Audit of the Inventory and
Distribution Cycle
The Complexity of Inventory
• Why?
• A major item
• Inventory items could
• Very diverse items are included
• Valuation needs to consider
• One client may use several methods
Inventory Cycle-2
Functions in the Inventory and
Warehousing Cycle
•
•
•
•
•
•
Process purchase orders
Receive new materials
Store materials
Process goods
Store finished goods
Ship finished goods
Inventory Cycle-3
An Overview of Functions, Documents, and
Accounting Systems
Starting point
• E.g. Stockroom
Purchase details
N
Prepare prenumbered
Purchase Requisition
Purchase Requisition
Accounts
Payable
Purchasing
Inventory Cycle-4
Purchasing Department
Stockroom
Purchase Requisition
Determine Vendor,
prepare prenumbered
Purchase Order
N
Originating Department
Purchase Order
Receiving
Accounts
Payable
Vendor
Inventory Cycle-5
Receive new materials
Purchasing
Goods
Blind copy of
Purchase Order
Count goods, match
with Purchase Order,
and prepare Receiving
Report
A
Filed until goods
received along
with invoice
copy
Blind copy of
Purchase Order
A
Receiving Report
Storage with goods
Purchasing
Accounts
Payable
Inventory Cycle-6
Vendor’s Invoice
Originating
Department
Purchase Requisition
Purchasing
Purchase Order
Receiving
Receiving Report
Vendor
Vendor’s Invoice
Compare. Then
prepare Voucher and
enter in Voucher
Register
Voucher Register to
General Accounting
Purchase Requisition
Purchase Order
Receiving Report
Vendor’s Invoice
Voucher
D
To Cash Disbursements
when due
Inventory Cycle-7
Storage
Production
Goods are placed in
storage. Raw materials
perpetual inventory
updated
Inventory
Master file
Cost Accounting
N
Goods
from
Receiving
Raw Materials
Raw Requisition
Materials
RawRequisition
Materials
Requisition
Goods are placed in
production
Production
Inventory Cycle-8
Manufacturing
Goods
Goods are placed in
storage in production
N
Raw Materials
Requisition
Storage
Finished Goods to
storage
Cost
Accounting
Records
Inventory Cycle-9
Finished Goods Storage
Finished Goods from Production
Update Perpetual
Inventory Master File.
Update Cost
Accounting Records
Finished
Goods
Master File
Finished Goods to
shipment
Cost
Accounting
Records
Inventory Cycle-10
Finished Goods Shipment
Order Entry
Approved
Sales
Order
SO
Billing and A/R
BL
BL
Prepare Multi-Part
Bill of Lading. Update
Perpetual Inventory
Master File on shipment
BL
BL
N
Customer
Common
Carrier
Finished
Goods
Master File
Inventory Cycle-11
The Audit of Inventory
Audit area
Cycle
Acquire and record raw
materials, labour, and
overhead
Acquisition and Payments,
Payroll and Personnel
Internally transfer
assets and costs
Inventory and warehousing
Ship goods and record
revenue and costs
Sales and Collections
Physically observe
inventory
Inventory and warehousing
Price and compile
inventory
Inventory and warehousing
Inventory Cycle-12
Cost Accounting
Typical Controls
• Good controls are essential
1. Physical controls
• Inventory must be protected from theft and misuse
• What does the auditor look for?
• If auditor assesses the physical controls and inadequate?
Inventory Cycle-13
2. Documents and Records
• If testing internal controls
• Auditor examines
• Testing a series of documents
• Does the auditor always test the controls around inventory
production?
.
Inventory Cycle-14
3. Inventory files
• When does the auditor examine the Perpetual Inventory
system?
• If level of control risk is low
Inventory Cycle-15
Analytical Procedures
• Compare gross margin percentage with previous years
• Compare inventory turnover with previous years
• Compare unit costs of inventory with previous years
• Compare extended inventory value with previous years
• Compare current-year manufacturing costs with previous year
Inventory Cycle-16
Inventory Tests of Details of Balances
Set materiality.
Assess Audit Risk and
Inherent Risk for Inventory
and Warehousing
Assess Control Risk for the
applicable cycles
Identify assertions where
substantive testing is
insufficient, and/or there is
risk of material misstatement
Design and perform test of
control for the applicable
cycles. Assess control risk
The type of audit procedures?
What is the sample size?
Items to be selected?
Timing – when to do the
procedures?
Design and perform
substantive tests of
inventory.
Inventory Cycle-17
Physical Inventory Observation: Existence
• Remember McKesson & Robbins 1937
• Select a random sample of tag numbers
• If inventory is not tagged
• Movement of inventory
Inventory Cycle-18
Physical Inventory Observation: Completeness
• Tagging inventory
• If tags are not used
• Enquire as to inventory in other locations.
