2.

3 Audit of inventory and warehousing cycle

The inventory and warehousing cycle is unique because of its close relationships to other
transaction cycles. For a manufacturing company, raw material enters the inventory and
warehousing cycle from the acquisition and payment cycle, while direct labor enters it from the
payroll and personnel cycle. 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:
Inventory is often the largest account on the balance sheet.
Inventory is often in different locations, making physical control and counting difficult.
Diverse inventory items such as chemicals and electronic parts are often difficult for
auditors to observe and value.
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 standards.
Business Functions in the Cycle and Related Documents and Records
Inventory takes many different forms, depending on the nature of the business. For retail or
wholesale businesses, the largest account in the financial statements is often merchandise
inventory available for sale. To study the inventory and warehousing cycle, we will use an
example of a manufacturing company, whose inventory may include raw materials, purchased
parts and supplies for use in production, goods in the process of being manufactured, and
finished goods available for sale. Still, most of the principles discussed apply to other types of
businesses as well.
The inventory and warehousing cycle can be thought of as comprising two separate but closely
related systems, one involving the physical flow of goods and the other the related costs. The
following six functions make up the inventory and warehousing cycle:
Process Purchase Orders
The inventory and warehousing cycle begins with the acquisition of raw materials for
production. Adequate controls over purchasing must be maintained whether inventory purchases
are for raw materials for a manufacturer or finished goods for a retailer.
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Purchase requisitions are forms used to request the purchasing department to order inventory.
These requisitions may be initiated by stockroom personnel as raw materials are needed, by
automated computer software when raw materials reach a predetermined level, by orders placed
for the materials required to produce a customer order, or by orders initiated on the basis of a
periodic raw materials count.
Receive Raw Materials
Receipt of the ordered materials, which is also part of the acquisition and payment cycle,
involves the inspection of material received for quantity and quality. The receiving department
prepares a receiving report that becomes a part of the documentation before payment is made.
After inspection, the material is sent to the storeroom and copies of the receiving documents, or
electronic notifications of the receipt of goods, are typically sent to purchasing, the storeroom,
and accounts payable.
Store Raw Materials
Once received, materials are normally stored in a stockroom. When another department needs
materials for production, personnel submit a properly approved materials requisition, work order,
or similar document or electronic notice that indicates the type and quantity of materials needed.
This requisition document is used to update the perpetual inventory master files and record
transfers from raw materials to work-in-process accounts.
Process the Goods
Processing inventory varies greatly from company to company. Companies determine the
finished goods items and quantities they will produce based on specific orders from customers,
sales forecasts, predetermined finished goods inventory levels, and economical production runs.
A separate production control department is often responsible for determining the type and
quantities to produce.
An adequate cost accounting system is an important part of the processing of goods function for
all manufacturing companies. The system shows the relative profitability of the products for
management planning and control and values inventories for preparing financial statements.
Two primary types of cost systems exist: job cost systems and process cost systems, but there
are many variations and combinations of these systems.
In a job cost system, costs are accumulated by individual jobs when material is issued and labor
costs incurred. In a process cost system, they are accumulated by processes, with unit costs for
each process assigned to the products passing through the process.
Cost accounting records consist of master files, spreadsheets, and reports that accumulate
material, labor, and overhead costs by job or process as those costs are incurred. When jobs or
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products are completed, the related costs are transferred from work-in-process to finished goods
based on production department reports.
Store Finished Goods
When finished goods are completed, 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.
Ship Finished Goods
Shipping completed goods is part of the sales and collection cycle. The actual shipment of goods
to customers in exchange for cash or other assets, such as accounts receivable, creates the
exchange of assets necessary for meeting revenue recognition criteria. For most sales
transactions, the actual shipment becomes the trigger for recognizing the related accounts
receivable and sales in the accounting system. Thus, shipments of finished goods must be
authorized by a properly approved shipping document.

