of the best date or dates, (2) suspending production in certain departments of the
plant, (3) segregating obsolete and defective goods, (4) establishing control over the counting
process through the use of inventory tags or sheets, (5) achieving proper cutoff of sales and
purchase transactions, and (6) arranging for services of engineers or other specialists to
determine the quality or quantity of certain goods or materials.

Once the plan has been developed, it must be documented and communicated in the form of
written instructions to the personnel taking the physical inventory. These instructions
normally will be drafted by the client and reviewed by the auditors, who will judge their
adequacy. In evaluating the adequacy of instructions, the auditors should consider the nature
and materiality of the inventories, as well as the existing internal control. Normally, the
auditors will assist that the inventory be taken at or near the balance sheet date. However, if
the client has an effective system of internal control, including perpetual records, the auditors
may be satisfied to observe inventory counts performed during the year. If the client plans to
use a statistical sampling technique to estimate the quantities of inventories, the auditor will
evaluate the statistical validity of the sampling method and the adequacy of the confidence
level and precision. If the instructions for taking inventory are adequate, then the auditors’
responsibility during the count is largely a matter of seeing that the instructions are followed
carefully.

Some companies prepare two sets of instructions for the physical inventory: one set for the
supervisors who will direct the count and a second set for the employees who will perform
the detailed work of counting and listing merchandise.

Advance planning by the senior auditor-in-charge is also necessary to assure efficient use of
audit staff members during the inventory taking. The auditor-in- charge should determine the
dates of the counts, the extent of the test counts, the number of auditors needed at each
location, and the estimated time required. The senior should then assign auditors to specific
locations and provide them with a written statement of their duties. The senior may also wish
to arrange for the cooperation of the clients internal auditing staff during count, and possibly
for the assistance of the company’s engineers or independent specialists.

When written instructions are prepared by the auditing firm for use of its staff in a particular
engagement, these instructions are not made available to the client. Their purpose is to make
sure that all auditors understand their assignments and can therefore work efficiently during
the physical inventory. And the audit staff members should have copies of the client’s
inventory instructions in their possession during the inventory observation.

Observe by taking physical inventory and make test counts:

SAS 1 states that the following requirement exists for inventory observation:

…it is ordinarily necessary for the independent auditor to be present at the time of count and,
by suitable observation, tests, and inquiries, satisfy himself respecting the effectiveness of the
methods of inventory taking and measure of reliance, which may be placed upon the client’s
presentations about the quantities and physical condition of the inventories.

An essential point in the SAS 1 requirement is the distinction between the observation of the
physical inventory count and the responsibility for taking the count. It is not the auditor’s
function to take the inventory or to control or supervise the taking; rather it is the client’s
responsibility for setting up the procedures for taking an accurate physical inventory and
actually making and recording the counts. The auditor’s responsibility is to evaluate and
observe the client’s physical procedures and draw conclusions about the adequacy of the
physical inventory. The auditors observe the inventory taking in order to obtain sufficient
competent evidence as to the existence and completeness of audit objectives. In brief,
observation of inventory taking gives the auditors a basis for an opinion as to the credibility
of representations by management of inventory quantities.

The requirement of physical examination of inventory is not applicable in the case of

inventory in public warehouse and on consignment. The examination of warehouse receipt is
not sufficient verification of goods stored in public warehouses. The AICPA has
recommended direct confirmation in writing from outside custodians of inventories, and
supplementary procedures when the amounts involved represent a significant proportion of
the current assets or of the total assets of a concern. These supplementary procedures include
review of the client’s procedures for investigating prospective warehouses and evaluating the
performance of warehouses having custody of stored goods. The auditors should also
consider obtaining accountants’ reports on the warehouses’ internal controls relevant to
custody of stored goods. If the amounts are quite material, or if any reason for doubt exists,
the auditors may decide to visit the warehouses and observe a physical inventory of the
client’s merchandise stored at all the warehouses.

The examination of goods in the hands of consignees may conveniently be begun by

obtaining from the client a list of all consignees and copies of the consignment contracts.
Contracts provisions concerning the payment of freight and other handling charges, the
extension of credit, computation of commissions, and frequency of reports and remittances
require close attention. After re view of the contracts and the client’s records of consignment
shipments and collections, the auditors should communicate directly with the consignees and
obtain full written information consigned inventory, receivables, unremitted proceeds, and
accrued expenses and commission as of the balance sheet date. Often, the client may own
raw materials that are processed by a sub contractor before being use in the client’s
production process. The auditors should request the subcontractor to confirm quantities and
descriptions of client-owned materials in the subcontractor’s possession.

