Chapter 12: Inventories and Cost

susbtantiate the existence of inventories and the occurence of

transactions affecting cost of goods sold

of Goods Sold establish the completeness of recorded inventories

verify the cutoff of transactions affecting cost of goods sold

determine that the client has rights to the recorded inventories

Course ACC5400
establish proper valuation of inventories and the accuracy of
Status Done transactions affecting the cost of goods sold

determine the presentation and disclosure of information about

Inventories and Cost of Goods Sold inventories and cost of goods sold are appropriate, including
disclosure of the classification of inventories, accounting methods
Sources and Nature of Inventories and Cost of Goods Sold used and inventories pledged as collateral for debt

inventories include auditors will also obtain evidence about the related purchases, sales and
purchase returns and sales returns account
goods on hand ready for sale
auditors also consider the methods for inventory accounts
goods in the process of production
period inventory system
goods to be consumed directly or indirectly in production
less reliable internal control
raw materials
stronger emphasis on observation
purchased parts
perpetual inventory system
supplies
stronger internal control
The Auditorsʼ Objectives in Auditing Inventories and Cost of no annual inventory account to be observed
Goods Sold
included periodic ones which the auditors can observe on a need
auditors objective are to
basis
use the understanding of the client and its environment to consider
inherernt risks, including fraud risks, related to inventories and COGS Internal Control over Inventories and Cost of Goods Sold
obtain and understanding of internal control over inventories and cost of management sometimes so not put an emphasis on this thought it is a crucial
goods sold aspect

assess the risks of material misstatement and design tests of controls and inventory as in the finished product might not be susceptible to theft but
substantive proceudres that parts that make it up can be
Control Environment Purchases and Production Cycles—Accounting Systems and
aspects of the control environment that are relevant to auditors consideration
Control Activities
of the inventories and cost of goods sold include the following are the physical functions directly connected with inventories

commitment to attract, develop and retain competent employees purchasing, receiving, storing, issuing, processing and shipping

integrity and ethical values the following are recording functions

organizational structure and assignment of authority and responsibility cost accounting and perpetual inventory records

The purchasing function

Risk Assessment
strong internal control should have a department of the company that
ROMMs of inventories is reduced when management evlaute and manages the
exclusively makes all purchases of materials and services
risks related to purchasing and producing goods and service
purchasing receiving and recording functions should be separate
aspects of concern include
the purchase transaction begins with the issuance of a properly approved
the availability ofsupply of goods, services and skilled labor
electronic or paper purchase requisition by the stores department or another
the stability of prices and labor rates department that need the goods
the generation of sufficient cash flow to pay for prucahses a copy of the requisition is sent to the purchasing department or another
changes in technology that affect manufacturing processes department to help in the creation of serially numbered purchase order

the obsolescence of inventory

Monitoring
relevant monitoring controls include

management review of reports of purchases from suppliers, invneotry on

hand and accounts payable balances

production cycle

observations by production supervisors of the performance of various

activities and quality and performance reviews

inventory schedule reviews

data analytics can be used to monitor transactions and other activities on a

continuous basis
copies of the purchase order should be forwarded to the accounting and
receiving departments
 copies sent to the receiving department should not have the quantities The storing function
listed so that they can carry their own independent count of the items
as they are delivered to stores, they are counted, inspected and receipted for
received
they then notify the accounting department of the amount reeived and
in larger companies purchase orders are issued only after compliance with
placed in stock
procedures for
roles filled:
determining the need for the item
by signing for the goods, its fixed it own responsibility
obtaining competitive bids
by notifying the accounting department of the actual goods received, it
obtaining approval for the financial aspect of the commitment
provides a verification of the receiving departments work
The receiving function
The issuing function
all goods recevied by the company should eb cleared through a receiving
The stores department requires signed requisitions or orders before releasing
department that is independent of the purchasing, storing and shipping
goods to ensure proper tracking and prevent misuse.
departments
In some businesses, official documents like sales orders or shipping orders
this department is responsible for
are used instead of factory requisitions to authorize item withdrawals.
the determination of quantities of goods received
The production/conversion function
the detection of damaged or defective merchandise
overall production should be controlled with a master production schedule
the preparation of receiving report
MPS presents the gross production needs for a particular period
the prompt transmittal of goods received to the stores department
developed based on forecasts of demand for the companyʼs products