PARTS OF THE AUDIT OF INVENTORY

The overall objective in the audit of the inventory and warehousing cycle is to provide assurance
that the financial statements fairly account for raw materials, work-in-process, finished goods
inventory, and cost of goods sold.
The audit of the inventory and warehousing cycle can be divided into five activities within the
cycle:
1. Acquire and record raw materials, labor, and overhead
2. Internally transfer assets and costs
3. Ship goods and record revenue and costs
4. Physically observe inventory
5. Price and compile inventory

Acquire and Record Raw Materials, Labor, and Overhead

This part of the audit includes processing purchase orders, receiving raw materials, and storing
raw materials.
The auditor obtains an understanding of internal controls over these three functions and then
performs tests of controls and substantive tests of transactions in both the acquisition and
payment cycle and the payroll and personnel cycle. These tests should satisfy auditors, that
controls affecting the acquisitions of raw materials and manufacturing costs are operating
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effectively and that acquisition transactions are correctly stated. When direct labor is a
significant part of manufactured inventory, auditors should verify the proper accounting for these
costs in the payroll and personnel cycle.
Transfer Assets and Costs
Internal transfers of inventory include process the goods and store finished goods. Clients
account for these activities in the cost accounting records, which are independent of other cycles
and are tested as part of the audit of the inventory and warehousing cycle.
Ship Goods and Record Revenue and Costs
Recording shipments and related costs is the last function. Because it is part of the sales and
collection cycle, auditors obtain an understanding and test internal controls over recording
shipments as a part of auditing that cycle, including procedures to verify the accuracy of the
credits to inventory recorded in perpetual inventory master files.
Physically Observe Inventory
Auditors must observe the client taking a physical inventory count to determine whether
recorded inventory actually exists at the balance sheet date and is correctly counted by the client.
Physical examination is an essential type of evidence used to verify the existence and count of
inventory.
Price and Compile Inventory
Costs used to value inventory must be tested to determine whether the client has correctly
followed an inventory method that is both in accordance with accounting standards and
consistent with previous years. Audit procedures used to verify these costs are called price tests.
In addition, the auditor must perform inventory compilation tests, which are tests to verify
whether the physical counts were correctly summarized, the inventory quantities and prices were
correctly extended, and the extended inventory correctly footed to equal the general ledger
inventory balance.
Generally, the five parts of audit of inventory and warehousing cycle is summarized as follows:
Part of audit Cycle in which tested

Acquire
Acquire and
and record
record raw materials, Acquisition and payment plus
labor, and overhead payroll and personnel

Internally transfer assets and costs Inventory and warehousing

Ship goods and record Sales and collection

revenue and costs
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 Inventory and warehousing
Physically observe inventory

Inventory and warehousing

Price and compile inventory

AUDIT OF COST ACCOUNTING

The audit of cost accounting begins with the internal transfer of assets from raw materials to
work-in-process to finished goods inventory.
Cost accounting systems and controls of different companies vary more than most other audit
areas because of the wide variety of items of inventory and the level of sophistication desired by
management. For example, a company that manufactures farm machines may have completely
different cost records and internal controls than a steel fabricating shop that makes and installs
custom-made metal cabinets. Of course, small companies with owners actively involved in the
manufacturing process need less sophisticated records than large, multiproduct companies.
Cost accounting controls are those related to processes affecting physical inventory and the
tracking of related costs from the time raw materials are requisitioned to the completion of the
manufactured product and its transfer to storage.
These controls are divided into two broad categories:
1. Physical controls over raw materials, work-in-process, and finished goods inventory
2. Controls over the related costs
Almost all companies need physical controls over their assets to prevent loss from misuse and
theft. To protect assets, most companies physically segregate and restrict access to storage areas
for raw material, work-in-process, and finished goods to control the movement of inventory. In
some instances, managers assign custody of inventory to specific individuals who are responsible
for protecting the inventory. Clients may use approved pre-numbered documents for authorizing
movement of inventory to protect the assets from improper use. Electronic or paper copies of
these documents should be sent directly to accounting by the persons issuing them, by passing
people with custodial responsibilities.
Perpetual inventory master files maintained by persons who do not have custody of or access to
assets are another useful cost accounting control for a number of reasons:
 They provide a record of inventory on hand, which is used to initiate production or acquisition of
additional materials or goods.

