Inventories and Cost

of Goods Sold

Chapter 12

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

12-2

The Special Significance of

Audit of Inventories

The valuation of goods on hand and in process often

presents complex and difficult issues

Determining the quantities of inventories may require

specialized techniques

Inventories often represent the largest current asset

of a company

Misstatements of inventories directly affect cost of

goods sold and, therefore, net income

Management fraud has often involved the fraudulent

overstatement of inventories

12-3

Source of Inventories

Includes

Goods on hand ready for sale

Goods in the process of production

Goods to be consumed directly or indirectly in

production such as raw materials, purchased

parts and supplies

12-4

Objectives

1. Use the understanding of the client and its environment to consider inherent risks,

including fraud risks, related to inventories and cost of goods sold.

2. Obtain an understanding of internal control over inventories and cost of goods sold.

3. Assess the risks of material misstatement and design tests of controls and substantive

procedures that:

a. Substantiate the existence of inventories and the occurrence

of transactions affecting cost of goods sold.

b. Establish the completeness of recorded inventories.

c. Verify the cutoff of transactions affecting cost of goods sold.

d. Determine that the client has rights to the recorded inventories.

e. Establish the proper valuation of inventories and the accuracy of transactions

affecting cost of goods sold.

f. Determine that the presentation and disclosure of information about inventories

and cost of goods sold are appropriate, including disclosure of the classification

of inventories, accounting methods used, and inventories pledged as collateral

for debt.

12-5

McKesson & Robbins

Fraud Case Significant impact on responsibility of auditors

with respect to validity of inventories

Case: 1939 – the audited financial statements

contained $19 million of fictitious assets

including $10 million of nonexistent inventories Auditors followed customary auditing practice which limited audit

work on inventories to examining records only

Statements on Auditing Procedures 1 and 2 – first formal

auditing standards issued by AICPA affirmed the importance of

auditors’ observation of physical inventories although other

auditing procedures could be substituted

12-6

Inventory Methods

Periodic inventory system

Determine inventory quantities solely by an

annual physical count

Perpetual inventory records

Inventory updated constantly

Strong internal control over inventories

May use test counts throughout the year

12-7

Internal Control (1 of 3)

Control environment

Commitment to competence and human resource

policies and practices

• Appropriately qualified and trained personnel assigned to

inventory

Integrity and ethical values

• Company purchasing agents do not accept ―kickbacks‖

Organizational structure and assignment of authority

and responsibility

• Purchasing, receiving and production understand roles

12-8

Internal Control (2 of 3)

Risk assessment; risks related to • Availability of a supply of goods, services, and

skilled labor

• Stability of prices and labor rates

• Generation of sufficient cash flow to pay for

purchases

• Changes in technology that affect manufacturing

processes

• Obsolescence of inventory

12-9

Internal Control (3 of 3)

Monitoring

Observations by production supervisors of

performance of various activities and

functions

Quality and performance reviews

Formal program to consider improvements in

purchasing and production noted by internal

auditors

12-10

Functions related to inventories

Purchasing

Receiving

Storing

Issuing

Processing

Shipping

12-11

Purchasing Function

Internal control

Segregation of purchasing, receiving and recording

Cycle

Purchase requisition form completed by department

Purchasing prepares purchase order

• May obtain bids but need approval

• Item description and quantity

• Copy forwarded to accounting

• Copy forwarded to receiving should not include

quantity

12-12

Receiving and Storing

Receiving

Determines quantity of goods received

Detects damaged or defective merchandise

Prepares receiving report

Prompt transmittal of goods received to stores

department

Storing

Counts, inspects and receives goods

Notifies accounting of receipt

Physically secures inventory

12-13

Issuing and Production

Stores department issues goods to

requesting department

Prenumbered requisition

Production

Controlled with master production schedule

Production orders

Materials requisitions and move tickets

Job time tickets

12-14

Shipping

Shipment upon authorized sales order

approved by credit department

Generates a prenumbered shipping document

• One copy in shipping

• One copy to billing

• Third copy used as packing slip

• For goods shipped common carrier – fourth copy

services as bill of lading

12-15

Cost Accounting

Accounts for usage of raw materials

Determines content and value of

goods in progress

Compute finished inventory

12-16

Other functions

Perpetual inventory system

Provide information essential to purchasing,

sales and production-planning policies

Allows companies to control high costs of

holding excessive inventory

IT systems

Easier to control inventories

EDI to coordinate production and purchasing

12-17

Controls Over the

Conversion Cycle

Segregation of duties over purchases and custody of inventory

Use of pre-numbered requisitions, purchase orders, and receiving reports

Procedures for authorizing purchase transactions and verifying them for payment

General ledger control of inventories and reconciliation to production records

Cost accounting controls

Analysis of variances from standard costs

Use of perpetual records for inventories

Use of appropriate procedures for taking inventory

Appropriate physical controls over inventories

12-18

Relating Controls to Assertions

12-19

Audit Steps (1 of 3)

A. Use the understanding of the client and its environment to

consider inherent risks, including fraud risks, related to

inventories and cost of goods sold.