ensures that materials and labor are available to meet the production
demands for the period

one the required resources are determined to be available, production order

are prepared to authorize the specific products

product order is a document that authorizes the production of a specific

quantitiy of a product

responsibility for the goods in production must be fixed usually on foctory

supervisors or superintendents

materials requisitions and move tickets deocument the flow of the goods
and related responsibility as they progress through the production process
 a designated supervisor should be in control of the materials as they one copy of the document should be retained by the shipping department
move through the production process as evidence of shipment

job time tickets are prepared to document the labor or machine hours devoted second copy should be sent to the billing department
to a particular production job
used with the purchase order and sales order as basis for invoicing the
should be reviewed by supervisors before they are entered into the cost customer
accounting system
works as a control as the customer will inspect the slips and notify
the controls for goods in production usually include regular inspection the company of any inconsistencies
procedures to reveal defective work
when the goods are shipped with a common carrier, a fourth copy of the
helps with process of scraping materials shipping document called the bill of landing is provided to the carrier

The cost accounting system

cost accounting system is necessary to account for the usage of raw materials
and supplies to determine the content and value of goods in process
inventories and to compute the finished goods inventory

keeps tracks of all types of manufacturing and indirect expenses

is an integral part of control of inventories

provides internal control by tracing the execution of managerial

directives in the factory, providing reliable inventory figures and
safeguarding company assets

the figures produced by the cost accounting system should be controlled by

general ledger accounts
The shipping function
many companies have established standard cost systems that help identify
shipments should also be made after proper authorization has b een received
the causes of ineffectiveness and waste through a study of variances between
usually a sales order approved by the credit department actual and standard costs

shipping function also includes the returning of defective goods to The perpetual Inventory system
suppliers
constitute an extremely important part of internal control
authorization may be a shipping authorization from a purchasing
by showing at all times the quantity of goods on hand, provide information
department executive
essential to intelligent purchasing, sales and production panning policies
the shipping department prepares a prenumbered shipping document
also allows companies to control the high costs of holding excessive
indicating the goods shipped
inventory while minimizing the risk of running out fo stock
 also discourages inventory theft and waste written comments on the manner in which the physical inventory was
taken
the records should be periodically verified through physical counts
elaborate analysis of production costs of finished goods and goods in
IT systems
process
helps to maintain control over inventories, purchasing and the manufacturing
process

IT system can automaticaly generate prucahse requisiton and orders when

Audit of Inventories and Cost of Goods Sold
inventory levels reach a predetermined reorder points the following steps indicate the general pattern of work performed by the
auditors in verification of inventories and cost of goods sold
can also be linked with suppliers with EDI
use the understanding of the client and ints environment to consider
the system can generate various reports such as
inherent risks, including fraud risks, related to inventories and cost of good
financial reports and responsibility accounting records sold
methods used obtain an understanding of internal control over inventories and cost of
barcodes good sold

RFIDs assess the risks of material misstatement and design further audit
procedures
Controls over Inventory Estimates
perform further audit procedures - tests of controls
large retail companies that develop estimates of certain inventory quantities
on hand  examples of tests of controls

these companies should establish controls over the development of a test controls over purchase transactions
estimates including b test control over the cost accounting system
involving competent and informed personnel in developing the c test management review controls
estimates
d test control over inventory estimates
establishing controls over the relevance, completeness and reliability
 if necessary, revise the risks of material misstatement based on the
of data used to make estimates and the accuracy of computations
results of tests of controls
requiring management review and approval of estimates
perform further audit procedures - substantive procedures for inventories
Audit Documentation for Inventories and Cost of Goods Sold and cost of goods sold