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  They provide a record of the use of raw materials and the sale of finished goods, which can be
reviewed for obsolete or slow-moving items.
 They provide a record to pinpoint responsibility when there are differences between physical
counts and the amounts shown on the perpetual listings.
Also, adequate internal controls that integrate production and accounting records to provide
accurate costs for all products are important to aid management in pricing finished goods,
controlling costs, and costing inventory.
The concepts in auditing inventory cost accounting are no different from those discussed for
other transaction cycles: understand internal controls in the cost accounting system, assess
planned control risk, determine extent of testing controls, and design tests of controls and
substantive tests of transactions to meet transaction-related audit objectives.
Generally, 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

Physical Controls Auditor tests of physical controls over raw materials, work-in-process, and
finished goods are limited to observation and inquiry. Auditors can examine the raw materials
storage area to determine whether the inventory is protected from theft and misuse by locks or
other security measures, including an inventory custodian. They can ask inventory custodians to
explain their duties related to their oversight of inventory monitored by them. If auditors
conclude that the physical controls are so inadequate that inventory will be difficult to accurately
count, they should expand observation of physical inventory tests to make sure that an adequate
count is carried out.
Documents and Records for Transferring Inventory The auditor’s primary concerns in
verifying the transfer of inventory from one location to another are that recorded transfers exist,
all actual transfers are recorded, and the quantity, description, and date of all recorded transfers
are accurate. Products labeled with standardized bar codes that can be scanned by laser bar-code
readers and other technologies make it easier for clients to track the movement of goods through
production.
When auditing inventory transfers, auditors first need to understand the client’s internal controls
for recording transfers before they can perform relevant tests. After they understand the internal
controls, they can easily perform tests of controls or substantive tests of transactions by
examining documents and records to test the occurrence and accuracy objectives for the transfer
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of goods from the raw material storeroom to manufacturing. For example, auditors may account
for a sequence of raw material requisitions, examine the requisitions for proper approval, and
compare the quantity, description, and date with the information recorded in the raw material
perpetual inventory master files to verify that related controls operated effectively and that
amounts are correctly recorded. Similarly, the auditor may compare completed production
records with perpetual inventory master files to be sure that all manufactured goods were
physically delivered to the finished goods storeroom.
Perpetual Inventory Master Files The reliability of perpetual inventory master files affects the
timing and extent of the auditor’s physical examination of inventory.
When perpetual inventory master files are accurate, auditors can test the physical inventory
before the balance sheet date. An interim physical inventory or use of cycle counts throughout
the year can result in significant cost savings for both the client and the auditor, and it enables
the audit to be completed earlier. The auditor may also reduce tests of physical inventory counts
when the client has reliable perpetual inventory records and assessed control risk related to
physical observation of inventory is low.
Auditors test perpetual inventory master files by examining documentation that supports
additions and reductions of inventory amounts in the master files. For example, as part of the
tests of the perpetual records, auditors may examine documents supporting inventory activities
including the addition of acquired raw material inventory, the reduction of raw material
inventory for use in production, the increase in finished goods inventory when goods have been
manufactured and the decrease when finished goods are sold. Usually, it is relatively easy to test
the accuracy of the perpetual inventory master files after the auditor determines the adequacy of
the design and implementation of inventory internal controls and the related level of assessed
control risk. Auditors test the perpetual records for acquisitions of raw materials in the
acquisition and payment cycle, while reductions in finished goods for sale are tested in the sales
and collection cycle.
Unit Cost Records Accurate cost data for raw materials, direct labor, and manufacturing
overhead is essential for fairly stated raw materials, work in progress and finished goods
inventories. To maintain accurate cost data, clients must integrate their cost accounting records
with production and other accounting records.
When testing inventory cost records, the auditor must first obtain an understanding of internal
control in the cost accounting system. This understanding can be time-consuming because the
flow of costs is integrated with accounting records in three other cycles: acquisition and
payment, payroll and personnel, and sales and collection.
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Secondly, auditors test cost accounting records. Auditors usually test cost accounting records as
a part of the acquisition, payroll, and sales tests to avoid testing the records more than once and
to increase audit efficiency.
When testing acquisition transactions, auditors should trace the units and unit costs of raw
materials to additions recorded in the perpetual inventory master files and the total cost to cost
accounting records. Similarly, when clients maintain payroll cost data for different jobs, auditors
should trace from the payroll summary directly to job cost records when they audit payroll.
Determining the reasonableness of manufacturing overhead costs assigned to work-in-process is
challenging for auditors because management must make assumptions that affect overhead
allocations that can significantly affect the unit costs of inventory and therefore the fairness of
inventory valuation. In evaluating these overhead cost allocations, the auditor must consider the
reasonableness of the allocation method, assuming the method complies with accounting
standards, and whether it is consistently applied.
Internal controls over cost accounting records vary significantly among companies. Auditors
should design appropriate tests based on their understanding of the cost accounting records and
the extent to which they will be relied on to reduce substantive tests.