B. Obtain an understanding of internal control over inventories and

cost of goods sold.

C. Assess the risks of material misstatement and design further

audit procedures.

D. Perform further audit procedures—tests of controls.

1. Examples of tests of controls:

a. Examine significant aspects of a sample of purchase

transactions.

b. Perform tests of the cost accounting system.

2. If necessary, revise the risks of material misstatement based

on the results of tests of controls.

12-20

Audit Steps (2 of 3)

E. Perform further audit procedures—substantive

procedures for inventories and cost of goods sold.

1. Obtain listings of inventory and reconcile to ledgers.

2. Evaluate the client’s planning of physical inventory.

3. Observe the taking of physical inventory and make test

counts.

4. Review the year-end cutoff of purchases and sales

transactions.

12-21

Audit Steps (3 of 3)

E. Perform further audit procedures

5. Obtain a copy of the completed physical inventory, test its

clerical accuracy, and trace test counts.

6. Evaluate the bases and methods of inventory pricing.

7. Test the pricing of inventories.

8. Perform analytical procedures.

9. Determine whether any inventories have been pledged and

review purchase and sales commitments.

10. Evaluate financial statement presentation of inventories

and cost of goods sold, including the adequacy of disclosure.

12-22

Figure 12.1 Objectives of Major Substantive

Procedures for Inventories and Cost of Goods Sold

12-23

Risks of Material Misstatements

1. Inventories constitute a large asset and very

susceptible to major errors and fraud.

2. The accounting profession allows numerous alternative

methods for valuation of inventories, and different

methods may be used for various classes of

inventories.

3. The determination of inventory value directly affects the

cost of goods sold and has a major impact on net

income for the year.

4. The determination of inventory quality, condition, and

value is inherently a more complex and difficult task

than is the case with most other elements of financial

position.

12-24

12-25

Relating

Controls

to

Assertions

12-26

Considerations in

Planning a Physical Inventory

Selecting of the appropriate date

Suspending production

Segregating obsolete and defective

goods

Establishing control over the counting

process

Achieving proper cutoff of sales and

purchases

Arranging for the services of specialists

12-27

Documentation of

Physical Inventory Plan should be documented and

communicated in form of written

instructions to personnel taking physical

inventory

Letter from client reviewed by auditors

Auditors consider nature and materiality of

inventories

Date is typically at or near balance sheet date

unless internal control is effective

12-28

Inventory Observation

Client counts and supervises inventory

Auditors observe

Determine all items included

Employees comply with instructions

Be alert for inclusion of obsolete or damaged

merchandise

Record numbers of final receiving and shipping

documents issued before inventory taking

Make test counts

Tag control

12-29

When the Auditors are Engaged

after Year-End

Inventory verification when auditor unable to observe

taking of inventory at close of year.

May conclude that sufficient appropriate evidence

cannot be obtained to express an opinion

Or could obtain satisfaction with alternative auditing

procedures

• Existence of strong internal control

• Perpetual inventory records

• Documentation of well-planned and executed

physical inventory

• Making of test counts

12-30

Proper Cut-off of Inventory

Examine on a test basis the purchase

invoices and receiving reports for several

days before and after the inventory date.

Determine that liability has been recorded for

all goods in inventory

Make sure shipments and purchases

recorded in proper period

12-31

Inventory Pricing

Emphasize:

What method of pricing does the client use?

Is the method of pricing the same as that

used in prior years?

Has the method selected by the client been

applied consistently and accurately in

practice?

• Test the pricing of inventories

12-32

12-33

Presentation and Disclosure

Disclosure of inventory pricing methods or

methods in use

Other important disclosures: Changes in methods

Classifications of inventory

Details of pledged inventory

Deduction of valuation allowance for inventory losses

Existence and terms of inventory purchase

commitments.

12-34

Problems with First Year Clients

Procedures to obtain evidence that beginning

inventory is fairly stated

Review predecessor’s working papers

Discuss with person who supervised physical

inventory at beginning

Study written instructions in planning

Trace numerous items from inventory tags to final

summary sheets

Test perpetual inventory records for previous year

Test overall reasonableness of beginning inventory