Chapter 4

Audit of the Inventory and

Warehousing Cycle
 2

Learning Objectives
21.1 Describe the business functions and the related documents
and records in the inventory and warehousing cycle
21.2 Explain the five parts of the audit of the inventory and
warehousing cycle
21.3 Design and perform audit tests of cost accounting
21.4 Apply substantive analytical procedures to the accounts in the
inventory and warehousing cycle
21.5 Design and perform physical observation audit tests for
inventory
21.6 Design and perform audit tests of pricing and compilation for
inventory
21.7 Integrate the various parts of the audit of the inventory and
warehousing cycle
 5.1 Nature of inventory 3

Inventory consists
– Items held for sale in ordinary course of business, :
– Goods in process of production for sale,
– Goods to be consumed directly or indirectly in production (Raw materials,
purchased parts, and supplies)

• Inventory (asset) and Inventory sold (Cost of goods sold) are major items that
appear on financial statements.
– Inventory appears on Balance sheet,
– Cost of goods sold appear on Income statement

• Misstatement in Inventory and Cost of goods misstates the financial statement,

thus inventory audit requires attention

• Inventories have received much attention due to the following reasons:

– It is usually the largest current asset on the balance sheet, and are susceptible
to major error and irregularities
– Various inventory valuation methods are used (FIFO, average..)
– The determination of ending inventory affects the figure that appears as cost
of goods sold (different valuation method can be used for different classes of
inventory)
– Some items are highly technical and difficult to observe and value, (eg.
Precious metals, sophisticated electrical parts, construction in progress)
 5.1 Nature of inventory 4

• The inventory and warehousing cycle can be thought of as

comprising two separate but closely related systems:
– The physical flow of goods
– The related costs
• 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:

– Inventory is often in different locations, making physical control and counting
difficult.
– Diverse inventory items such as jewels, chemicals, and electronic parts are
often difficult for auditors to observe and value.
– inventory is often the largest account on the balance sheet.
– Inventory valuation is also difficult when estimation of inventory obsolescence
is necessary and when manufacturing costs must be allocated to inventory.
– There are several acceptable inventory valuation methods and some
organizations may prefer to use different valuation methods for different parts
of the inventory, which is acceptable under accounting standard
 5

...5.1 Nature of inventory

• Business Functions in the Cycle and Related Documents and Records
• There are six functions that make up the inventory and warehousing
cycle: (using Manufacturing process as an example)
–Process purchase orders
–Receive raw materials
–Store raw materials
–Process the goods
–Store finished goods
–Ship finished goods
How this cycle differ from others?
The inventory and warehousing cycle is unique because it has close
relationships to other transaction cycles (acquisition & Payment; Sales
& collection)
 6

...5.1 Nature of inventory

• ..Business Functions in the Cycle and Related Documents
and Records
The overall objective in the audit of the inventory and
warehousing cycle is to provide assurance that the financial
statements fairly account for raw materials, work-in-
process, finished goods inventory, and cost of goods
sold.
• Auditors achieve this purpose by:
– Determining the adequacy of internal control system
over inventories
– Testing the financial statement assertion relevant to
inventory
 7

...5.1 Nature of inventory

Figure 21.2 Functions in the Inventory and Warehousing Cycle
 8

...5.1 Nature of inventory

…..Business Functions in the Cycle and Related Documents and Records
– Key assertions for inventory are:
 Existence, valuations, completeness &
Rights
– Sources of evidence:
 Aged inventory listing
 inventory assets/items
 Inventory count sheets
 Purchase invoice
 Goods receiving notes (GRN)
 Sales invoice
 Goods dispatch notes (Shipping doc,, Store issue vouchers (SIV))
 Overhead allocation sheets, absorption & apportionment &
percentage of completion for work in process.
 9

...5.1 Nature of inventory

…..Business Functions in the Cycle and Related Documents and Records
– Inventory items must exist, be completely recorded, be valued
appropriately, and must be owned and controlled by the entity.
– In the audit of inventory two factors are considered:
 1. Quantity of inventory-determined by count
 2. Valuation of individual inventory items
– A perpetual inventory master file is a type of record used for
inventory which typically includes information about:
 the units of inventory acquired, sold, and on hand
– Separate computerized perpetual records are likely to be kept for raw
materials, work-in-process, and finished goods
 10