ANALYTICAL PROCEDURES
Analytical procedures are important in auditing inventory and warehousing, as they are in all
other cycles. Common analytical procedures and possible misstatements that may be indicated
when fluctuations occur are summarized below:
Analytical Procedure
Compare gross margin percentage with that
of previous years.
Compare inventory turnover (cost of goods
cost of goods sold.
sold divided by average inventory) with
that of previous years.
Compare unit costs of inventory with those
of previous years.
Compare extended inventory value with that
of previous years.
Compare current year manufacturing costs
with those of previous years (variable
costs should be adjusted for changes in
volume).
Possible Misstatement
Overstatement or understatement of
Inventory and cost of goods sold.
Obsolete inventory, which affects inventory and
Overstatement or understatement of inventory.
Overstatement or understatement of unit costs,
which affect inventory and cost of goods sold.
Misstatements in compilation, unit costs, or
extensions, which affect inventory and cost of
goods sold.
Misstatements of unit costs of inventory, especially
direct labor and manufacturing overhead, which
affect inventory and cost of goods sold

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In addition to performing analytical procedures that examine the relationship of inventory
account balances with other financial statement accounts, auditors often use nonfinancial
information to assess the reasonableness of inventory-related balances. For example, auditors
may need knowledge about the size and weight of inventory products, their methods of storage
(stacks, tanks, etc.), and the capacity of storage facilities (available square footage) to determine
whether recorded inventory is consistent with available inventory storage. After performing the
appropriate tests of the cost accounting records and analytical procedures, auditors have a basis
for designing and performing tests of details of the ending inventory balance.

PHYSICAL OBSERVATION OF INVENTORY

Because inventory varies significantly for different companies, 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.
Examples of key considerations 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 combined with owned inventory.
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. The tour should be led by a supervisor who can answer questions about
production, especially about any changes in internal controls and other processes since last year.
While gaining an understanding of the effect of the client’s business and industry on inventory,
auditors assess client business risk to determine if those risks increase the likelihood of material
misstatements in inventory. Examples of common sources of business risk for inventory include
short product cycles, potential obsolescence, use of just-in-time inventory, reliance on a few key
suppliers, and use of sophisticated inventory management technology.
After assessing client business risk, the auditor decides tolerable misstatement and assesses
inherent risk for inventory, which is typically highly material for manufacturing, wholesale, and
retail companies. Auditors often assess a high inherent risk for companies with significant
inventory, depending on the circumstances. Auditors often have a greater concern for
misstatements when inventory is stored in multiple locations, the costing method is complex, and
the potential for inventory obsolescence is great.

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When assessing control risk, the auditor is primarily concerned with internal controls over
perpetual records, physical controls, inventory counts, and inventory compilation and pricing.
The nature and extent of these controls varies widely from company to company.

