CHAPTER FOUR

 4. AUDIT OF INVENTORIES AND COST OF SALES

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 Chapter Outline
 Meaning of Inventories and the Significance of Audit of
Inventories
 Functions making up the Inventory and Warehousing Cycle
 Audit objectives for Inventories/Cost of Sales
 Audit Program for Inventories/Cost of Sales
 Verification of Inventories

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 4.1Meaning of Inventories and the Significance of Audit of Inventories

 Inventories are goods held for resale in the ordinary course of

business or goods that will be used or consumed in the production
of goods to be sold.
 They are mainly divided into two major categories:
a) Inventories of merchandising businesses
b) Inventories of manufacturing businesses

Source of Inventories
 Inventories include:

 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.
Special significance of Audit of Inventories

 The audit of inventory is quite complex and time consuming

part for the following reasons:
1. Inventory is generally a major item on the balance
sheet.
2. The inventory may be in different locations, which
makes physical counting difficult.
3. The diversity of items in inventory creates another
difficulty for auditors.
4. The valuation of inventory is also difficult due to such
factors as obsolescence and the need to allocated
manufacturing costs to inventories.
Conti---

5. There are several acceptable inventory valuation methods but any

given client must apply a method consistently from year to year.

6. Misstatements of inventories directly affect cost of goods sold and,

therefore, net income.

7. Management fraud has often involved the fraudulent overstatement of

inventories.

 Risks of Material Misstatements

 Inventories constitute a large asset and are very susceptible to
major errors and fraud.
 The accounting profession allows numerous alternative methods
for valuation of inventories, and different methods may be used for
various classes of inventories.
Cont…
 The determination of inventory value directly affects the cost of
goods sold and has a major impact on net income for the year.
 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.
 4.2 Functions making up the Inventory and Warehousing Cycle
 Inventory takes many different forms, depending on the nature
of the business.
 For retail or wholesale businesses, the largest account in the
financial statements is often merchandise inventory available for
sale.
4.2 Functions making up the Inventory and Warehousing Cycle

 To study the inventory and warehousing cycle, we will use an

example of a manufacturing company, whose inventory may
include:-
 raw materials,
 purchased parts and supplies for use in production,
 goods in the process of being manufactured, and
 finished goods available for sale.
 Six functions make up the inventory and warehousing cycle.
1) Process Purchase Orders

2) Receive Raw Materials

3) Store Raw Materials

4) Process the Goods

5) Store Finished Goods Ship Finished Goods

The following figure shows the above six functions in the inventory and
warehousing cycle and below the figure brief discussions have been made for
each function.
4.3 Audit objectives for Inventories/Cost of Sales

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

inherent risks, including fraud risks,
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:
 Substantiate the existence of inventories and the occurrence of transactions.
 Establish the completeness of recorded inventories.
 Verify the cut-off of transactions affecting cost of goods sold.
 Determine that the client has rights to the recorded inventories.
 Establish the proper valuation of inventories and the accuracy of transactions.
 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.
 4.4 Audit Program for Inventories/Cost of Sales

 The auditor needs to design an appropriate audit program for

inventories/cost of sales.

 The primary objective of an auditor is to verify effectiveness of

internal control of the client to enhance efficient and effective
utilization of inventory.

 Internal Control over inventory includes

a) Documentation of authorization and approval procedures
b) Appropriate separation of responsibilities
c) Safeguarding assets and records: Inventory Balances
a) Documentation of authorization and approval procedures

 The more important procedures for inventory and cost of sales

require that:
 A properly approved purchase requisition be originated as the
first document in support of materials acquisition.
 Purchase orders, be sequentially numbered and a procedure be
established.
 Debit memos, issued in connection with purchase returns and
allowances, be sequentially numbered and controlled.
 Sequentially numbered vouchers be prepared and properly
approved in support of all cash disbursements.
 A voucher register be maintained to record all approved
vouchers.
 Properly controlled, sequentially numbered receiving report
forms be used.
Documentation----
 Job order cost sheets or cost of production reports be used
to account for goods in the process of being manufactured.
 Subsidiary perpetual inventory records be maintained for
raw materials and finished goods.
 Bills of material or raw material requisitions be used to
account for materials issued into production.
 Properly controlled, sequentially numbered pay checks be
used to pay all employees.
b) Appropriate separation of responsibilities
 The appropriate separation of responsibilities should be checked by
making inquiries, observing procedures, and examining policy and
procedures manuals.
 This requires as follows:

 Persons preparing and approving the vouchers for payment should have no other
responsibilities relating to cash payments.
 The person authorized to sign checks should have no responsibilities relating to the
preparation of vouchers and have no access to cash receipts or the cash records.
 The authority to borrow should be separated from the cash handling transactions.
 The stores ledger clerk should not have access to the store room or to the handling
of inventory items.
 The various authorization and approval functions associated with payments of
accounts should be divided among a number of different persons.
 Persons having a responsibility for the purchase of goods or services should have
no access to cash.
c) Safeguarding assets and records: Inventory Balances

 All assets and records associated with the cost of sales system
should be appropriately protected from physical loss or alteration.
 This requires that:
 All payments be made by use of pre-numbered checks.