Inventory Cycle-19
Physical Inventory Observation: Accuracy
• Recount client’s counts
• Should also trace inventory in both directions.
• Perpetual inventory master file
• Record client counts test-counted for subsequent testing.
Inventory Cycle-20
Physical Inventory Observation: Classification
• Examine inventory tags:
• What to look for?
• How about percentage of completion for work-inprocess?
Inventory Cycle-21
Physical Inventory Observation: Cutoff
• Record for subsequent follow-up
• Inventory for that shipment
• Review shipping area for inventory
• The receiving process
Inventory Cycle-22
Physical Inventory Observation: Valuation
• What is the auditor looking for?
• What else should the auditor do?
Inventory Cycle-23
Physical Inventory Observation: Rights and
Obligations
• Ownership of inventory is the prime focus in this
instance
• About what type of item is the auditor concerned?
Inventory Cycle-24
Tests for Compilation and Detail tie-in
• What about accounting principles?
• What does compilation mean?
• What items should be used in this test?
• What else should be done?
• Detail tie-in?
Inventory Cycle-25
Tests for Existence
• What items should be used for this test?
• What type of test is performed?
Inventory Cycle-26
Tests for Completeness
• What about unused tags?
• How about the tags sequence?
• Hand-held computers
Inventory Cycle-27
Tests for Accuracy
• Want to ensure that the counts are accurate. What
type of test?
• Perform pricing tests. Type of tests?
• Manufacturing
• Non-Manufacturing
Inventory Cycle-28
Tests for Classification
• Want to inventory is classified correctly as to the type
of inventory
Inventory Cycle-29
Tests of Valuation
• Remember the physical inventory observation. What
was performed in this regard?
• Perform test of lower of cost or market, selling price,
and obsolescence
Inventory Cycle-30
Tests for Rights and Obligations
• The auditor is concerned about what type of
inventory?
• What type of test?
Inventory Cycle-31
Tests for Presentation and Disclosure
• What document should be examined here?
Inventory Cycle-32
Interrelationship of Various Audit Tests
Tests of acquisition
and payments cycle
Raw materials
Beginning
inventory
+
Acquisitions of
raw materials
Ending inventory
=
Raw material
used
Tests of cost
accounting:
Perpetual inventory
records
Unit cost records
Tests of physical
inventory
observation
Compilation and
pricing
Tests of payroll and
personnel cycle
Work in
process
Beginning
inventory
+
Direct labour
+
Raw material used
+
Indirect labour and
other
manufacturing
overhead
Ending inventory
=
Cost of goods
manufactured
Finished
goods
Beginning inventory
+
Cost of goods
manufactured
Ending inventory
=
Cost of goods sold
Tests of sales
and collection
cycle
Inventory Cycle-33
Problem 17-18, p. 552
The table below shows sales, cost of sales, and inventory data for Aladdin Products Supply Inc.,
a wholesale distributor of cleaning supplies. All amounts are in the thousands.
2012
Sales
2011
2010
2009
$23.2
$21.7
$19.6
$17.4
17.1
16.8
15.2
13.5
Beginning inventory
2.3
2.1
1.9
1.5
Ending inventory
2.9
2.3
2.1
1.9
Cost of Sales
REQUIRED:
a. Calculate the following ratios:
1)
Gross margin as a percentage of sales
2)
Inventory turnover
b. List several logical causes of the changes in the two ratios.
c. Assume that $500,000 is considered material for audit planning purposes for 2010. Could
any of the fluctuations in the computed ratios indicate a possible material misstatement?
Demonstrate this by performing a sensitivity analysis.
d. What should the auditor do to determine the actual cause of the changes?
Inventory Cycle-34
Problem 17-16, p. 551
Items 1 through 8 are selected questions typically found in questionnaires used by auditors to obtain an
understanding of internal controls in the inventory and distribution cycle. In using the questionnaires for a
particular client, a ‘yes’ response to a question indicates a possible internal control, whereas a ‘no’ response
indicates a potential weakness.
1. Does the receiving department prepare prenumbered receiving reports and account for the numbers
periodically for all inventory received, showing the description and quantity of materials?
2. Is all inventory stored under the control of a custodian in areas where access is limited?
3. Are all shipments to customers authorized by prenumbered shipping documents?
4. Is a detailed perpetual inventory master file maintained for raw materials inventory?
5. Are physical inventory counts made by someone other than storekeepers and those responsible for
maintaining the perpetual inventory master file?
6. Are standard cost records used for raw materials, direct labour, and manufacturing overhead?
7. Is there a stated policy with specific criteria for writing off obsolete or slow moving inventory?
8. Is the clerical accuracy of the final inventory compilation checked by a person independent of those
responsible for preparing it?
a.
b.
c.
d.
