AUDIT OF INVENTORIES
Business Processes
Audit Direction
Purchase to Pay (Audit of
Liabilities)
Relevant Account Balances
●​ Routinary
○​ Test of Controls
○​ Substantive Test
(Less Extensive)
Order to Cash (Audit of
Receivables)
Plan to Inventory
Trade Liabilities
Cash
INVENTORY
Trade Receivables
Cash
INVENTORY (Derecognition)
INVENTORY (Work-in-Process,
Finished Goods)
EXPECTED THEORY QUESTIONS
1.​ Internal Controls / Test of Controls
2.​ Substantive Testing
Business
Process
Production
Planning
Materials, Labor
& Overhead
Requisition
Production and
Inventory Control
(Technically
separated;
Interrelated)
Cost Accounting
and Recording
(Technically
Separated;
Transaction
Trail
Production
Order
Requisition
Forms (DM,
DL, OH)
Production
Report
Control Objective
Control Risk
To ensure production is at Overproduction - Will result
optimum level (Do not
in slow-moving, therefore
over/underproduce).
high obsolescence risk.
FS Assertion
Affected
Valuation of
Inventories
Production based on
authorised and carefully
planned sales
forecasts/budgets.
Underproduction Operational Risk; Company
will fail to satisfy the
customer.
Materials, labour and OH
requested to be released
to production are
appropriate in terms of
quantity and
specifications. - Should
also be authorised.
Materials, labour and OH
are used in the production
are not appropriate which
might lead to
PRODUCTION
WASTAGES.
Valuation of
Inventories
Goods produced are
appropriate in terms of
quantity and quality.
(Production)
Inability to follow
appropriate production
protocols may lead to
production wastages.
Valuation of
Inventories
Physical safeguard over
inventories to avoid
inventory pilferage/theft.
(Inventory Control)
Inventory loss due to
pilferage/theft.
Accurate assignment of
cost to production (Cost
Accounting).
●​ Quantity of raw
Inaccurate Costing of
Production
Existence of
Inventories
Existence of
Inventory
Valuation of
Inventories
Interrelated)
materials as to
materials
requisition
●​ Quantity of direct
labor to time
sheets and labor
distribution
reports
●​ Reasonableness
of Applied
Overhead Rates
Maintenance of accurate
record of inventories
(Recording)
●​ Standard overhead rates shall be regulated for valuation assertions.
○​ Checking the actual production cost
○​ Mechanism to check the applied and actual overhead cost (Over/Underapplied)
■​ If significant, allocate to Finished Goods, Cost of Sales, and Work-in-Process
●​ If always allocated, there shall be adjustments on the production cost?
■​ If insignificant, allocate to Cost of Sales
●​ If control risk is high
○​ DO NOT Test of Controls
○​ DIRECTLY go to Substantive Testing
SUBSTANTIVE TESTING: PLAN TO INVENTORY
●​ Overstatement Risk (Asset)
FS Assertion
Audit
Objective
Audit Procedure
Existence and Rights
●​ Cut-off Procedures (Purchases and Sales) = Audit
of Receivables and Audit of Payable
●​ Observation of Physical Count of Goods = Primarily
Test of Control
●​ Test Count with Vouching (Client’s summary to test
count) = Substantive Test of the Observation of
Physical Counts of Goods
●​ Confirmation (for goods offsite)
Valuation
●​ Analytical Procedures (Inventory Estimation) =
Answers all assertions; Can be done when
expected misstatements are low.
●​ Test of Lower of Cost or Net Realizable Value
(LCNRV)
●​ Identifying slow-moving and obsolete inventories
Completeness
●​ Cut-off Procedures (Purchases and Sales)
●​ Test Count with Vouching (Client’s summary to test
count)
Cut-Off Procedures
1.​ Sales Cut-Off
2.​ Inventory Cut-Off
3.​ Purchases Cut-Off
Substantive Tests: Audit of Inventory
Dual Purpose Test
●​ Test of Controls
○​ Inquire Physical Count Procedures
○​ Observe Physical Count Procedures
●​ Substantive Testing
○​ Test Counts - After the count of the client, the auditor may count a random or planned inventory
counting.
