Auditing and Investigations

AC404

Inventory and Production Cycle

 Outline
• 1. Introduction
• 2. Financial statement assertions and the
inventory and production cycle
• 3. Important accounting aspects
• 4. Fraud in the cycle
• 5. Tests of controls
 1. Introduction
• The risk identification and assessment process in the audit of
a company’s inventory cycle is facilitated by carrying out
procedures to obtain a thorough understanding of the client
and the environment in which it operates.
• Once risk assessment has been carried out the auditor will
be able to assign a level of risk to the individual assertions
applicable to the account balance and then plan the nature,
timing and extent of further audit procedures.
• The objective is to devise an audit strategy and plan which
reduce audit risk to an acceptable level.
 2. Financial statement assertions and the
inventory and production cycle
• Rights: the company holds or controls the rights to all
inventory reflected in the financial statements
• Existence: all inventory included in the account balance
actually existed at the reporting date
• Completeness: all inventory to which the company has the
rights of ownership, is included in the financial statements. All
inventory that should have been recorded, has been
recorded.
• Valuation and allocation: inventory is reflected in the
financial statements at an appropriate amount  
• Presentation and disclosure
 3. Important accounting aspects
• Definitions
• Inventory should be presented at the lower
of cost and net realisable value
• Cost of inventories
• Cost of manufactured goods
• Cost formulae
• Pricing of imported inventory
Definitions
• Inventories consist of:
– assets held for sale in the ordinary course of
business.
– assets held in the process of production.
– materials or supplies to be consumed in the
production process.
• net realisable value is the estimated selling
price in the ordinary course of business less
the estimated costs of completion and the
estimated costs necessary to make the sale.
Inventory should be presented at the lower of
cost and net realisable value
• Inventory should not be carried at an amount
greater than is expected to be realised from
the sale of the asset.
• Such a situation could arise where:
– inventory has been damaged
– inventory has become obsolete
– the selling price has declined to below the cost of
the asset due to a drop in demand.
Cost of inventories
• The cost of inventories should consist of :
– all costs of purchase including import duties and transaction
costs that are not reclaimable, transport costs incurred in
the acquisition of materials, goods for resale, etc.
– costs of conversion e.g. direct labour and production
overheads
– costs incurred in bringing the inventory to its present
location and condition, e.g. costs incurred in designing a
product for a specific customer.
• The following should be excluded from the cost of
inventory:
– Storage costs
– Administrative costs
– Selling costs.
Cost of manufactured goods
• The allocation of overheads to the cost of
manufactured inventory must
– include only fixed and variable production
overheads,
– be based on normal capacity, and
– be allocated on a systematic basis which is
reasonable.
• Abnormal amounts of wasted material, labour
or other (abnormal) production costs should
be excluded.
Cost formulae
• IAS 2 permits the adoption of three cost
formulae:
– Specific identification
– Weighted average
– FIFO
Pricing of imported inventory
• The exchange rate at which purchased
inventory must be recorded is the rate at
transaction date (not payment date).
• Even if the exchange rate is different at the
financial year-end, no change is made to the
value of inventory at year-end.
 4. Fraud in the cycle
• Fraudulent Financial Reporting
• Misappropriation of assets
Fraudulent Financial Reporting
• The directors may
– Include fictitious inventory(existence).
– Understate the write downs of inventory for
obsolescence, damage etc(valuation).
– Exclude inventory which should be included
and/or overstate inventory write downs (existence
and valuation).
• Read about the “Great Salad Oil Swindle”.
Misappropriation of assets
• Theft of the goods will depend on
– the nature of the goods,
– the physical control over inventory
– the extent of division of duties.
– the frequency of physical and theoretical
reconciliations of inventory.
– the controls in the other cycles which directly
affect the inventory cycle.
5. Tests of controls and substantive procedures
• Tests of controls
• Substantive procedures (Not for AC404)
– Attendance at the inventory count is both a test of controls and
a substantive procedure.