REQUIRED:
For each of the preceding questions, state the purpose of the internal control.
For each internal control, list a test of controls to test its effectiveness.
For each of the preceding questions, identify the nature of the potential financial misstatement(s) if the
control is not in effect.
For each of the potential misstatements in part (c), list a substantive audit procedure to determine whether
a material misstatement exists.
Inventory Cycle-35
Problem 19-22, p. 664 Canadian 11th. Edition
You are testing the summarization and cost of raw materials and purchased part
inventories as part of the audit of Rubber Products and Supply Corp. There are
2,000 inventory items with a total recorded value of $648,500.
Your audit will compare recorded descriptions and counts with the final inventory
listing, compare unit costs with vendors’ invoices, and extend unit costs times
quantity. A misstatement in any of those is defined as a difference. You plan to use
monetary unit sampling.
You make the following decisions about the audit of inventory:
Tolerable misstatement (same as for upper as for lower)
Average percent of error assumption - overstatements
Average percent of error assumption - understatements
Acceptable risk of incorrect acceptance
Estimated error rate in the population
$24,000
50%
100%
5%
0.5%
Inventory Cycle-36
REQUIRED:
a. What are the advantages of using monetary unit sampling in this situation?
b. What is the sample size necessary to achieve your audit objectives using monetary unit
sampling?
c. Disregarding your answer to part (b), assume that a sample of 125 items is selected and
that the following differences between book and audited values are identified
(understatements are in parentheses). The book or recorded amounts are also shown.
d.
Item No.
Difference
Book Amount
1
$19
$700
2
11
136
3
(19)
820
4
40
250
5
90
300
6
38
210
7
(90)
8
70
300
9
(85)
950
Total
$74
2,150
For each of the other 116 items in the sample, there was no difference between book and
audited values.
Based on this sample, calculate the adjusted overstatement and understatement error
bounds.
Are the book values misstated?
Inventory Cycle-37
c. Misstatements
Item
1.
2.
3.
4.
5.
6.
7.
8.
9.
Recorded Accounts
Receivable Amount
$700
136
820
250
300
210
2,150
300
950
Audited
Misstatement
Misstatement Divided
Amount
by Recorded Amount
681
$19
125
11
839
(19)
210
40
210
90
2150
38
2240
(90)
230
70
1035
(85)
Percentage Misstatement Bounds
Read along the row of 125 sample size on the first table (5% ARACR)
Number of
Upper Precision
Misstatements Limit from Table
13-8
0
1
2
3
4
5
6
Increase in Precision Limit
Resulting from Each
Layer (Layers)
Inventory Cycle-38
Determination of Initial Upper and Lower Misstatement Bounds
Overstatements
Number of Misstatements
Upper
Precision
Limit Portion
Recorded
Value
Unit
Misstatement
Assumption
Misstatement
Bound Portion
(Columns
2 X 3 X 4)
Upper
Precision
Limit Portion
Recorded
Value
Unit
Misstatement
Assumption
Misstatement
Bound Portion
(Columns
2 X 3 X 4)
0
1
2
3
4
5
6
Upper precision limit
Initial misstatement bound
Understatements
Number of Misstatements
0
1
2
3
Lower precision limit
Initial misstatement bound
Inventory Cycle-39
Determination of Adjusted Misstatement Bounds
Number of
Misstatements
Unit
Misstatement
Assumption
Sample
Size
Recorded
Population
Point
Estimate
Bounds
Unit
Misstatement
Assumption
Sample
Size
Recorded
Population
Point
Estimate
Bounds
Initial overstatement
bound
Understatement
misstatements
1
2
3
Sum
Adjusted overstatement
bound
Number of
Misstatements
Initial understatement
bound
Overstatement
misstatements
1
2
3
4
5
6
Sum
Adjusted understatement
bound
Inventory Cycle-40
Table 14-9
Estimated Population
Exception Rate (EPER)
(in percentage)
Tolerable Exception Rate (TER)
(in percentage)
2
3
4
5
6
7
8
9
10
15
20
29
46
46
46
46
46
46
46
46
61
61
61
61
61
76
76
89
116
179
19
30
30
30
30
30
30
30
30
30
30
30
30
30
40
40
40
40
50
68
14
22
22
22
22
22
22
22
22
22
22
22
22
22
22
22
22
30
30
37
5-Percent ARACR
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
3.00
3.25
3.50
3.75
4.00
5.00
6.00
7.00
149
236
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
99
157
157
208
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
74
117
117
117
156
156
192
227
.
.
.
.
.
.
.
.
.
.
.
.
59
93
93
93
93
124
124
153
181
208
.
.
.
.
.