...5.1 Nature of inventory

Figure 21.1 Flow of Inventory and Costs

 11

...5.1 Nature of inventory

• Parts of the Audit of Inventory
• The audit of the inventory and warehousing cycle can
be divided into five activities within the cycle:
– Acquire and record raw materials, labor, and overhead
– Internally transfer assets and costs
– Ship goods and record revenue and costs
– Physically observe inventory
– Price and compile inventory
...5.1 Nature of inventory 12

…Parts of the Audit of Figure 21.3 Audit of Inventory

Inventory
 13

5.2 Control activities and Tests of Controls

Good internal control is a means of providing accurate
cost data for inventories and CGS as well as accuracy in
reporting physical quantities.

Inadequate internal control may cause losses by

permitting inaccurate cost data to be used by management
in setting selling prices, and making other decisions based
on reported gross profit margin.
Internal controls that assure fair valuation of inventories
are found in the acquisition and payment cycle.

Internal control procedures for inventories affect almost

all functions involved in purchasing and disposing of the
company’s product
Clearly there is an overlap with the purchases and sales
systems and the system needs to ensure that damaged
goods are not received into inventory.
 14

5.2 Control activities and Tests of Controls

Objectives of inventory control: Inventory control aims at ensuring
that
Goods cannot be misappropriated (ie stolen)
๏ Goods cannot be damaged (ie conditions of storage are
suitable)
๏ Obsolete or slow-moving items can be identified (because they
will need to be written down)
๏ Goods are only dispatched with approval (SIV, Shipping doc)
๏ Inventory records are complete and accurate
๏ A correct ‘cut-off’ is established at the year end

For a manufacturer, the inventory system would also include:

 The process of converting raw materials into finished goods.
 Controls over the transfer of raw materials from stores to the factory
and
Procedures for assigning costs to inventories and the determination of
cost of goods sold.
There would be overlap with the payroll system (as labour cost would
be included in the cost of production).
 15

5.2 Control activities and Tests of Controls

The Controls include procedures for:
General control
Selection of vendors,
Ordering materials
Inspecting goods received
Storing
Recording liability
Authorizing and making payment to suppliers
Issuing, Processing/production, Product/service costing, shipping

General control include separation of duties, authorization, approval &

monitoring:
•Requires separate unit with authority to make all purchases of
materials and services
•Separation of Purchasing. Receiving, and Recording function
•Monitoring inventory and purchase levels by management
 ….5.2 Control activities and Tests of Controls 16

….Controls include procedures for:

Selection of vendors,
Vendors should be selected considering the following factors:
Quality product or service, meeting any technical specifications.
Value with reasonable cost and terms.
Transportation costs.
Discounts for volume and early payment.
On-time delivery.
Financial strength.
Excellent customer references.
Ordering materials
The preparation of purchase orders after
Determining the need for the item
Obtaining completive bids
Obtaining approval of the financial aspect of the commitment
Use of serially numbered purchase orders
 17

….5.2 Control activities and Tests of Controls

…….Controls include procedures for:
Inspecting goods received
Requires having receiving unit independent of purchasing,
storing and shipping departments
Responsibilities of the receiving unit:
Determining quantities of goods received
Ensuring that goods meet the required specification
Detecting damaged/defective merchandise
Preparation of a receiving report
Immediate transfer of goods to the storing unit
Storing
Counting, inspecting and receiving of goods
 Signing on goods receiving note and notifying the
accounting department by sending copies
By signing on the Goods Receiving Note, the Storing
Unit verify the work of the Receiving Unit.
 18

….5.2 Control activities and Tests of Controls


…..Controls include procedures for
Recording liability
After ensuring the proper receipt of goods purchased,
liability is recorded. Note: This part is discussed in the Audit of
Accounts Payable)
Authorizing and making payment to suppliers
Payments are effected after checking the validity of
documents (material requisition, purchase order, invoice,
Goods receiving note….) Note: This part is also discussed in
the Audit of Accounts Payable)
Issuing
•Requires the Storing unit to issue goods after receiving
authorized goods requisition form
•The preparation of pre-numbered Store Issue Voucher (SIV)
as an evidence of issuing goods
The storing unit notify the accounting department by sending
a copy of Store Issue voucher.
 19