auditor may prepare a great variety of working papers in their verification of  obtain listings of inventory and reconcile to ledgers
inventories and cost of goods sold  evaluate the clients planning of physical inventory
these papers will range from  observe the taking of physical inventory and make test counts
  review year end cutoff of purchases and sales transactions A. Use the understanding of the client and its environment to consider inherent
risk, including fraud risk, related to inventories and cost of goods sold
 obtain a cpy of the completed physical inventory, test its clerical
accuracy and trace test counts generally inventories are assets with significant inherent risks

 evaluate the bases and methods of inventory pricing business risk

 test the pricing of inventories losses due to poor product quality, obsolesence or theft

 perform analytical procedures or data analytics RoMMs

 determine whether any inventories have been pledged and review inventories often constitute a large current assets and very susceptible
purchase and sales commitments to major errors or fraud

 evaluate financial statement presentation of inventories and cost of alternative methods of valuation are allowed and different methods can
goods sold including the adequacy of disclosure be used for various classes of inventories

determination of inventory value directly affect COGS and has a major

impact on NI  fraudulent reporting possibility

determination on inventory quality condition and value is inherently

more complex and difficult task especially if dealing with precious
materials and CIPs

after considering all this, auditors will make sure

they understand the programs and controls established by management to

control the risk

they will then determine fi the controls have been implemented

finally, they will design appropriate procedures to respond to that risk

B. obtain an understanding of internal control over inventories and cost of

goods sold

consideration of internal control may involve

filling out a questionnaire

writing a descriptive memo

preparation of flowchasrts depicting the org structure and the flow of

materails and documents

in obtaining an understanding of internal control over inventory,

 the auditors should become familiar with the procedures for purchasing,
receiving, storings and isssuing goods and for controlling production

they should obtain an understanding of the cost accounting system and

the perpetual inventory records

they should also focus on the physical protection of inventories

when the auditors have prepared a flow chart of IC, they should determine
whether the controls have been implemented

determined through inquiry, inspection and observation of activities

C. Assess the risks of material misstatement and design further audit

procedures

auditors will then identify and assess the risks of amterail misstatement at the
FS and assertion levels

to make these assessments, the auditors should consider the realtionships

between specific misstatements and controls

these assessments are then used to design further audit procedures including
tests of controls and susbtantive procedures

some of the risk identified can be considered significant risk that require
special audit consideration

for a significant risk the auditors

evaluate the design of the related controls and determine that they are
implemented

perform substantive procedures

test the operating effectiveness of the related controls in the current

period when they plan to rely on those controls

D. Perform further audit procedures - tests of control

 these tests hlep to evaluatethe clients internal control and detemine whether c Test management review controls
the auditors can support their planned assessed level of control risk for the
management review controls may be effective at detecting and
assertion sbaout inventory and cost of goods sold accounts
correcting misstatements tha tare not detected
 Examples of Tests of Control
auditors will evaluate by considering the relevance of the assertions
a Test controls over purchase transaction address by the controls, the level of aggregation of the data, how often
it is performed, the predictability of management expectation and the
performed generally in conjunction with the audit of cash
criterial used to detemine when the items are investigated
disbursements
if the controls are determined to be effective, auditors will do further
tests of the purchases cycle include the following steps
test by examining control documents
select a sample of purchase transactions
d Test controls over inventory estimates
examine the purchase requistion or other authorization for each
auditors may evaluate and test controls over the client development of
purchase transaction in the sample
the estimate including review and testing fo the data used,
examine the related vendor invoice, receving report and paid computations and the assumptions made
check - trace to coucher register or cash register
the competence of the personnel involved should also be evaluated
inspect vendor invoices for approval of prices, freight and credit
 If necessary, review the risks of material misstatemnet based on the results
terms
of tests of controls
compare quantities and prices in the invoice, purchase order and
the descriptions and the tests of controls of the clientw internal control over
receiving report
inventories and cost of goods sold provide the auditors with evidence as to
trace posting from voucher register to general ledger and any weaknesses and strengths of the system
applicable subledgers
if problems are revealed, the auditors should reassess the romms for the fs
data analytics software may be used for this process assertions
b Test controls over the cost accounting function