Inventory Observation Requirements

Auditing standards require auditors to satisfy themselves about the effectiveness of the client’s
methods of counting inventory and the reliance they can place on the client’s representations
about the quantities and physical condition of the inventories.
To meet the requirement, auditors must:
 Be present at the time the client counts their inventory for determining year-end balances
 Observe the client’s counting procedures
 Make inquiries of client personnel about their counting procedures
 Make their own independent tests of the physical count
An essential point in the auditing standards is the distinction between who observes the physical
inventory count and who is responsible for taking the count. The client is responsible for setting
up the procedures for taking an accurate physical inventory and actually making and recording
the counts. The auditor is responsible for evaluating and observing the client’s procedures,
including doing test counts of the inventory and drawing conclusions about the adequacy of the
physical inventory.

Controls over Physical Count

Regardless of the inventory record-keeping method, the client must make a periodic physical
count of inventory. The physical count may be performed at or near the balance sheet date, at an
interim date, or on a cycle basis throughout the year. The latter two approaches are appropriate
only if there are adequate controls over the of the perpetual inventory master files.
Adequate controls over the client’s physical count of inventory include proper client instructions
for the physical count, supervision by responsible company personnel, independent internal
verification of the counts by other client personnel, independent reconciliations of the physical
counts with perpetual inventory master files, and adequate client control over count sheets or
tags used to record inventory counts.
Auditors need to understand the client’s physical inventory count controls before the count of
inventory begins. While this understanding is necessary to evaluate the effectiveness of the
client’s procedures, it also enables the auditor to make constructive suggestions beforehand.
Obviously, if the client’s physical inventory count controls are inadequate, the auditor must
spend more time making sure that the physical count is accurate.
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Audit Decisions

The auditor’s decisions in the physical observation of inventory are similar to those made for
other audit areas. They include selecting audit procedures, deciding the timing of the procedures,
determining sample size, and selecting items for testing.
Timing The auditor decides whether the physical count can be taken before year-end primarily
on the basis of the accuracy of the perpetual inventory master files. When a client does an
interim physical count, which the auditor will agree to only when internal controls are effective,
the auditor observes the inventory count at that time, and also tests transactions recorded in the
perpetual inventory records from the date of the count to year-end. When the perpetual records
are accurate and related controls operate effectively, it may be unnecessary for the client to count
the entire inventory at year-end. Instead, the auditor can compare the perpetual with the actual
inventory on a sample basis at convenient times throughout the year, as long as controls over
additions and reductions to the perpetual records are tested and found to operate effectively.
When there are no perpetual and the inventory is material, the client must take a complete
physical inventory near the end of the accounting period.
Sample Size The number of inventory items auditors should count is difficult to specify because
auditors concentrate 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, accuracy of the perpetual inventory master files, total dollar amount
and type of inventory, number of different significant inventory locations, nature and extent of
misstatements discovered in previous years, and other inherent risks.
In some situations, inventory is so material that it requires dozens of auditors to observe the
physical count. In other situations, one auditor can complete the observation in a short time.
Audit planning for inventory count testing and coordination with client personnel is critical. Poor
planning may lead to audit difficulties.
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

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Physical Observation Tests
The same balance-related audit objectives discussed in previous sections for tests of details of
balances provide a frame of reference for discussing the physical observation tests.
The most important part of the observation of inventory is determining whether the physical
count is being taken in accordance with the client’s instructions. To do this effectively, it is
essential that the auditor be present while the physical count is taking place.
When the client’s employees are not following the inventory instructions, the auditor must either
contact the supervisor to correct the problem or modify the physical observation procedures. For
example, if the procedures require one team to count the inventory and a second team to recount
it as a test of accuracy, the auditor should inform management if both teams are observed
counting together.
The common tests of details of balances audit procedures for physical inventory observation are:
1. Existence: inventory as recorded on tags exists.
Procedures:
 Select a random sample of tag numbers and identify the tag with that
number attached to the actual inventory.
 Observe whether movement of inventory takes place during the count.
2. Completeness: existing inventory is counted and tagged, and tags are accounted for to
make sure none are missing.
Procedure:
 examine inventory to make sure it is tagged
 Observe whether movement of inventory takes place during the count
 Inquire as to inventory in other locations.
 Account for all used and unused tags to make sure none are lost or intentionally
omitted.
 Record the tag numbers for those used and unused for subsequent follow-up.
3. Accuracy: Inventory is counted accurately
Procedure:
 Recount client’s counts to make sure the recorded counts are accurate on the tags (also
check descriptions and unit of count, such as dozen or gross).
 Compare physical counts with perpetual inventory master file.
 Record client’s counts for subsequent testing.
4. Classification: Inventory is classified correctly on the tags

