Chapter 13Auditing the Inventory

Management Process

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Overview of the Inventory

Management Process

Purchasing

process

Inventory

management

process

Revenue

process

• Purchase of

raw materials

• Payment of

manufacturing

overhead

Human resource

management

process

• Assignment of

direct and indirect

labor costs

• Sale of

goods

LO# 1

13-2

Types of Documents and Records

1. Production Schedule – Based on the expected demand for the

entity’s products.

2. Receiving Report – Records the receipt of goods from vendors.

3. Materials Requisition – Used to track materials during the

production process.

4. Inventory Master File – Contains all the important information

related to the entity’s inventory, including the perpetual inventory

records.

Production Schedule

LO# 2

Inventory Master File

13-3

5. Production Data Information – Contains information about the

transfer of goods and related cost accumulation at each stage

of production.

6. Cost Accumulation and Variance Report – Material, labor, and

overhead costs are charged to inventory as part of the

manufacturing process. The variance report compares actual

costs to standard or budgeted costs.

7. Inventory Status Report – Shows the type and amount of

products on hand.

8. Shipping Order – Used to remove goods from the perpetual

inventory records.

Types of Documents and Records

Shipping Order

LO# 2

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The Major Functions

LO# 3

13-5

Key Segregation of Duties

LO# 4

13-6

Key Segregation of Duties

Segregation of duties is a particularly important control

in the inventory management process because of the

potential for theft and fraud.

LO# 4

13-7

Inherent Risk Assessment

The auditor should consider industry-related factors

and operating and engagement characteristics

when assessing the possibility of a material

misstatement.

If industry competition is intense,

there may be problems with the

proper valuation of inventory.

Technology changes in certain

industries may also promote

material misstatement due to

obsolescence.

Products that are small and of

high value are more susceptible

to theft. The auditor must be

alert to related-party transactions

for acquiring raw materials and

selling finished products. Prior-year

misstatements are good indicators

of potential misstatements in the

current year.

LO# 5

13-8

Control Risk Assessment

Major steps in setting the control risk in the

inventory management process.

Understand and document the inventory

management process based on a reliance strategy.

Set and document the control risk for the inventory

management process.

Plan and perform tests of controls on inventory

transactions.

LO# 6

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Control Activities and Tests of

Controls – Inventory Transactions

LO# 7

13-10

Control Activities and Tests of

Controls – Inventory Transactions

Occurrence of Inventory Transactions

The auditor’s main concern is that all recorded

inventory exists. The auditor should also be

concerned that goods may be stolen. Review and

observation are the main tests of controls used by

the auditor to test the control procedures.

LO# 7

13-11

Control Activities and Tests of

Controls – Inventory Transactions

Completeness of Inventory Transactions

The primary control procedure for completeness

relates to recording inventory that has been

received. Controls are closely related to the

purchasing process.

LO# 7

13-12

Control Activities and Tests of

Controls – Inventory Transactions

Authorization of Inventory Transactions

The auditor’s concern with authorization in the

inventory system is with unauthorized purchase or

production activity that may lead to excess levels of

certain types of finished goods.

LO# 7

13-13

Control Activities and Tests of

Controls – Inventory Transactions

Accuracy of Inventory Transactions

Inventory transactions that are not properly recorded

result in misstatements that directly affect the

amounts reported in the financial statements.

Inventory purchases must be recorded at the correct

price and actual quantity received. Inventory

shipped must be properly recorded in cost of goods

sold and the related revenue recognized.

LO# 7

13-14

Control Activities and Tests of

Controls – Inventory Transactions

Cutoff of Inventory Transactions

Inventory transactions recorded in the improper

period could affect a number of accounts, including

inventory, purchases, and cost of goods sold.

LO# 7

13-15

Control Activities and Tests of

Controls – Inventory Transactions

Classification of Inventory Transactions

The entity must have control procedures to ensure

that inventory is properly classified as raw materials,

work in process, or finished goods. By knowing

which manufacturing department holds the

inventory, the auditor is able to classify it by type.

LO# 7

13-16

Auditing Inventory

LO# 8

13-17

LO# 8

Auditing Inventory

13-18

LO# 8

Auditing Inventory

13-19

Substantive Analytical

Procedures

LO# 9

13-20

Auditing Standard Costs

Materials

Test the quantity and

type of materials

included in the product

and the price of the

materials.

Labor

Gather evidence about

the type and amount of

labor needed for

production and the labor

rate.

Overhead

Review the entity’s method of

overhead allocation for

reasonableness, compliance

with GAAP, and consistency.

LO# 10

13-21

Observing Physical Inventory

During the observation of the physical inventory

count, the auditor should do the following:

1. Ensure that no production is scheduled. If production is scheduled

proper controls must be established for movement between

departments in order to prevent double counting.

2. Ensure that there is no movement of goods during the inventory

count.

3. Make sure that the entity’s count teams are following the inventory

count instructions.

4. Ensure that inventory tags are issued sequentially to individual

departments.

LO# 11

13-22

5. Perform test counts and record a sample of counts in the working

papers.

6. Obtain tag control information for testing the entity’s inventory

compilation.

7. Obtain cutoff information, including the number of the last shipping

and receiving documents issued.

8. Observe the condition of the inventory for items that may be obsolete,

slow moving, or carried in excess quantities.

9. Inquire about goods held on consignment for others or held on a “bill-

and-hold” basis.

LO# 11

Observing Physical Inventory

13-23

Tests of Details of Transactions

LO# 12

13-24

Tests of Details of Account

Balances

LO# 12

13-25

Tests of Details of Disclosures

LO# 12

13-26

Tests of Details of Transactions,

Account Balances, and Disclosures

Possible causes of book-to-physical differences:

1. Inventory cutoff errors.

2. Unreported scrap or spoilage.

3. Pilferage or theft.

LO# 12

13-27

Tests of Details of Transactions,

Account Balances, and DisclosuresExamples of Disclosure Items:

1. Cost method (FIFO, LIFO, retail method).

2. Components of inventory.

3. Long-term purchase contracts.

4. Consigned inventory.

5. Purchases from related parties.

6. LIFO liquidations.

7. Pledged or assigned inventory.

8. Disclosure of unusual losses from write-downs

or losses on long-term purchase commitments.

9. Warranty obligations.

LO# 12

13-28

Evaluating the Audit Findings -

Inventory

At the conclusion of testing, the auditor should

aggregate all identified misstatements. The likely

misstatement is compared to the tolerable

misstatement allocated to the inventory account.

Likely misstatement < Tolerable misstatement

The auditor may accept the inventory account as fairly presented.

Likely misstatement > Tolerable misstatement

The auditor must conclude the inventory is not fairly presented.

LO# 13

13-29

End of Chapter 13

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