Chapter Thirteen
Auditing the
Inventory
Management
Process
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Overview of the
Inventory Management Process
Purchasing
process
• Purchase of
raw materials
• Payment of
manufacturing
overhead
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Inventory
management
process
Human resource
management
process
• Assignment of
direct and indirect
labour costs
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Revenue
process
• Sale of
goods
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
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Inventory
Master File
Type of Documents and Records
(continued)
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,
labour, 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.
Shipping
Order
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The Major Functions
Functions in the Inventory Management Process
Inventory management
Raw materials stores
Manufacturing
Finished goods stores
Cost accounting
General ledger
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Authorization of production activity and maintenance of
inventory at appropriate levels; issuance of purchase
requisitions to the purchasing department.
Custody of raw materials and issuance of raw materials to
manufacturing departments.
Production of goods.
Custody of finished goods and issuance of goods to the
shipping department.
Maintenance of the costs of manufacturing and inventory in
cost records.
Proper accumulation, classification, and summarization of
inventory and related costs in the general ledger.
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Key Segregation of Duties
Segregation of Duties
Possible Errors or Fraud
If the individual responsible for inventory management
The inventory management function also has access to the cost-accounting records,
should be segregated from the cost- production and inventory costs can be manipulated.
accounting function.
This may lead to an over- or understatement of
inventory and net income.
The inventory stores function should If one individual is responsible for both controlling and
be segregated from the costaccounting for inventory, unauthorized shipments can
accounting function.
be made or theft of goods can be covered up.
If one individual is responsible for the inventory
The cost-accounting function should records and also for the general ledger, it is possible for
be segregated from the general
that individual to conceal unauthorized shipments. This
ledger function.
can result in the theft of goods, leading to an
overstatement of inventory.
The responsibility for supervising
If the individual responsible for production
physical inventory should be
management or inventory stores functions is also
separated from the inventory
responsible for the physical inventory, it is possible that
management and inventory stores
inventory records to the physical inventory, resulting in
functions.
an overstatement of inventory.
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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.
Inventory Function
Preparation of production schedules
Issuance of materials requisition
Updating cost records with materials
labour and overhead usage
Updating of inventory records
Release of goods to the shipping department
Approval and issuance of purchase requisition
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Inventory
Management
X
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Department
Raw
Finished
Materials Goods
Cost
Stores
Stores Accounting
IT
X
X
X
X
X
X
X
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.
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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.
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.
Plan and perform tests of controls on inventory
transactions.
Set and document the control risk for the inventory
management process.
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Control Activities and Tests of Controls –
Inventory Transactions
Assertion
Occurrence
Completeness
Authorization
Accuracy
Cut-off
Classification
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Test of Controls
Observe and evaluate proper segregation of duties. Review and test procedures for transfer
of inventory. Review and test procedures for issuing materials to manufacturing
departments. Review and test client procedures for account for numerical sequence of
materials requisitions.
Observe the physical safeguards over inventory. Review and test client's procedures for
consignment goods.
Review authorized production schedules. Review and test procedures for developing
inventory levels and procedures used to control them.
Review and test procedures for taking physical inventory. Review and test procedures used
to develop standard costs. Review and test cost accumulation and variance reports. Review
and test procedures for identifying obsolete, slow-moving, and excess quantities. Review
the reconciliation of perpetual inventory to general ledger control account.
Review and test procedures for processing inventory included on receiving reports into the
perpetual records. Review and test procedures for removing inventory from perpetual
records based on shipments of goods.
Review the procedures and forms used to classify inventory.
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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
activities.
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Control Activities and Tests of Controls –
Inventory Transactions
Completeness of Inventory Transactions
The primary control activity for completeness
relates to recording inventory that has been
received. Controls are closely related to the
purchasing process.
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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.
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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.
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Control Activities and Tests of Controls –
Inventory Transactions
Cut-off of Inventory Transactions
Inventory transactions recorded in the improper
period could affect a number of accounts,
including inventory, purchases and cost of goods
sold.
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Control Activities and Tests of Controls –
Inventory Transactions
Classification of Inventory Transactions
The client must have control activities 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.
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Relating the Assessed Level of Control Risk
to Substantive Procedures
Assertions about Classes of Transactions and Events:
Occurrence. Inventory transactions and events are valid.
Completeness. All inventory transactions and events have
been recorded.
Authorization . All inventory transactions and events are
properly authorized.
Accuracy. Inventory transactions have been properly computed
and ending inventory, and related revenue and cost of goods sold
have been properly accumulated from journals and ledgers.
Cut-off. Inventory receipts and shipments are recorded in the
correct accounting period.
Classification. Inventory is recorded in the proper accounts.
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Relating the Assessed Level of Control Risk
to Substantive Procedures
Assertions about Account Balances at the Period End:
Existence. Inventory recorded on the books and records
actually exists.
Rights and obligations. The entity has the legal right of the
recorded inventory.
Completeness. All inventory is recorded.
Valuation and allocation. Inventory is properly recorded in
accordance with the applicable financial reporting framework.