….5.2 Control activities and Tests of Controls


…..Controls include procedures for
Processing/Production
•Requires factory supervisors to control the use of raw
materials and other items, from the time materials are
received by the factory until they are completed and sent to
finished goods store room
•Control includes regular inspection to reveal defective works
•Requires the production department to notify the accounting
department about the scrapped, defective items so that the
value of normal goods should not be inflated

Product/service costing:-This requires having an accurate cost

accounting system to accumulate and determine costs (topic 5.3).
The Shipping function
Requires shipment of goods to be after proper authorization
The use of pre-numbered shipping document on which
customer orders are referred
Notifying the billing department by sending a copy of shipping
document, this is a base to prepare sales invoice
 20

….5.2 Control activities and Tests of Controls


Tests of control
• The auditor’s test of control begins with obtaining understanding
about inventory and related controls and assessing risk of material
misstatement.
• Obtaining an understanding of client’s industry and business is very
important for auditors to know the nature of the client’s inventory,
risks and controls

Risk assessment
• Auditors visit client’s inventory facilities, including receiving,
storage, production, planning, and record-keeping areas to be
familiar with client’s inventory and assess risk
 Key issues that auditors should consider include:
 The inventory valuation method selected by management,
 The potential for inventory obsolescence,
 and the risk that consignment inventory might be intermingled
with owned inventory.
 21

….5.2 Control activities and Tests of Controls


..Risk Assessment
Assessing inherent risk
Because of its nature, inventory is a high inherent risk area
Inherent risk is high for inventory If:
 The inventory is stored in multiple locations,
 The costing method is complex, and
 The potential for inventory obsolescence is great.
Assessing Fraud Risk
 Frauds in this cycle involve overstatement of inventory or
assets and understatement of expenses
(eg. By over counting the items, not writing off obsolete inventory,
recording cost of goods sold by lower amount to inflate net
income, not recording the cost of goods sold )
• Theft of inventory by the employee
• Inventory shrinkage: Reduction in inventory presumed to be due
to physical loss or theft
• Employee schemes involving fictitious vendors as means to
transfer payments to themselves
 22

….5.2 Control activities and Tests of Controls


…..Risk assessment
Assessing control risk
 This requires understanding internal control for this area of audit
 To have an overall understanding of internal controls, auditors
consider :
 Entity-wide controls (the strength/weakness of the control
environment) by considering
▪Commitment to integrity and ethical values
▪Holding individuals accountable for their internal control
responsibilities (eg. if management takes action on
irregularities reported)
 Controls at transaction and account levels (by using
transaction and balance related audit objectives as a framework)
 Understanding of internal control is normally obtained by means of:
 Observation,
 inquiry,
 A walkthrough of the process, and
 review of the client’s documentation
 23

….5.2 Control activities and Tests of Controls

…..Risk
 assessment
..Assessing control risk
Control risk is said to be low if:
 All purchases are authorized
 Controls are strong in the purchasing area ( eg. If competitive bidding
process is used, if purchasing agents are rotated)
 There is timely, accurate, and complete recording of inventory transactions
 Receipt of inventory is properly accounted for and independently tested to
verify quality in adherence to company standards
 Cost accounting system is up-to-date
 There is Cycle counts ( Periodic testing of accuracy of perpetual inventory
record by counting all inventories on a cyclical basis)
 Products are systematically reviewed for obsolescence
 Management periodically reviews inventory and
 Takes action on excessive inventory
 Manages inventory to minimize losses caused by technological
obsolescence
 New products are introduced only after market studies and quality-control
tests are made
 Long-term contracts are closely monitored
 24

….5.2 Control activities and Tests of Controls


Response to identified Risks
 After performing risk assessment, auditors determine on audit
procedures that are proportional to assessed risks.
▪Areas of higher risk receive more audit attention and effort.
▪Auditors customize the audit program (eg more tests of detail or
less)
Auditors develop audit procedures that contain:
1. Tests of controls : Transactions are selected to test whether related
controls are working.
2. Substantive procedures, including analytical procedures
 transactions are selected to determine whether monetary errors have
occurred
SELECTING CONTROLS TO BE TESTED
 Normally, many internal controls exist for this area of audit but auditor
test major ones. Auditors focus on those that help to assure that all
purchases are:
 Authorized and all payments are for goods received,
 Made at appropriate amount and in correct time period
 Paid only once to the authorized vendor
 25

