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AUDIT FOR INVENTORIES

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AUDIT FOR INVENTORIES /
COST OF SALES
Learning objective 1
• To identify the audit objectives for inventories, COS, and related
accounts
• Describe the primary substantive test audit procedure for inventories,
COS, and related accounts
• Identify assertions addressed by audit procedures for inventories,
COS, and related accounts
Introduction
• Inventories are one of the significant portions of entities current
assets especially for manufacturing, servicing, and trading industries.
• What are the significant risks involved when auditing
inventories?
• What are the factors affecting the nature, timing, and extent
of audit procedures for inventory?
Audit objectives
• What are the audit objectives in the audit of inventories? What
assertions are accomplished thru these objectives? Name at least two
Internal controls
• What’s the importance of maintaining a perpetual inventory records
instead of a periodic inventory system?
• IF the entity is maintaining a perpetual inventory system where ending
inventory is readily known/available, is physical count still necessary?
WHY?
• On the inventory count date, there should be a reconciliation of physical
count, stock cards, and the general ledger account inventory. How is the
reconciliation accomplished? How are the differences disposed of?
Frauds on Inventory
• Overstating issuances and understating receipts of goods to show
small inventory quantities
• Physical count of goods duplicated
• Listing obsolete, slow-moving and shopworn goods as first class
products.
• Deceptive packing and mislabeling of products
Audit Procedures
• Verify Beginning inventories
• Observing inventory counts and performing test counts
• Confirming inventories held by others
• Performing purchases and inventory cut-off
• Checking appropriate valuation in accordance with accounting
policies
Audit Procedures
• Performing lower of cost or NRV test
• Determining whether any inventories have been pledged and
reviewing purchase commitment, and
• Performing test of details on COGS
• Performing analytical procedures
Verify beginning balances
• General ledger are compared with inventory balances per audited FS
of the preceding year in a repeat engagement
• Review predecessor’s working paper when available
• Vouching the disposition of the beginning inventory
• Examination of purchase orders, receiving reports, and purchase
invoices supporting the inventory
Observation during inventory count and test
controls
• What assertion is accomplished thru observation? How is observation
relevant as an audit procedure for inventory?
• Compare the management’s Vs Auditor’s responsibility during
inventory count
Observation during inventory count and test
controls
• Observation may include ensuring the following
• Client’s employees are complying with the written inventory count
instruction
• Items belonging to the audit client are accurately counted and
recorded
• Items to be excluded the inventory are either subject to
satisfactory control and excluded from the counting process or are
accurately counted and recorded, including a clear description of
their non-inventory status.
• Proper cut off has been established
• Count tags, count sheets or stock cards are properly controlled.
Observation during inventory count and test
Counts
• Test Count:
• During observations, the auditor should make test counts of
selected inventory items and trace it to the inventory count
sheet. If there is a discrepancy between the number of items
counted and the inventory count sheet, the auditor will
normally perform a recount and any errors are resolved with
the client.
Observation during inventory count and test
Counts
Alternative procedures in lieu of observations
• Examining internal control on inventories
• Examining the availability of instructions and other
records showing the client had carried out a well planned
inventory count
• Performing test counts on some items considered material
and significant
• Other procedures that the auditor thinks feasible and
necessary.
Confirmation of inventories held by others
• When does an auditor perform confirmation for inventories held by
third parties?
• What are the requests or details found in the confirmation letter
which will be sent to the custodian?
• What happens if there are no replies received from the confirmation?
What alternative procedures are done to confirm existence of such
inventory?
Confirmation of inventories held by others
• Alternative procedures
• Inspection of:
• Shipping docs
• Receipts from logistic companies
• Reports of and payments for subsequent consignment sales; and
• Correspondence with the third party.
• Consideration of whether physical inspection of the
inventory is required.
Year-end inventory/Purchase cutoff
• Primary objectives: Existence, Occurrence, Completeness
• What are the common purchase cutoff concern?
CUT OFF PROCEDURES:
• Examining a sample of receiving reports for inventory receipts immediately
before and after the inventory count to check whether its recorded in the
correct accounting period; and
• Examining a sample of shipping docs for shipments immediately prior to
and subsequent to the count to check whether it is recorded in the correct
accounting period.
Reconciliation of Inventory Summary Sheet
with General Ledger
Review of reconciliation:
• Footing the reconciliation
• Reconciling the book and physical inventory figures to the compilation
and uncorrected general ledger respectively
• Investigating significant differences between book and physical
inventories
• Reviewing the nature of the reconciling items
• Agreeing reconciling items to the supporting working papers,
adjusting journal entries and the general ledger
• Verifying that an accrual for inventory received prior to the count
date, but not billed, was included in books.
Valuation in accordance with Accounting
Policies
• What standard addresses the question – “What method of valuation
does the client use?” Explain the prescribed valuation as
recommended by the standard.
• What standard addresses the question – Is the method of valuation
the same as that used in prior years?” Explain how any changes of
valuation is accounted for according to the standard.
• To make sure that there is consistency of application of valuation
method, auditor will test:
• Raw Materials – verified with purchase invoice
• WIP & FG – cost is traced to the accounting records.
Lower of Cost or NRV
• To verify NRV of inventories, the following should be observed
• F/G = based on selling prices (evidences: subsequent sales, list price,
contracts) less any estimated cost to dispose them
• WIP = based on selling prices less any estimated cost to complete and
dispose the item.
• RM = based on replacement cost (by purchase or reproduction) less
any estimated cost to complete and dispose the item.
• *Note that raw materials are no longer subjected to lower of cost or
NRV test IF the NRV of the resulting F/G exceeds its cost.
• Write-down or reversal should be charged to expense (COGS)
Determine whether any inventories have been
pledged and review purchase commitment
• How does an auditor confirm the existence of a pledged inventory to
secure a bank loan? How are they presented to the FS?
• What should an auditor do if there are purchase commitments by the
client?
Perform test of details on COGS
• To perform the test, the auditor requests for the related COS info
(subsidiary ledger of COS), and reconcile it with a corresponding
accounting record depending on the understanding of the inventory
transaction cycle of the audit client
• Corresponding accounting record:
• corresponding credit in inventory accounts for the audit period
• Corresponding sale transaction
• After reconciliation, the auditor divides the COS into two population:
total debits and total credits.
Perform test of details on COGS
• To perform the test, the following audit procedures may be
done:
1. The auditor makes audit selections on both populations
2. The auditor obtains audit evidences such as PO, invoices,
shipping docs, proof of payments
3. Vouch the details on step 1 to evidences obtained on step 2
• Determine the appropriate general ledger account used by inspecting
material description on the purchase order
• Determine if the accurate amount was recorded (check invoice)
• Determine if the recorded COS pertains to the entity (evaluate when the
title of the goods were transferred)
• Determine if the cost was valid by checking the proof of payment
Analytical procedures
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Questions
• How would you proceed in the audit of products that are subject to
rapid obsolescence? Examples are cellphones, digital cameras,
computer programs, computer hardwares, etc
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