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 Procedure:
 Examine inventory descriptions on the tags and compare with the actual inventory for
raw material, work-in-process, and finished goods.
 Evaluate whether the percent of completion recorded on the tags for work-in-process
is reasonable.
5. Cutoff: Information is obtained to make sure sales and inventory purchases are recorded
in the proper period (cutoff).

Procedure:

 Record in the audit files for subsequent follow-up the last shipping document number
used at year-end.
 Make sure the inventory for the above item was excluded from the physical count.
 Review shipping area for inventory set aside for shipment but not counted.
 Record in the audit files for subsequent follow-up the last receiving report number
used at year-end.
 Make sure the inventory for the above item was included in the physical count.
 Review receiving area for inventory that should be included in the physical count.
6. realizable value: Obsolete and unusable inventory items are excluded or noted

Procedure:
 Test for obsolete inventory by inquiry of factory employees and management and
alertness for items that are damaged, rust- or dust-covered, or located in inappropriate
places.
7. Rights: The client has rights to inventory recorded on tags
Procedure:
 Inquire about consignment or customer inventory included on client’s premises.
 Be alert for inventory that is set aside or specially marked as indications of non
ownership.

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.

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Adequate internal controls surrounding the tracking of unit costs that are integrated with
production and other accounting records provides assurance that clients use reasonable costs for
valuing ending inventory. Standard cost records that indicate variances in material, labor, and
overhead costs are helpful to evaluate the reasonableness of production records if management
has procedures in place to keep the standards updated for changes in production processes and
costs. Management should also have someone independent of the department responsible for
determining the costs review them for reasonableness.
To prevent including or overstating the value of obsolete inventory, clients should have a formal
review and reporting of obsolete, slow-moving, damaged, and overstated inventory items. The
review should be done by a knowledgeable employee who reviews perpetual inventory master
files for inventory turnover.
Clients need inventory compilation internal controls to ensure that the physical counts are
correctly summarized, priced at the same amount as the unit records, correctly extended and
totaled, and included in the perpetual inventory master file and related general ledger inventory
accounts at the proper amount. The most important internal control for accurate unit costs,
extensions, and footings is internal verification by a competent, independent person, who relies
on adequate documents and records that were used for taking the physical count. If the physical
inventory counts are recorded by the client on pre-numbered tags and carefully reviewed before
the personnel who counted the inventory are released from the physical examination of
inventory, there should be little risk of misstatement in summarizing inventory count tags.
The audit objectives and related tests for inventory pricing and compilation:
1. Detail tie-in: Inventory in the inventory listing schedule agrees with the physical
inventory counts, the extensions are correct, and the total is correctly added and agrees
with the general ledger
2. Existence: listing schedule exist Inventory items in the inventory
3. Completeness: Existing inventory items are included in the inventory listing schedule
4. Accuracy: Inventory items in the inventory listing schedule are accurate
5. Classification: Inventory items in the inventory listing schedule are correctly classified
6. Realizable value: Inventory items in the inventory listing are stated at realizable value
7. Rights: The client has rights to inventory items in the inventory listing schedule