….5.2 Control activities and Tests of Controls

…Response
 to identified Risks
Audit Procedures to Test Controls
 Inquiry of relevant personnel
 Observation of the control being performed
Observation and inquiry are the evidences that auditors rely in getting
assurance over physical controls over inventory
 Eg visiting storeroom to observe whether materials are protected
from theft; asking custodians about their responsibility
 If auditors conclude that physical controls are inadequate, they will
expand their test to observe physical count
 Examination of documentation corroborating that the control has been
performed (eg. Checking documents showing transfer of inventories
from one location to other, SIVs, GRNs )
 Reperformance of the control by the auditor testing the control
 26

….5.2 Control activities and Tests of Controls

…Response to identified Risks

Auditors action based on the Outcome of Tests of Control

When control deficiencies are When No control deficiencies are
identified identified:
Assess those to Determine whether the preliminary
deficiencies
determine their severity assessment of control risk as low is still
appropriate
Modify the preliminary control risk
assessment Determine the extent that controls
can provide evidence on the
Document the implications of the correctness of account balances
control deficiencies
Determine planned substantive audit
procedures
 27

….5.2 Control activities and Tests of Controls

…Response
 to identified Risks
 Substantive test is mainly performed to obtain reasonable assurance
that:
 Inventory Exists (existence)
 Inventory is complete (no omission)
 Inventory is actually owned by the company (Rights)
 Inventory is valued accurately (Valuation)

Substantive Analytical procedures (tests of Reasonableness)

• Reasonableness test (for example to estimate inventory and CGS
balance and to determine whether that amount is close to what the
client has recorded)
 These procedures are important to show unusual fluctuation
 In addition to the financial information obtained by analytical
procedures, auditors usually use nonfinancial information (information
about the size and weight of inventory products, their methods of
storage) to assess the reasonableness of inventory-related balances.
 28

….5.2 Control activities and Tests of Controls

…Substantive Analytical Procedures
– Substantive analytical procedures are important for auditors to
examine the relationship of inventory account balances with other
financial statement accounts
– Significant improvements in audit effectiveness and efficiency
may be achieved by use of audit data analytics
 For example, the following ratios are computed:
▪ Eg. Percentage of inventory as compared to total assets;
▪ Percentage of CGS from total sales are computed
▪ Comparing budgeted inventory levels with actual
• Auditors may be able to use audit software to test entire populations
for certain audit tests, eliminating the need for more costly tests
involving sampling
 29

….5.2 Control activities and Tests of Controls

Table 21.1 Substantive Analytical Procedures for the Inventory and
Warehousing Cycle
Substantive Analytical Procedure 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 Obsolete inventory, which affects inventory
sold divided by average inventory) with and cost of goods sold.
that of previous years. Overstatement or understatement of
inventory.
Compare unit costs of inventory with those Overstatement or understatement of unit
of previous years. costs, which affects inventory and cost of
goods sold.
Compare extended inventory value with that Misstatements in compilation, unit costs, or
of previous years. extensions, which affect inventory and
cost of goods sold.
Compare current-year manufacturing costs Misstatements of unit costs of inventory,
with those of previous years (variable especially direct labor and manufacturing
costs should be adjusted for changes in overhead, which affect inventory and
volume). cost of goods sold.
 30

….5.2 Control activities and Tests of Controls

Audit Procedure to check Existence:
 Existence of inventory is ensured by:
 Checking perpetual record and
 Observing physical count-the most reliable evidence

Why auditors check Perpetual inventory records?

 The reliability of perpetual inventory records affect the time and extent
of the auditor’s physical examination of inventory.
 If these records are accurate, auditors can test the physical inventory
before the balance sheet date (interim checking),and this helps them to
complete the audit on time.

