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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
Revenue
process
• Sale of
goods
• Assignment of
direct and indirect
labour costs
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13-3
Type 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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Type of Documents and Records
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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13-5
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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13-6
Key Segregation of Duties
Segregation of Duties
The inventory management function
should be segregated from the costaccounting function.
The inventory stores function should
be segregated from the costaccounting function.
The cost-accounting function should
be segregated from the general
ledger function.
The responsibility for supervising
physical inventory should be
separated from the inventory
management and inventory stores
functions.
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Possible Errors or Fraud
If the individual responsible for inventory management
also has access to the cost-accounting records,
production and inventory costs can be manipulated.
This may lead to an over- or understatement of
inventory and net income.
If one individual is responsible for both controlling and
accounting for inventory, unauthorized shipments can
be made or theft of goods can be covered up.
If one individual is responsible for the inventory
records and also for the general ledger, it is possible for
that individual to conceal unauthorized shipments. This
can result in the theft of goods, leading to an
overstatement of inventory.
If the individual responsible for production
management or inventory stores functions is also
responsible for the physical inventory, it is possible that
inventory records to the physical inventory, resulting in
an overstatement of inventory.
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13-7
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
Department
Raw
Finished
Materials
Goods
Stores
Stores
Cost
Accounting
IT
X
X
X
X
X
X
X
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13-8
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.
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13-9
Control Risk Assessment
Major steps in setting the control risk in the
inventory management process.
Understanding and documenting the inventory
management process based on a reliance strategy.
Planning and performing tests of controls on
inventory transactions.
Setting and documenting the control risk for the
inventory management process.
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Control Activities and Tests of Controls –
Inventory Transactions
Completeness
Authorization
Accuracy
Cutoff
Classification
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Observe the physical safeguards over inventory. Review and tests client's procedures for
consignment goods.
Review authorized production schedules. Review and test client's procedures for
developing inventory levels and procedures used to control them.
Review and test client's procedures for taking physical inventory. Review and test client's
procedures used to develop standard costs. Review and test cost accumulation and
variance reports. Review and test client's procedures for identifying obsolete, slow-moving
and excess quantities. Review the reconciliation of perpetual inventory to general ledger
control account.
Review and test client's procedures for processing inventory included on receiving reports
into the perpetual records. Review and test client's procedures for removing inventory from
perpetual records based on shipments of goods.
Review client's procedures and forms used to classify inventory.
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13-11
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
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.
Cutoff. 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 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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13-19
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
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13-20
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
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 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 “billand-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.
Cutoff. 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 cutoff 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 - Inventory
At the conclusion of testing, the auditor should
aggregate all identified misstatements. The
aggregated amount of misstatement is compared to
the tolerable misstatement allocated to the inventory
account.
Aggregated misstatement < Tolerable misstatement
The auditor may accept the inventory account as fairly presented.
Aggregated misstatement > Tolerable misstatement
The auditor may conclude the inventory is not fairly presented.
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End of Chapter 13
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