■​ Vouching (From client’s summary to test counts) = Existence Assertion
■​ Tracing (From test counts to client’s summary) = Completeness Assertion
○​ Identifying Slow Moving or Obsolete Inventory - used to audit the valuation assertion of the
client, such as the adequacy of allowance for such inventories.
Inventory Estimation - **Refer to End of the Reviewer
1.​ When physical count is no longer possible
a.​ Inventories lost due to casualty events or due to theft.
2.​ When physical count is not practicable (not cost beneficial) = Interim reporting purposes
Definition and Presentation
Assets held for sale in the normal course of business
Merchandise Inventory (Merchandising)
Finished Goods (Manufacturing)
Assets in the process of being produced or manufactured
to be HELD FOR SALE in the normal course of business
upon completion
Work-in-Process Inventory (Manufacturing)
Materials and supplies to be supplied used in the
manufacturing process or in rendering services
Raw Materials Inventory and Factory
Supplies (Manufacturing)
Service Supplies (Service)
●​ Store and office supplies are not consumed in the manufacturing process, thus classified as Prepaid
Expenses
●​ Service businesses can still have inventory (e.g. restaurants - Food and Beverage Inventories)
●​ According to liquidity, 4th in the line item, (CCE, Financial Instruments, TAOR, Inventory)
●​ Presentation: ALWAYS Current Assets
Measurement
Initial Measurement
@ Cost
1.​ Cost of Purchase (Merchandise Inventory or
Raw Materials) = Cash Purchase Price
a.​ Purchase Price
b.​ Import Duties
c.​ Non-Refundable Taxes Net of
Discounts and Rebates
2.​ Cost of Conversion (Applicable only to
Manufacturing Companies)
a.​ Direct Labour
b.​ Overhead Cost
3.​ DAICs (Costs incurred up to the condition
that the inventory is available until the
warehouse/storage)
a.​ Freight on purchases (Freight-in), for
Merchandising
b.​ Insurance while in transit, for
Merchandising
c.​ All costs up to transferring FG to
warehouse, for Manufacturing
Subsequent Measurement
@ Lower of Cost or Net Realizable Value
●​ Two types of Cost:
○​ Prime Cost = Direct Materials + Direct Labor
○​ Conversion Cost = Direct Labor + Overhead
●​ Input Vat - Refundable Taxes = Not included as cost; Input Vat is deducted to Output, not
capitalizable
○​ Output VAT - Input VAT = Net VAT Payable (Current Liability)
●​ All subsequent costs after the goods are transferred to warehouse, not already capitalizable
●​ Costs that should not be included
○​ Storage Cost (Finished Goods)
■​ If WIP (Integral Part of the Manufacturing Process), capitalizable
○​ Selling Costs
○​ Administrative Costs
○​ ABNORMAL Spoilages/Breakages/Shrinkages = Treated as Outright Loss
■​ Normal Spoilages/Breakages/Shrinkages = Absorbed in Cost of Sales
Recognition and Derecognition
Recognition
Derecognition
VALID PURCHASE
General Rule: Upon Receipt
Exception:
1.​ In Transit
FOB Shipping Point (Valid Sale) = RECOGNIZE
FOB Destination (Invalid Sale) = DO NOT
RECOGNIZE
VALID SALE
General Rule: Upon Delivery
Exception:
1.​ In Transit
FOB Shipping Point (Valid Sale) = DERECOGNIZE
FOB Destination (Invalid Sale) = DO NOT
DERECOGNIZE
2.​ Special Agreement
> Consignment Basis = DO NOT RECOGNIZE
> Purchase with resale agreement = DO NOT
RECOGNIZE
> Bill and Hold Agreement = RECOGNIZE
2.​ Special Agreement
> Consignment Basis = DO NOT DERECOGNIZE
> Purchase with resale agreement = DO NOT
DERECOGNIZE
> Bill and Hold Agreement = DERECOGNIZE
●​ Revenue is recognized upon the satisfaction of performance obligation by transferring a good or
service.