 Tests of physical inventory counts will reduce:

 When the client has reliable perpetual inventory records
 When observation shows physical control is effective. (when assessed
control risk related to physical control of inventory is low)
 ….5.2 Control activities and Tests of Controls 31

…Audit Procedure to check Existence:

• Periodic physical count of inventory is a must
When to Perform a Physical Count? (Timing decision)
 The physical count may be performed
 at the end of the year,
 at or near the balance sheet date,
 at an interim date, or
 on a cycle basis throughout the year.
 Inventory count on an interim date, or on a cycle basis are appropriate
only if there are adequate controls over the of the perpetual inventory
records.
 . inventory count on an interim date, or on a cycle basis are appropriate
only if :
 ….5.2 Control activities and Tests of Controls 32

…Audit Procedure to check Existence:

When Inventories are located in multiple location, Auditors :
 Review a variety of locations for comparison
 Use analytical procedures to see if locations not visited seem to have
inventory levels that are significantly different from those observed
Additional Testing methods
Auditors can also:
– Confirm inventory amounts with the trading partner
– Examine subsequent payments from the trading partner, or visiting
selected trading partners to inspect inventory
Checking Unit cost record
 Inaccurate unit costs misstate financial statements
 Auditors are required to understand the cost accumulation procedures
(the cost flows) to get assurance about the accuracy of unit costs
 Auditors usually test cost accounting records as a part of the acquisition,
payroll, and sales tests to increase audit efficiency
 ….5.2 Control activities and Tests of Controls 33

Audit Procedure to check Completeness:

This involves:
 Performing year-end cutoff tests
 Purchase cutoff procedures should be designed to test whether all inventory
owned by the company was recorded
 This is done by taking a note of last shipping and receiving document
numbers used before physical inventory is taken to see if items on these
documents are included in inventory
 Reviewing the purchase and sales journals for a period of time shortly before
and after year end
 Taking a note of the shipping and receiving document numbers to determine
whether the goods are recorded in the proper time period
 Making inquiries regarding the potential existence of goods on consignment
or located in outside warehouses
 For material items, either visiting the locations or sending a confirmation to
the outside warehouse management

Audit Procedure to check Rights & Obligation: This involves:

• Reviewing vendor invoices when testing disbursements to determine that
proper title is conveyed
• Reviewing purchase contracts to assess rights to return merchandise
 ….5.2 Control activities and Tests of Controls 34

Audit Procedure to check Valuation:

In performing inventory valuation tests (often called price tests), the auditor
has two concerns.
1. The method must be in accordance with accounting standards (as per
IAS 2).
2. The application of the method must be consistent from year to year.

Procedures involve:
 Testing inventory cost by taking a sample of recorded inventory, and
tracing to source documents, including:
▪ Raw material purchases to vendor invoices
▪ Testing standard costs as built up through the standard cost
system
 Testing for possibility of obsolete inventory that should be written
down to market value: (Auditors may review trade journals for
changes in product technology)
 Following-up on potentially obsolete items noted during the
observation of the client’s physical inventory counts
 Using audit software to read inventory file and age the inventory
items and compute inventory turnover
 ….5.2 Control activities and Tests of Controls 35

…Audit Procedure to check Valuation:

 Inquiring of the client about sales adjustments that have been offered
to sell any products
 Verifying sales price by reviewing recent price list
 Analyzing sales by product line
 Reviewing purchase commitments for potential loss exposures
 Using audit software to test extensions and prepare a printout of
differences
 Using audit software to foot the inventory compilation
 Valuation of ending inventory is directly affected by quality of client’s cost
system
 Auditor should inquire about the following: Method for developing
standard costs
 How recently the standards have been updated
 Method for identifying components of overhead and of allocating
overhead to products
 Methods for identifying variances, following up on their causes, and
allocating them to inventory and cost of goods sold
 ….5.2 Control activities and Tests of Controls 36

…Audit Procedure to check Valuation:

 Using inventory analysis
 An inventory turnover analysis is useful to detect the existence of
obsolete merchandise (If obsolete items are valued at cost, inventory
will overstate. Obsolete inventory should be written down to their net
realizable value)
Auditors are required to test the perpetual inventory system to ensure that:
 Authorized receipts and sales of inventory are recorded accurately and
promptly
 Only authorized receipts and sales of inventory have been recorded

Audit Procedure to test Presentation and disclosure

Presentation and disclosure is tested by reviewing client’s financial statement
disclosures of:
 Inventory valuation methods used
 Percentage of inventory valued by different methods
 Classification of inventory as raw material, work in process, and finished goods
 Existence of contingent losses associated with long-term contracts or purchase
commitments
 Inventory policy regarding returns and allowance
 ….5.2 Control activities and Tests of Controls 37