because cost account methods vary so widely audit procedures for

cost accounting system must be designed to fit the specific
circumstances encountered in each case

the auditors tests of the clients cost accounting system must be

designed to fir the specific circumstances encountered in each case

to achieve this objective, the auditors test the propreity of direct

materials quantities, unit costs, direct labor hours and hourly rates
and overhead rates and allocation bases
 the auditors goal is to make sure the inventory records agree with that is
recorded in the financial statements

 evaluate the clients planning of physical inventory

clientʼs role

determine the plan for the physical inventory and assigned a personnel
to be responsible for the process

draft instructions and forward them to the person leading the inventory
count

generally should be done near the balance sheet date but exceptions
can be made

auditors role

the auditor in charge determines the dates of the counts, the extent of
the counts, the need for the client assistance number of people
E. Perform further audit procedures - substantive procedures for inventories
required and estimated time needed
and cost of goods sold
auditors may also employ the use of specialist
 Obtain listing of inventory and reconcile to ledger
auditors will also have written instructions which are not made
available to the client

 observe the taking of physical inventory and make test counts

auditors will obtain a schedule of listings of inventories that will be

reconciled to boht the general ledger and appropriate sub ledgers
 the extent of the test counts will depend on the assessed level of
romms and the materiality of the clients inventory

if RFID or barcodes are not atached to inventory, serially numbered tags

are usually attached to each lot of goods

if the test counts indiciate descrepancies, the goods are recounted at once
by the clients employees and the error is corrected

if excessive errors are found, the auditor can request the client to
recount

the test counts and tag numbers are listed in WPs which will be traced
later to the clients inventory summary sheets

a discrepancy is not treated as an error in counting but as a mistake

from copying data from the tags, a purposeful alteration of a tag or a
creation of a fictitious tag

auditors should also discuss and consider items on consignments and its
auditors responsibility is to observe the inventory taking while
details
management is responsible of actually doing they activity.
each auditor involved will prepare WPs
auditors should
it should indicate
inspect the inventory to determine its existence and condition and
make test counts the extent of the counts

observe compliance with managements instructions for taking the describe any deficiencies noted
inventory express a conclusion as to whether the physical inventory was
obtain audit evidence audit evidenceabout the reliability of the count done properly
procedures auditor in charge should also prepare a summary memo
auditors will also record the serial number of the final receiving and explains the process and extent
shipping documents issed before the taking of inventory
also includes comments on the considerations given to the factors
so that the accuracy of the cutoff can be determined at a later date of quality and condition of stock, the treatment of consigned goods
special attention should also be placed on the tagging system to at hand and the control of shipments and receipts during the
determine if tagging is consistent counting process

auditors will also make test counts of the selected inventory items Outside Inventory taking firms
 some clients may hire firms that specialize in taking phsyical  review the year-end cutoff of purchases and sales transactions
inventories for other organizations

while these firms are independent, the counts are not considered
sufficient appropriate audit evidence ‘

auditors should evaluate the effectiveness of the procedures used and

perform other procedures

Inventories in public warehouses and on consignment

examination of receipts from public werehouses is not sufficient

verifications of goods stored

both AICPA an dPCOAB recommend direct confirmation in writing from

outside custdians of inventories and supplementary procedures when
the amounts involved represent a significant portion of the current
assets or of total assests

reports of warehouse controls may also be obtained

for goods on consignments, list of all consigness and copies of

consignment agreements should be obtained

consignees should be directly communicated with for verification

purposes an accurate cutoff or purchases is one of the most imporattnt factors in
if the client owns raw materials that is processed by a subcontractor, verifying the existence and completeness of the year end inventory
the auditors should request to confirm quantities and descriptions of to ensure that the liability to suppliers have been recorded for all goos
such items included in inventory
Inventory verification when auditors are engaged after the end of the year auditors examine on a test basis the purchase invoices and receiving
if auditors are employed after, advanced planning is not possible reports for several days before and after the inventory date