 The inventory storage areas should be fitted to the goods stored

in them.
 Inventory records should be stored so as to protect them from
damage or alteration.
(II) Substantive Audit Procedures for Inventories/Cost of Sales

 Perform the following Substantive procedures for

inventories/cost of goods sold.
 Obtain listings of inventory and reconcile to ledgers.
 Evaluate the client’s planning of physical inventory.
 Observe the taking of physical inventory and make
test counts.
 Review the year-end cutoff of purchases and sales
transactions.
 Obtain a copy of the completed physical inventory,
test its clerical accuracy, and trace test counts.
Substantive Audit -----

 Evaluate the bases and methods of inventory pricing.

 Test the pricing of inventories.
 Perform analytical procedures.
 Determine whether any inventories have been
pledged and review purchase and sales
commitments.
 Evaluate financial statement presentation of
inventories and cost of goods sold, including the
adequacy of disclosure.
Summary of Major Substantive Tests of Inventories

Substantive Test Preliminary Audit

Objectives
Obtain listings of inventory and reconcile to ledgers Clerical Accuracy
Evaluate the client’s planning of physical inventory Existence and rights
Completeness
Observe the taking of the physical inventory Valuation
Review the year end cut-off of purchase and sales Existence and rights
transactions Completeness
Obtain a copy of the completed physical inventory Clerical accuracy
and test its accuracy
Evaluate the bases and methods of inventory Valuation
pricing
Determine whether any inventories have been Valuation Presentation and
pledged and review commitments disclosure
Evaluate financial statement presentation and Presentation and disclosure
4.5 Verification of Inventories

1. Verification of Existence: Inventory Balance

 Auditors must observe the client taking a physical inventory count

to determine whether recorded inventory actually exists.

 Physical examination is an essential type of evidence used to

verify the existence and count of inventory

 These procedures must be performed as soon as possible after the

balance sheet date and include the following:

1) Review of client inventory instructions.
2) Inquiry of the client as to how counts were made.
3) Inspection of physical inventory records, noting that the proper procedures
were performed and adjustment were made where necessary.
4) Test counting of selected items, tracing the movement of inventories back
through the perpetual records by use of issue slips and receiving reports, and
then reconciling the resultant calculations with amounts shown on the
perpetual records as of the balance sheet date.
2. Verification of Valuation: Inventory Balance

 The verification of inventory valuation generally begins when the

auditor investigates the valuation method used by the client.
 The auditor must then determine whether that method produces,
within the limits of materiality, a valuation that is in accordance
either with one of the generally accepted cost-flow assumptions or
with the lower of cost or market valuation procedures.
 Specifically, the investigation of inventory valuation (pricing)
often will emphasize the following questions:
a) What method of pricing (costing) does the client use?
b) Is the method of pricing the same as that used in prior years?
c) Has the method selected by the client been applied
consistently and accurately in practice?
4. Verification of Ownership of inventory: Inventory Balance

 The verification of ownership requires the auditor to inspect, on test basis, the documents
underlying to the acquisition of individual inventory items including purchase orders,
receiving reports and vender invoices.
 With respect to consigned goods, the auditor should inquire about them and secure an
inventory representation letter stating that such goods have been excluded from the
inventory accounts.
 He or she can then examine the final inventory listing to verify that such goods have, in fact,
been excluded from inventories.

5. Verification of cut off (Periodicity): Inventory Balance

 Cut off errors occur near the beginning or end of the audit period when entries involving the

acquisition or disposal of merchandise are included as transactions in the wrong period.

 In verifying proper cut-off the auditor must inspect the underlying documents relating to

both purchases and sales made near the end of the period under audit and during the first few
days of the succeeding period.

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6. Verification of Statement Presentation
 The verification of statement presentation primarily involves seeing that
the disclosure requirement relating to inventory has been met.

 The auditor must inquire of the client as to whether any part of the
inventory has been pledged as security against creditor claims.

 If so, the auditor must ascertain that the amount of the pledged
inventory has been appropriately disclosed in the balance sheet.

 It is also necessary for the financial statement to disclose the method

used in valuing the inventory.

 Furthermore, in case of manufacturing firm, appropriate distinction

should be made between inventories of raw materials, work in process
and finished goods.
THE END!!