…Audit Procedure to check Valuation:

Fraud related substantive procedures:
Auditors use the following substantive procedures when there is a high
risk of fraud:
 Observe all inventory locations simultaneously
 Confirm inventories at locations that are outside the entity
 Compare carrying inventory amounts to recent sales amounts
 Examine consignment agreements and determine that
consignments are properly accounted for
 Send confirmations to vendors confirming invoices and unusual
terms
 Determine if there are bulk sales at steep discounts Indication of
decreasing values for the company’s products
 38

5.3 Audit of the Cost Accounting System

The Cost Accounting System:
• This system requires:
– Having a system that accumulates the cost of materials, labor cost (part
of the payroll function)and overhead, and determine costs of goods on
process and finished goods
• The auditor is concerned with four aspects of cost accounting:
1) Physical controls over inventory
2) Documents and records for transferring inventory
3) Perpetual inventory master files
4) Unit cost records (e.g how standard costs for DM,DL,FOH are
developed)
– Inaccurate cost accounting provides inaccurate data
(overstated/understated cost information)
– Testing the entity's computation of standard overhead rates would provide
assurance that a manufacturing entity's inventory valuation is proper
The auditor reviews client’s cost accounting system to obtain evidence
about the valuation of work-in-process, finished goods, and CGS
 39

5.3 Audit of the Cost Accounting System

Audit of the Perpetual Inventory System:
The Perpetual Inventory System requires:
• Having a system that continuously record the movement of goods
and shows quantity and value of goods that should be on hand
–Cost accounting systems and related controls differ from company to
company depending on the type of inventory and the level of
sophistication desired by management
• There are two broad categories of Cost accounting controls:
– Physical controls over raw materials, work-in-process, and finished goods
inventory
– Controls over the related costs
 In verifying debits to perpetual inventory records of a non-manufacturing
firm, the auditor would be most interested in examining the Vendor’s
invoices
 In verifying credits to perpetual inventory records of a non-manufacturing
firm, the auditor would be most interested in examining Shipping
documents
 ..5.3 Audit of the Cost Accounting System 40

• …Audit of the Perpetual Inventory System

Who should maintain perpetual record?
– Perpetual records showing the movement of goods in both quantity &
cost should be maintained by the cost accounts section
– The storekeeper is not responsible for maintenance of perpetual
inventory records. The storekeeper keeps bin card , showing
movement in quantity only
– For a better control, periodically, perpetual records are reconciled with
bin cards
• The accuracy of perpetual inventory records may be established, in part,
by comparing perpetual inventory records with GRN, Shipping doc & SIV.
• Failure to record purchase of inventories could result in inventory
quantities in the client's physical count of inventories to be higher than
what the perpetual record shows.
• Failure to record sales/issuance of inventories could result in inventory
quantities in the perpetual records is to be higher than the client's physical
count of inventories.
 41

5.4 Observing Physical Inventory

• Observing physical inventory is the most reliable evidence to ensure
existence of inventory
• ISA 501 Audit Evidence-Specific considerations for selected items
require the auditor to:
– Attend the physical inventory count (unless impracticable), if
inventory is material to the financial statement,
– Perform procedures on the final inventory records to determine
whether they accurately reflect the count results.
The standard require auditors to meet following inventory
observation requirements:
– Be present at the time the client counts its inventory
– Observe the client’s counting procedures
– Make inquiries of client personnel about their counting procedures
– Make their own independent tests of the physical count
 42

5.4 Observing Physical Inventory

• During observing the count, the auditor is required to:
– Evaluate management’s instructions and procedures for the inventory
count.
– Observe the performance of the count to ensure that all items are
counted, and nothing is counted twice
– Inspect the inventory
– Be alert for goods that appear to be damaged or obsolete
– Obtain information to test the client's cutoff of purchases and sales
– Perform Test counts and record in working paper to later test the
accuracy of the final inventory listing.
– Make inquiries regarding goods on consignment

• Note: Inventory count is the responsibility of the client. The auditor

does not perform the count.
• The auditor is there to observe the count, not supervise the client’s
personnel involved in couting
 43