in this case, auditors can conclude that sufficient appropriate evidence a supplementary approach would be to examine the records of the
cannot be obtained concerning inventories to permit them to express receiving department
an overall opinion on the fairness of the FS generally failing to record things is not that much of a major issue as long
in some cases they may be able to obtain satisfaction through as the corresponding liability is also not recorded in the current period
alternate procedures  obtain a copy of the completed physical inventory, test its clerical accuracy,
strong internal control, perpetual inventory record, evidence of a and trace test counts
strong physical inventory
 the auditors are responsible for determining that the bases and methods of
ricing inventory are in accordance with generally accepted accounting
principles

the investigation of inventory pricing deals with:

what method of pricing does the client use

cost method: LIFO, FIFO, weighted avg, standard cost

is the method of pricing the same as that used in prior years

must have justification - auditors should include an explanatory

paragraph for the change

has the method selected by the client been applied consistently

and accurately in practice

test the pricing of a representative number of inventory items

the testing of extensions and footings on the final inventory listing may
disclose misstatements of physical inventories  test the pricing of inventories

generally done approximately or using a computer software the testing or prices applied to inventories, urchased parts, and supplies
by a manufacturing company is similar to the testing of prices of
in testing extensions, auditors should be alert for two sources of
merchandise in a trading bsiness
substantial errors, misplaced decimal points and the incorrect extension of
count units by price units cost of inventory is verified with reference to purchase invoices

auditors should also trace to the completed physical inventory their test to determine whether the inventory valuation method used by the client
counts made during the observation of physical inventory has been properly applied, the auditor should amkke tests of the pricing of
selected items of finished goods and goods in process
physical counts should also be reconciled to inventory records
through reference to the cost accounting system
 evaluate the bases and methods of inventory pricing
Lower-of-cost-or-market-test
 as a general rule, inventories should be carried at an amount in excess also used to identify obsolete inventory - rate of inventory turnover
of net realizable value comparison

LCM test is used to measure the loss of utility in inventories also review ledgers for unusual entries

LCM involves comparing the recorded cost within the cieling and the non-financial data may also be used
floor
 determine whether any inventories have been pledged and review purchase
ceiling → net realizable value and sales commitments

floor → net realizable value minus normal profit

 perform analytical procedures or data analytics

the verification of inventories includes a determination by the auditors as

to whether any goods have been pledged or subjected to a lien of any kind

examine purchase commitments and other contracts

comparison of the prices quoted with vendors prices prevailing at the

BS date may indicate substantial losses if firm purchase commitments
are not protected by the firm sales contracts

examine sales commitments

material misstatements of inventory may be disclosed by analytical losses arise from valuation issues
procedures designed to establish the general reasonableness of inventory
figures auditors should review the clients cost estimates for sales orders

any major difference between the ending inventory estimated by the gross if estimated total costs exceed fixed sales prices, the loss and related
rofit margin method and the count of inventory at year-end should be liability should be recorded
investigated fully  evaluate financial statement presentation of inventories and cost of goods
the auditors analytical procedures for inventory transctions will ften sold including the adequacy of disclosure
include a volume comparison
 one of the most important factors in proper presentation of inventories in the
financial statements is disclosure of inventory pricing method

other important disclosures includes

changes in valuation methods with effect and justification

various classifications of inventory

details of any pledged inventory

decution of valuation allowances for inventory losses

existence and terms of inventory purchase commitments

Problems Associated with Inventory of First-Year Audit Clients

in the initial audit, auditors may not have been present at the physical
inventory count

alternate procedures to be followed

if previously audited by another firm and the method are in accordance

with GAAP, beginning balance may be used with various othe forms of
investigations

if not, additional investigations must be conducted

if the auditors are satisfied,

an unqualfied opinion may be be issued on all statements

if not

unqualified opinion may only be given to BS and disclosure for the rest