– The subsequent audit procedures i.e. After the inventory count,
will be substantive in nature.
– Recording of the last document numbers for all documents used.
– Obtaining a list of goods received notes numbers which have not
been matched to suppliers invoices at the year-end
• Inventory count attendance
– Prior to the inventory count
– During the inventory count
– At the conclusion of the count.
Tests of controls
• Observation of the inventory count.
• Inspection of reconciliations and cycle count
amendment forms for cycle counts carried out
during the year, to determine frequency and
materiality of discrepancies and how they were
resolved and for authorising signatories.
• Observation of warehouse controls.
• Inspection of records controlling inventory
movement
• Inquiry of production and warehousing as to what
control procedures they actually perform.
Substantive procedures
– Attendance at the inventory count.
– The subsequent audit procedures
– Recording of the last document numbers for all
documents used.
– Obtaining a list of goods received notes numbers
Attendance at the inventory count is both a test of controls and a
substantive procedure.
• The auditor will be gathering evidence as to the
effectiveness of the control procedures put in place to
establish the quantity of inventory actually held (test of
controls).
• The auditor will also be gathering substantive evidence
about:
– The existence of the quantity of inventory recorded by testing
from the records to the physical inventory.
– The condition of inventory by inspecting and looking for
damaged/obsolete items, as well as evidence of slow moving
inventory.
– The completeness of inventory by testing from the physical
inventory to the inventory records.
The subsequent audit procedures
• i.e. After the inventory count, will be
substantive in nature.
Recording of the last document numbers for all
documents used
– e.g. goods received notes, issue notes, delivery
notes etc, to facilitate “cut off” testing.
– The recorded movement of inventory must match
the physical movement of inventory up to
reporting date.
• A list of goods received notes numbers which have
not been matched to suppliers invoices at the year-
end should be obtained.
• Inventory count attendance
– Prior to the inventory count
– During the inventory count
– Conclusion of the count
Prior to the inventory count the auditor should:
– Liaise with the client about date and times of the
inventory count.
– Confirm all locations at which the client holds
inventory and if necessary visit the locations.
– Perform administrative planning e.g. Organize
audit staff to attend.
– Obtain and review a copy of the written
instructions given to the client’s count teams.
– Enquire as to whether the client has any inventory
which should not be included in the count
– Brief the audit staff allocated to the count on their
responsibilities.
During the inventory count the auditor should:
• Observe inventory taking procedures to ensure
that the client’s written instructions are adhered
to.
• Walk through the warehouse and identify
inventory which is obsolete or damaged or
appears to be slow moving
• Conduct test counts on the inventory in the
warehouse in both directions, making sure all
sections and categories are tested:
– From inventory sheets to physical inventory (existence).
– From physical inventory to inventory sheets
(completeness).
• Resolve discrepancies in test counts before
conclusion of the count by recounting with the
client staff and confirming that amendments are
made to the inventory sheets where necessary.
• Test the numerical sequence of the inventory
sheets both before and at the conclusion of the
count to ensure that all inventory sheets are
accounted for.
• Confirm by enquiry of inventory counters and
inspection of the inventory sheets that inventory
which should not be included in the client’s
inventory, has been excluded.
At the conclusion of the count, the auditor should:
• Inspect inventory sheets to confirm that:
– Lines have been drawn through blank spaces (so
that items cannot be added),
– Alterations /corrections have been signed, and
inventory sheets have been signed by the counters
responsible.
• Create audit records in respect of the inventory
count attendance by:
– Taking copies of all inventory sheets (hardcopy or digital)
– Recording observations as to the client’s count
procedures
– Recording results of all test counts preformed by the
audit team
– Recording any damaged, obsolete or slow moving
inventory.
• Record cut-off numbers for all documents used in
the inventory and production cycle.
• Compile a list of goods received notes which have
not been matched to supplier invoices.
The end