5.5.2 Audit of Pricing and Compilation

An important part of the audit of inventory is to perform all the procedures necessary to make
certain that the physical counts or perpetual record quantities were properly priced and
compiled. Inventory price tests include all the tests of the client’s unit prices to determine
whether they are correct. Inventory compilation tests include all the tests of the
summarization of the physical quantities, the extension of price times quantity, footing the
inventory summary, and tracing the totals to the general ledger.

Evaluate the bases and methods of inventory pricing: the auditors are responsible for
determining that the bases and methods of pricing inventory are in accordance with generally
accepted accounting principles. The investigation of inventory pricing often will emphasize
the following three questions:
 What method of pricing does the client use?

 Is the method of pricing the same as that used in prior years?

 Has the method officially selected by the client been applied consistently and accurately
in practice?

For the first question a method of pricing a long list of alternatives is possible, including such
methods as cost; cost or market, which ever is lower; the retail method; and quoted market
price(as for metals and staple commodities traded on organized exchanges). The cost method,
of course, includes many diverse systems, such as last-in, first-out (LIFO); first-in, first-out
(FIFO); specific identification; weighted average; and standard.

The second question raised in this section concerns a change in method of pricing inventory
from one year to the next. For example, let us say that client has changed from FIFO method
to the LIFO method. The nature and justification of the change in method of valuing
inventory and its effect on income should be disclosed. In addition, the auditors must insert
in the audit report an explanatory paragraph concerning the lack of consistency between the
two years.

The third question posed deals with consistent accurate application in practice of the method
of valuation officially adopted by the client. To answer this question the auditors must test
the pricing of a representative number of inventory items.

Pricing and compilation controls

The existence of adequate internal controls for unit costs that are integrated with production
and other accounting records is important to ensure that reasonable costs are used for valuing
ending inventory. One important internal control is the use of standard cost records that
indicate variances in material, labor, and overhead costs and can be used to evaluate
production. When standard costs are used, procedures must be designed to keep the standards
updated for changes in production process and costs. The review of unit costs for
reasonableness by someone independent of the department responsible for developing the
costs view sis also a useful control over valuation.
 An internal control designed to prevent the overstatement of inventory through the inclusion
of obsolete inventory is a formal review and reporting of obsolete, slow-moving, damaged,
and overstated inventory items. The review should be done by a competent employee by
reviewing perpetual inventory master files for inventory turnover and holding discussions
with the engineering or production personnel.

Compilation internal controls are needed to provide a means of insuring 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. Important
compilation internal controls are adequate documents and records for taking the physical
count and proper internal verification. If physical inventory is taken on prenumbered tags and
carefully reviewed before the personnel are released from the physical examination of
inventory, there should be little risk of misstatements in summarizing the tags. The most
important internal control over accurate determination of prices, extensions, and footings is
internal verification by competent, independent person.

Pricing and compilation procedures:

Balance related audit objectives for tests of details of balances are also useful in discussing
pricing and compilation procedures. The balance-related audit objectives and related tests of
details of balances for inventory pricing and compilation are summarized as follows:

Balance related audit Common inventory pricing and compilation comments

objective procedures

Inventory in the inventory  Perform compilation tests (see existence, Unless controls are
listing schedule agrees with weak, extending and
the physical inventory completeness, and accuracy objectives). footing tests should be
counts, the extensions are limited.
 Foot the inventory listing schedules for raw
correct, and the total is
materials, work-in-process and finished goods.
correctly added and agrees
with the general ledger(detail  Trace the totals to the general ledger.
tie-in)
 Extend the quantity times the price on selected items.

Inventory items in the Trace inventory listed in the schedule to inventory stags The next six
inventory listing schedule and auditors recorded counts for existence and objectives are affected
exists(existence) description. by the results of the
physical inventory
observation. The tag
numbers and counts
verified as part of
physical inventory
observation are traced
to the inventory-listing
schedule as a part of
these tests.