○​ When a customer obtains control of the asset:
■​ Right to direct the use of the asset
■​ Right to obtain substantially all the economic benefits
●​ Determinations of Transferring Control
○​ Right to payment/obligation to pay exists
○​ Transfer of legal right
○​ Transfer of physical possession
○​ Transfer of significant risk and rewards
○​ Customer acceptance of the asset
●​ Sale with Repurchase Agreement
○​ General Rule: Not Valid Sale
■​ If Repurchase Price < Original Selling Price (Lease IFRS 16)
■​ If Repurchase Price >= Original Selling Price (Inventory Financing - Loan Agreement)
○​ Exception: Valid Sale
■​ If the buyer has the RIGHT to request the repurchase; and
■​ If buyer has NO Significant Economic Incentive
●​ Valid Sale (where refund liability is recognized)
Consignment
Consignor
Consignee
(1) Cost of Inventory Out on Consignment
(1) Cost of Inventory
Initial Cost
xxx
+ DACs to Bring Goods to Consignee (ex. Freight
Cost)
xxx
Adjusted Cost
xxx
(2) Receivable from Consignee
NONE
(2) Payable to Consignor
Consignment Sales
xxx
Consignment Sales
xxx
Commission Expense
(xxx)
Commission Expense
(xxx)
Advances from Consignee*
(xxx)
Advances from Consignee
(xxx)
Receivable from Consignee
xxx
Payable to Consignor
xxx
(3) Consignment Net Income
(3) Consignment Net Income
Consignment Sale
xxx
Consignment Cost of Sale
(xxx)
Commission Expenses
(xxx)
Other Expenses
(xxx)
Consignment Net Income
xxx
Commission Income
xxx
●​ All expenses related to the consignment should be in the Consignor’s Account, regardless who pays for
it.
○​ If the consignee paid the expenses, advances from the consignee on behalf of the consignor.
Balance Sheet Measurement
BS Date Measurement: Lower of Cost or Net Realizable Value
1.​ Cost of Inventory
Cost Formula
Specific Identification
-​ Not homogenous
-​ High Volume
-​ Low Turnover
-​ Ex. Construction Companies when constructing buildings.
Recording Method
Perpetual Recording
First-in First-Out (FIFO) =
> Inventory at Year End x Cost of Latest Purchases
-​ Homogenous
-​ Low Volume
-​ High Turnover
Perpetual Recording/Periodic
Recording
Average
-​ Homogenous
-​ Low Volume
-​ High Turnover
Perpetual Recording (Moving
Average) / Periodic Recording
(Weighted Average)
●​ Perpetual = Account for all movements of inventory (Sales and Purchases)
●​ Periodic = Does not account all movements, only at year-end after the physical counting of inventory.
●​ Moving Average = Average Inventory Cost changes every purchase.
○​ Inventory x Last Moving Average Unit cost
●​ Simple/Weighted Average = Often not computed on COS regularly.
○​ Inventory x COGAS/GAS
Perpetual
Periodic
Purchases
Inventory
Purchases
xxx
Accounts Payable/Cash
xxx
Inventory
Freight-in
xxx
xxx
Accounts Payable/Cash
Payment (within discount period)
Accounts Payable
Cash (Net)
Inventory
Payment (within discount period)
xxx
xxx
xxx
Purchase Returns and Allowances
Accounts Payable
Inventory
xxx
Accounts Payable
Cash
Purchase Discount
xxx
xxx
xxx
Purchase Returns and Allowances
xxx
xxx
Sales
Accounts Payable
Sales
xxx
xxx
Sales
Accounts Receivable
Sales
xxx
Cost of Sales
Inventory
xxx
xxx
xxx
xxx
xxx
Sales Returns
Sales Returns
Sales Returns
Accounts Receivable
xxx
Inventory
xxx
Cost of Sales
Accounts Receivable
Sales
xxx
xxx
Sales Returns
Accounts Receivable
xxx
xxx
2.​ Net Realizable Value (NRV) - Concerned with Estimates
Merchandise Inventory; Finished Goods
Estimated Selling Price - Cost to Sell
Work-in Process
Estimated Selling Price - Cost to Sell - Cost to Complete
Raw Materials
Replacement cost (Current Purchase Price)
-​ Tested only if the related FG had been written down.