…5.4 Observing Physical Inventory

• Obtaining an understanding of the client’s industry and business is
more important for both physical inventory observation and inventory
pricing and compilation than for most audit areas
• Auditors often first familiarize themselves with the client’s inventory by
conducting a tour of the client’s inventory facilities, including receiving,
storage, production, planning, and record-keeping areas

• Adequate controls over the client’s physical count of

inventory include:
– Proper client instructions for the physical count
– Supervision by responsible company personnel
– Independent internal verification
– Independent reconciliations of the physical counts with
perpetual inventory master file
 … 5.4 Observing Physical Inventory
Sample Size
44

• It is difficult to specify the number of inventory items auditors should

count because auditors focus on observing the client’s procedures
rather than on selecting items for testing.
• For convenience, sample size in physical observation may be
considered in terms of the total number of hours spent rather than
the number of inventory items counted.
• The key determinants of the amount of time needed to test inventory
are:
– The adequacy of internal controls over the physical counts
– The accuracy of the perpetual inventory records
– The total dollar amount and type of inventory
– The number of different significant inventory locations
– The nature and extent of misstatements discovered in previous
years, and other inherent risks
 …5.4 Observing Physical Inventory 45

After deciding the sample size, the next decision is on which item to
select:
Selection of Items
 When auditors observe the client counting inventory, they should be careful
to:
 Observe the counting of the most significant items and a representative
sample of typical inventory items
 Inquire about items that are likely to be obsolete or damaged
 Discuss with management the reasons for excluding any material items
Tasks Auditors perform during year end count also include:
 Making test counts of selected items and records them for tracing into
client’s inventory compilation
 Taking notes of all items that appear to be obsolete or are in
questionable condition
 Observing the handling of scrap and other material
 Looking for evidence of slow-moving, obsolete, or damaged inventory
needed to be written down to lower of cost or market
 Observing whether any physical movement of goods occurs during
counting of inventory
 Recording high-dollar-value items for subsequent tracing into client’s
records
 …5.4 Observing Physical Inventory 46

EXAMPLES OF FRAUD IN THE PHYSICAL OBSERVATION OF

INVENTORY
– Empty boxes in stacked goods
– Mislabeled boxes containing scrap, obsolete items, or lower-value
materials
– Consigned inventory, inventory that is rented, or traded-in items for
which credits have not been issued
– Inventory diluted so it is less valuable
 47

5.5 Audit of Pricing and Compilation

• Auditors must verify that the physical counts or perpetual
record quantities are correctly 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:
– testing the client’s summarization of the inventory
counts,
– recalculating price times quantity,
– footing the inventory summary, and
– tracing the totals to the general ledger
 48

..5.5 Audit of Pricing and Compilation

Adequate internal controls surrounding the tracking of unit
costs that are integrated with production and other
accounting records provide assurance that clients use
reasonable costs for valuing ending inventory
• In performing inventory valuation tests, the auditor
has two concerns:
– The method must be in accordance with accounting
standards (IAS 2)
– The application of the method must be consistent from
year to year
..5.5 Audit of Pricing and Compilation 49

Integration of the Tests

• The audit of the inventory and warehousing cycle consists of the
following series of integrated tests:
– Tests of the acquisition and payment cycle
– Tests of the payroll and personnel cycle
– Tests of the sales and collection cycle
– Tests of cost accounting
– Physical inventory, pricing, and compilation
 50

..5.5 Audit of Pricing and Compilation

DOCUMENTATION RELATED TO THE INVENTORY & CGS SUBSTANTIVE
PROCEDURES
AUDITORS KEEP THE FOLLOWING DOCUMENTS RELATED TO THE
SUBSTANTIVE PROCEDURES APPLIED TO INVENTORY & CGS:
Evidence about:
 Substantive analytical procedures conducted, conclusions reached,
and related actions taken
 Physical inventory observations for all material amounts
 Mathematical accuracy of inventory records
 Recent shipments used for cutoff testing
 Items counted during physical inventory observation
 Product costing
 Inventory whose cost exceeds market value
 Net realizable valuable calculations (as per IAS 2)
 Comparison of inventory quantities to budgetary plans
 Inventory items with unusual prices, units, or descriptions
 Views from inventory specialists
 51

End of Chapter 5:

Questions