Existing inventory items are
included in the inventory
listing
schedules(completeness)
 Account for unused tag numbers shown in the auditor’s
documentation to make sure no tags have been added.
 Trace from inventory tags to the inventory listing
schedules and make sure inventory on tags is
included.

 Account for tag numbers to make sure none have

been deleted.

Inventory items in the  Trace inventory listed in the schedule to inventory

inventory listing schedule are tags and auditors recorded counts for quality and
accurate(accuracy) description.

 Perform price tests of inventory.

Inventory items in the Verify the classification in to raw materials, work-in-

inventory listing schedule are process, and finished goods by comparing the
properly descriptions on inventory tags and auditors recorded test
classified(classification) counts with the inventory-listing schedule.

Inventory items in the Perform Tests of lower of cost or market, selling price,
inventory listing are stated at and obsolescence.
realizable value (realizable
value).

The client has rights to  Trace inventory tags identified as non-owned during
inventory items in the physical observation to the inventory listing schedule
inventory listing to make sure these have not been included.
schedule(rights)
 Review contracts with suppliers and customers and
inquire of management for the possibility of the
inclusion of consigned or other non-owned
inventory, or exclusion of owned inventory.

Inventory and related Examine financial statements for proper presentation and Pledge of inventory
accounts in the inventory and disclosure, including: and sales and purchase
warehousing cycle are commitments are
 Separate disclosure of raw materials, work-in-
properly presented process, and finished goods. usually uncovered as
&disclosed(presentation & part of other audit
 Proper description of the inventory costing method.
disclosure) tests.
 Description of pledged inventory, inclusion of
significant sales and purchase commitments.

5.6 Integration of the Tests

The most difficult part of understanding the audit of the inventory and warehousing cycle is
grasping the interrelationships of the many different tests the auditor makes to evaluate whether
inventory and cost of goods sold are fairly stated.

Tests of the acquisition and payment cycle: when the auditor verifies acquisitions as part of the
acquisition and payment cycle, evidence is being obtained about the accuracy of raw materials
acquired and all manufacturing overhead costs except labor. These acquisition costs either flow
directly in to cost of goods sold or became the most significant part of the ending inventory of
raw material, work-in-process, and finished goods. In audits involving perpetual master files, it is
common to test these as a part of tests of controls and substantive tests of transactions procedures
in the acquisition and payment cycle. Similarly, if manufacturing costs are assigned to individual
jobs or process, they are usually tested as a part of the same cycle.

Tests of the payroll and personnel cycle: when the auditor verifies labor costs, the same
comments apply as for acquisitions. In most cases, the cost accounting records for direct and
indirect labor costs can be tested as part of the audit of the payroll and personnel cycle, if there is
adequate advance planning.

Tests of the sales and collection cycle: although the relationship is less close between the sales
and collection cycle and the inventory and warehousing cycle than the relationship inventory and
warehousing cycle have with acquisition and payment cycle and payroll and personnel cycle, it is
still important. Most of the audit testing in the storage of finished goods as well as the shipment
and recording of sales and collection cycle is tested. In addition, if standard cost records are
used, it may be possible to test the standard cost of goods sold at the same time that sales tests
are performed.

Tests of cost accounting: this tests are meant to verify the controls affecting inventory that were
not verified as part of the acquisition and payment cycle, payroll and personnel cycle, and the
sales and collection cycle. Tests are made of the physical controls, transfer of raw material costs
to work-in-process, transfers of costs of completed goods to finished goods, perpetual inventory
master files, and unit cost records.

Physical inventory, pricing and compilation: in most audits, the underlying assumption is
testing the inventory and warehousing cycle is that cost of goods sold is a residual of beginning
inventory plus acquisitions of raw materials, direct labor, and other manufacturing costs minus
ending inventory. When the audit of inventory and cost of goods sold is approached with this
idea in mind, the importance of ending inventory becomes obvious. Physical inventory, pricing,
and compilation are each equally important in the audit because a misstatement in any one
results in misstated inventory and cost of goods sold.
In testing the physical inventory, it is possible to rely heavily on the perpetual inventory master
files if they have been tested as a part of one or more of the previously discussed tests. In fact, if
the perpetual inventory master files are considered reliable, the auditor can observe and test the
physical count at some time during the year and rely on the perpetual to keep adequate records of
the quantities.