●​ NRV of Raw Material is not based on selling price. The basis is on the current price or the replacement
cost.
3.​ Lower of Cost or Net Realizable Value
If NRV < Cost: Loss on Write down / Allowance (Only the increase is the writedown from the allowance) - Can
be recorded on COS or Other expense, depending on the company policy. If the write-down is normal, add to
cost of sales
a.​ Direct Writeoff Method
b.​ Allowance Method
i.​ If physical obsolescence = Direct Writeoff already
ii.​ Economic Indicators = Allowance Method, there’s chances that it can be recovered
If NRV > Cost: No Loss / Required Allowance automatically Zero (0).
a.​ Individual Approach (Item-per-item Basis)
b.​ Group Basis (Group inventories with similar characteristics)
Audit Procedures Relating to Cost:
1.​ Inquiry - Inventory record and cost formula used by the client
2.​ Recomputation - Test the mathematical accuracy of records.
Audit Procedures Relating to NRV:
1.​ Inquiry - Reasonable of the estimates
2.​ Recomputation - Test the mathematical accuracy of records.
3.​ Test of Reasonableness (Audit of Accounting Estimates)
a.​ Subsequent events review
Inventory Estimation
●​ Determining the cost of inventory without rendering physical count.
APPLICATION
1.​ When physical count is no longer possible (Inventory lost due to casualty events or due to theft)
2.​ When physical count is not practicable (Not cost beneficial - in interim reporting purposes)
3.​ Audit: Substantive Test of Analytical Procedures
METHODS
Gross Profit Method
Actual COGAS
Inventory, Beg
+ Gross Purchases
+ Freight In
- Purchase Returns, Allowance, Discounts​
+ Dept. Transfer-in/Debit​
- Debt. Transfer-out/Credit​
- ABNORMAL Breakages
Less: Estimated Cost of Sales
Gross Sales x Cost % (If GP is Based on Sales)
Gross Sales / SP% (If GP is Based on Cost)
1.​ Sales Discounts
a.​ To Customers: IGNORED
b.​ Special Discounts (E.g. to employees:
ADDED TO SALES
2.​ Sales Returns
a.​ With Physical Transfer: DEDUCTED
FROM SALES
3.​ Sales Allowance
a.​ No Physical Transfer Yet: IGNORED
b.​ Treat it as returns
4.​ NORMAL Spoilage/Breakages/Shrinkages:
ADDED TO SALES
Retail Method
Actual COGAS @ Retail price
Inventory, Beg @ Retail Price
+ Gross Purchases @ Retail Price
- Purchase Returns @ Retail Price​
+ Dept. Transfer-in/Debit @ Retail Price​
- Debt. Transfer-out/Credit @ Retail Price​
- ABNORMAL Breakages @ Retail Price​
+ Net Markup
- Net MarkDown
Less: Estimated Cost of Sales @ Retail Price
Gross Sales
1.​ Sales Discounts
a.​ To Customers: IGNORED
b.​ Special Discounts (E.g. to employees:
ADDED TO SALES
2.​ Sales Returns
a.​ With Physical Transfer: DEDUCTED
FROM SALES
3.​ Sales Allowance
a.​ No Physical Transfer Yet: IGNORED
b.​ Treat it as returns
4.​ NORMAL Spoilage/Breakages/Shrinkages:
ADDED TO SALES
Average Cost
= Inventory, end @ Retail x Cost %
Cost % = COGAS @ Cost / COGAS @ Retail
FIFO
= Inventory, end @ Retail x Cost %
Cost % = COGAS @ Cost - Beg. Inventory / COGAS
@ Retail - Beg. Inventory
Convention/Conservation/LCA
= Inventory, end @ Retail x Cost %
Cost % = COGAS @ Cost / COGAS @ Retail + Net
Markdown