Audit of the Inventory

and Warehousing Cycle

Chapter 20

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 1
 Learning Objective 1

Describe the business functions

and the related documents and
records in the inventory
and warehousing cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 2
 Flow of Inventory and Costs

Raw Materials Work in Process

Beginning Raw
inventory materials
Purchases used
Ending
inventory
Manufacturing Manufacturing
Direct Labor Overhead
Actual Applied Actual Applied

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 3
 Flow of Inventory and Costs

Work in Process Finished Goods

Beginning Beginning
inventory inventory Cost of
Cost of goods
Ending manufactured Ending goods sold
inventory inventory

Cost of Goods Sold

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 4
 Functions in the Inventory and
Warehousing Cycle
Process
purchase Receive raw
orders materials

Store
raw Process the materials
materials

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 5
 Functions in the Inventory and
Warehousing Cycle

Ship
Store
finished finished
goods goods

Perpetual inventory
master file
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 Learning Objective 2

Describe how e-commerce

affects inventory management.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 7
 How E-Commerce Affects
Inventory Management

The Internet enables clients to provide expanded

descriptions of their inventory on a real-time basis.
The use of the Internet and other e-commerce
applications may lead to financial reporting
risks if access to inventory databases and
systems is not adequately controlled.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 8
 Learning Objective 3

Explain the five parts of

the audit of the inventory
and warehouse cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 9
 Audit of Inventory
Part of audit Cycle in which tested
Acquire and record Acquisition and
raw materials, labor, payment plus
and overhead. payroll and personnel

Internally transfer Inventory and

assets and costs. warehousing

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 10
 Audit of Inventory
Part of audit Cycle in which tested
Ship goods and record Sales and
revenue and costs. collection
Physically observe Inventory and
inventory. warehousing
Price and compile Inventory and
inventory. warehousing
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 Learning Objective 4

Design and perform audit

tests of cost accounting.

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 Cost Accounting Controls

1. Physical Controls

Raw materials WIP Finished goods

2. Controls over the related costs

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 Methodology for Designing
Controls and Substantive Tests
Understand internal control –
cost accounting system.

Assess planned control risk –

cost accounting system.

Evaluate cost-benefit
of testing controls.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 14
 Methodology for Designing
Controls and Substantive Tests

Design tests of controls Audit procedures

and substantive tests of
transactions for the cost Sample size
accounting system to meet Items to select
transaction-related
audit objectives. Timing

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 15
 Tests of Cost Accounting

Physical Controls
Documents and records for
transferring inventory
Perpetual inventory master files
Unit cost records

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 Learning Objective 5

Apply analytical procedures to

the accounts in the inventory
and warehousing cycle.

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 Analytical Procedures for
Manufacturing Equipment

Analytical Procedure Possible Misstatement

Compare gross margin Overstatement or
percentage with that of understatement of
previous years. inventory and cost
of goods sold
Compare inventory turnover Obsolete inventory
(cost of goods sold divided Overstatement or
by average inventory) with understatement of
that of previous years. inventory
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 18
 Analytical Procedures for
Manufacturing Equipment

Analytical Procedure Possible Misstatement

Compare unit costs of Overstatement or
inventory with those of understatement of
previous years. unit costs
Compare extended Misstatements in
inventory value with that compilation, unit
of previous years. costs, or extensions

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 19
 Analytical Procedures for
Manufacturing Equipment

Analytical Procedure Possible Misstatement

Compare current year Misstatement of unit
manufacturing costs with costs of inventory,
those of previous years especially direct
(variable costs should be labor and
adjusted for changes in manufacturing
volume). overhead

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 20
 Methodology for Designing Tests of
Balances – INVENTORY
Identify client business risks affecting
the inventory and warehousing cycles.

Set tolerable misstatement and

assess inherent risk for the
inventory and warehousing cycles.

Assess control risk for several cycles.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 21
 Methodology for Designing Tests of
Balances – Inventory
Design and perform tests of
controls and substantive tests
of transactions for the
several cycles.

Design and perform analytical

procedures for the inventory
and warehousing cycle.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 22
 Methodology for Designing Tests of
Balances – Other Accounts

Design tests of details Audit procedures

of inventory to satisfy Sample size
balance-related Items to select
audit objectives. Timing

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 Learning Objective 6

Design and perform

physical observation
audit tests for inventory.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 24
 Controls

Proper instructions for the physical count

Supervision by responsible personnel
Independent interval verification of the counts
Independent reconciliations of the physical
counts with perpetual inventory master files
Adequate control over count sheets or tags

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 Audit Decisions

Timing

Sample size
Selection
of items

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 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.

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 Balance-Related Objectives:
Physical Inventory Observation

Inventory as
Existence
recorded on tags exist.

Existing inventory is
Completeness
counted and tagged.

Inventory is counted
Accuracy
accurately.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 28
 Balance-Related Objectives:
Physical Inventory Observation

Inventory is classified
Classification
correctly on the tags.

Transactions are recorded

Cutoff
in the proper period.

Obsolete and unusable

Realizable
inventory items are
Value
excluded or noted.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 29
 Balance-Related Objectives:
Physical Inventory Observation

Obsolete and unusable

Realizable
inventory items are
Value
excluded or noted.

The client has rights

Rights to inventory recorded
on tags

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 30
 Learning Objective 7

Design and perform audit

tests of pricing and
compilation for inventory.

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 Audit of Pricing and
Compilation

Inventory price tests

Inventory compilation tests

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 Audit of Pricing and
Compilation

Pricing and
compilation
controls Pricing and
compilation
procedures Valuation
of inventory

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 Balance-Related Objectives: Inventory
Pricing and Compilation

Detail
Existence
tie-in

Completeness Accuracy

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 34
 Balance-Related Objectives: Inventory
Pricing and Compilation

Realizable
Classification
value

Presentation
Rights
and disclosure

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 Valuation (Pricing)
of Inventory

Pricing Purchased Inventory

Pricing Manufactured Inventory

Cost or Market

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 Learning Objective 8

Integrate the various parts of

the audit of the inventory
and warehousing cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 37
 Interrelationship of
Various Audit Tests

Tests of acquisition
and payment cycle

Raw materials Work in process

Acquisitions of Other manufacturing
raw materials overhead
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 38
 Interrelationship of
Various Audit Tests

Tests of payroll
and personnel cycle

Work in process Work in process

Direct labor Indirect labor

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 39
 Interrelationship of
Various Audit Tests

Inventory tests

Raw materials Work in process

Ending inventory Ending inventory

Finished goods
Ending inventory
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 40
 Interrelationship of
Various Audit Tests

Tests of sales and

collection cycle

Finished goods
Cost of goods sold
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 41
 Integration of the Tests

 Acquisition and Payment Cycle

 Payroll and Personnel Cycle
 Sales and Collection Cycle
 Cost Accounting
 Physical Inventory, Pricing, and Compilation

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 End of Chapter 20

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 43