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Relating the Assessed Level of Control
Risk to Substantive Procedures
Assertions about Presentation and Disclosure:
Occurrence and rights and obligations. All disclosed events,
transactions and other matters relating to inventory have occurred and
pertain to the entity.
Completeness. All disclosures relating to inventory that should
have been included in the financial statements have been included.
Classification and understandability. Financial information
relating to inventory is appropriately presented and described, and
disclosures are clearly expressed.
Accuracy and valuation. Financial and other information relating
to inventory are disclosed fairly and at appropriate amounts.
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Auditing Inventory
Substantive Analytical Procedures
Substantive Analytical Procedure
Possible Misstatement Detected
Compare raw material, finished goods, and total inventory
Obsolete, slow-moving, or excess inventory
turnover to previous years' and industry averages.
Compare days outstanding in inventory to previous years'
and industry average.
Compare gross profit percentage by product line with
previous years' and industry data.
Compare actual cost of goods sold to budgeted amounts.
Compare current-year standard costs with prior years' after
considering current conditions.
Compare actual manufacturing overhead costs with
budgeted or standard overhead costs.
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Obsolete, slow-moving, or excess inventory
Unrecorded or fictitious inventory
Over- or understated inventory
Over- or understated inventory
Inclusion or exclusion of overhead costs
Auditing Inventory
Auditing Standard Costs
Material
Test the quantity and
type of materials
included in the
product and the price
of the materials.
Labour
Gather evidence
about the type and
amount of labour
needed for production
and the labour rate.
Overhead
Review the client’s method
of overhead allocation for
reasonableness, compliance
with applicable financial
reporting framework, and
consistency.
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Auditing Inventory
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 client’s count teams are following the
inventory count instructions.
4. Ensure that inventory tags are issued sequentially to individual
departments.
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Auditing Inventory
Observing Physical Inventory (continued)
5. Perform test counts and record a sample of counts in the
working papers.
6. Obtain tag control information for testing the client’s inventory
compilation.
7. Obtain cut-off 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.
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Tests of Details of Transactions, Account
Balances and Disclosure
Substantive Tests of Transactions
Occurrence. Vouch a sample of inventory additions to receiving
reports and purchase requisitions.
Completeness. Trace a sample of receiving reports to the
inventory records.
Authorization. Test a sample of inventory shipments to ensure
there is an approved shipping ticket and customer sales.
Accuracy. Recompute the mathematical accuracy of a sample
of inventory transactions. Audit standard costs or other methods
used to price inventory.
Cut-off. Trace a sample of time cards before and after period
end to the appropriate weekly inventory report.
Classification. Examine a sample of inventory checks for
proper classification into expense accounts.
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Tests of Details of Transactions, Account
Balances and Disclosure
Test of Details of Account Balances
Existence. Observe count of physical inventory.
Rights and obligations. Verify that inventory held on
consignment for others or 'bill-and-hold' goods are not included in
inventory.
Completeness . Trace test counts and tag control information
to the inventory compilation.
Valuation and allocation. Obtain a copy of the inventory
compilation and agree totals to general ledger. Test
mathematical accuracy of extensions and foot the inventory
compilation. Inquire of management concerning obsolete, slowmoving, or excess inventory. Review book-to-physical adjustment
for possible misstatements.
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Tests of Details of Transactions,
Account Balances and Disclosure
Tests of Details of Disclosures
Occurrence and rights and obligations. Inquire of
management and review any loan agreements and board of directors'
minutes for any indication that inventory has been pledged or
assigned. Inquire of management about issues related to warranty
obligations.
Completeness. Complete financial reporting checklist to ensure
that all financial statement disclosures related to inventory are made.
Classification and understandability. Review inventory
compilation for proper classification among raw materials, work in
process and finished goods. Read notes to ensure that required
disclosures are understandable.
Accuracy and valuation. Determine if the cost method is
accurately disclosed. Read notes and other information to ensure that
the information is accurate and properly presented at the appropriate
amounts.
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Tests of Details of Transactions,
Account Balances and Disclosure
Possible causes of book-to-physical differences:
1. Inventory cut-off errors.
2. Unreported scrap or spoilage.
3. Pilferage or theft.
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Tests of Details of Transactions,
Account Balances and Disclosure
Examples of Disclosure Items:
1. Cost method (e.g. FIFO or weighted average).
2. Components of inventory.
3. Long-term purchase contracts.
4. Consigned inventory.
5. Purchases from related parties.
6. Pledged or assigned inventory.
7. Expenses from write-downs.
8. Warranty obligations.
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Evaluating the Audit Findings
The auditor compares the aggregated identified
misstatement to materiality to determine if the identified
misstatement would affect the audit.
The auditor requests the client to correct the identified
misstatements and then compares the uncorrected
misstatements with materiality to conclude whether the
financial statements are fairly stated.
If uncorrected misstatements in inventory, and when
considered together with other uncorrected misstatements,
are less than materiality, the auditor may accept that the
financial statements are fairly presented. Conversely, if the
uncorrected misstatement exceeds the materiality, the
auditor should conclude that the financial statements are
not fairly presented.
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End of Chapter 13
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