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Valuation of Inventory

In performing inventory valuation tests (often called price tests), the auditor has three concerns.
1. The method must be in accordance with accounting standards.
2. The application of the method must be consistent from year to year.
3. Inventory cost versus market value (replacement cost or net realizable value) must be
considered.
Pricing Purchased Inventory The primary types of inventory included in this category are raw
materials, purchased parts, and supplies. As a first step in verifying the valuation of purchased
inventory, the auditor must determine whether the client uses LIFO, FIFO, weighted average, or
some other valuation method. Auditors must also determine which costs should be included in
the valuation of an item of inventory. For example, the auditor must find out whether freight,
storage, discounts, and other costs are included and the auditor must compare the findings with
the preceding year to make sure that the costs are determined consistently.

In selecting specific inventory items for pricing, auditors should focus on larger dollar amounts
and on products that are known to have wide fluctuations in price. They should also test a
representative sample of all types of inventory and departments.
Stratified variables or monetary unit sampling is commonly used for these tests.
The auditor should list the inventory items to be verified for pricing and request the client to
locate the appropriate vendors’ invoices. The auditor must examine sufficient invoices to account
for the entire quantity of inventory for the item being tested, especially for the FIFO valuation
method.
When the client has perpetual inventory master files that include unit costs of acquisitions, it is
usually much faster to test the pricing by tracing the unit costs to the perpetual rather than to
vendors’ invoices. Naturally, when perpetual inventory records are used to verify unit costs,
auditors must test the unit costs recorded in the perpetual records to vendors’ invoices as a part
of the tests of the acquisition and payment cycle transactions.
Pricing Manufactured Inventory In pricing work-in-process and finished goods, the auditor
must consider the cost of raw materials, direct labor, and manufacturing overhead. The need to
verify each of these makes the audit of work-in-process and finished goods inventory more
complex than the audit of purchased inventory.

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Nevertheless, several considerations that apply to the audit of purchased inventory still apply,
such as selecting the items to be tested, testing for whether cost or market value is lower, and
evaluating the possibility of obsolescence.
In pricing raw materials in manufactured products, auditors must consider both the unit cost of
the raw materials and the number of units required to manufacture a unit of output. The unit cost
can be verified in the same manner as that used for other purchased inventory, by examining
vendors’ invoices or perpetual inventory master files. Auditors must examine engineering
specifications, inspect the finished product, or find a similar method to determine the number of
units it takes to manufacture a product.
Similarly, while testing direct labor, auditors must verify the hourly costs of direct labor and the
number of hours it takes to manufacture a unit of output. Hourly labor costs can be verified by
examining labor payroll or union contracts. Auditors can determine the number of hours needed
to manufacture the product from engineering specifications or similar sources.
The proper manufacturing overhead in work-in-process and finished goods depends on the
approach the client uses to allocate manufacturing overhead. Auditors must evaluate the method
being used for consistency and reasonableness and re compute the costs to determine whether the
overhead is correct. For example, if the rate is based on direct labor dollars, the auditor can
divide the total manufacturing overhead by the total direct labor dollars to determine the actual
overhead rate. This rate can then be compared with the overhead rate used by the client to
determine unit costs.
Testing of pricing for work-in-process and finished goods is often done in conjunction with tests
of standard costs. When auditors have tested standard costs with satisfactory results, they can
limit testing of the unit costs of ending inventory to tracing the price used to value ending
inventory to the standard cost records.
When the client has standard costs records, an efficient and useful method of determining
valuation is to review and analyze variances. Small variances in material, labor, and
manufacturing overhead are evidence of reliable cost records.
Cost or Market In pricing inventory, auditors must consider whether replacement cost or net
realizable value is lower than historical cost.
 For purchased finished goods and raw materials: auditors can test for replacement cost
by examining vendor invoices of the subsequent period or recent invoices if no purchases
of an inventory item were made after year-end.
 For work-in-process and finished goods for manufactured inventory: all manufacturing
costs must be considered in evaluating realizable value. In addition auditors must
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 consider the sales value of inventory items and the possible effect of rapid fluctuation of
prices to determine net realizable value.

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