.
.
.
.
.
49
78
78
78
78
78
103
103
127
127
150
173
195
.
.
.
.
.
.
.
42
66
66
66
66
66
66
88
88
88
109
109
129
148
167
185
.
.
.
.
36
58
58
58
58
58
58
77
77
77
77
95
95
112
112
129
146
.
.
.
32
51
51
51
51
51
51
51
68
68
68
68
84
84
84
100
100
158
.
.
.
Inventory Cycle-41
TER
EPER
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
3.00
3.25
3.50
3.75
4.00
4.50
5.00
5.50
6.00
7.00
7.50
8.00
8.50
2
3
4
5
6
7
8
9
10
15
22
38
38
38
38
38
38
38
38
38
38
52
52
52
52
52
65
65
78
103
116
199
15
25
25
25
25
25
25
25
25
25
25
25
25
25
25
25
25
34
34
34
45
52
52
60
68
20
10–Percent ARACR
114
194
194
265
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
76
129
129
129
176
221
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
57
96
96
96
96
132
132
166
198
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
45
77
77
77
77
77
105
105
132
132
158
209
.
.
.
.
.
.
.
.
.
.
.
.
.
38
64
64
64
64
64
64
88
88
88
110
132
132
153
194
.
.
.
.
.
.
.
.
.
.
32
55
55
55
55
55
55
55
75
75
75
94
94
113
113
131
149
218
.
.
.
.
.
.
.
28
48
48
48
48
48
48
48
48
65
65
65
65
82
82
98
98
130
160
.
.
.
.
.
.
25
42
42
42
42
42
42
42
42
42
58
58
58
58
73
73
73
87
115
142
182
.
.
.
.
.
.
.
11
18
18
18
18
18
18
18
18
18
18
18
18
18
18
18
18
18
18
18
25
25
25
25
32 Cycle-42
Inventory
Table 14-10
ACTUAL NUMBER OF DEVIATIONS FOUND
SAMPLE SIZE
0
25
30
35
40
45
50
55
60
65
70
75
80
90
100
125
150
200
11.3
9.5
8.2
7.2
6.4
5.8
5.3
4.9
4.5
4.2
3.9
3.7
3.3
3.0
2.4
2.0
1.5
1
17.6
14.9
12.9
11.3
10.1
9.1
8.3
7.7
7.1
6.6
6.2
5.8
5.2
4.7
3.7
3.1
2.3
2
3
4
5
6
7
8
9
5 PERCENT RISK OF OVER RELIANCE
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
19.5
.
.
.
.
.
.
.
16.9
.
.
.
.
.
.
14.9 18.3
.
.
.
.
.
13.3 16.3 19.2
.
.
.
.
12.1 14.8 17.4 19.9
.
.
.
.
11.0 13.5 15.9 18.1
.
.
.
10.1 12.4 14.6 16.7 18.8
.
.
9.4 11.5 13.5 15.5 17.4 19.3
.
8.7 10.7 12.6 14.4 16.2 18.0 19.7
8.2
7.7
6.8
6.2
4.9
4.1
3.1
10.0
9.4
8.4
7.6
6.1
5.1
3.8
11.8
11.1
9.9
8.9
7.2
6.0
4.5
13.5
12.7
11.3
10.2
8.2
6.9
5.2
15.2
14.3
12.7
11.5
9.3
7.7
5.8
16.9
15.8
14.1
12.7
10.3
8.6
6.5
18.4
17.3
15.5
14.0
11.3
9.4
7.1
20.0
18.8
16.8
15.2
12.2
10.2
7.7
10
.
.
.
.
.
.
.
.
.
.
.
.
18.1
16.4
13.2
11.0
8.3
Inventory Cycle-43
Sample size
ACTUAL NUMBER OF DEVIATIONS FOUND
0
1
2
3
4
5
6
7
8
9
10
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
17.9
15.7
14.0
12.7
10.6
8.0
6.4
19.5
17.2
15.3
13.8
11.6
8.7
7.0
.
.
.
.
.
.
.
.
.
.
10 PERCENT RISK OF OVER RELIANCE
20
25
30
35
40
45
50
55
60
70
80
90
100
120
160
200
10.9
8.8
7.4
6.4
5.6
5.0
4.5
4.1
3.8
3.2
2.8
2.5
2.3
1.9
1.4
1.1
18.1
14.7
12.4
10.7
9.4
8.4
7.6
6.9
6.3
5.4
4.8
4.3
3.8
3.2
2.4
1.9
.
19.9
16.8
14.5
12.8
11.4
10.3
9.4
8.6
7.4
6.5
5.8
5.2
4.4
3.3
2.6
.
.
.
18.1
15.9
14.2
12.9
11.7
10.8
9.3
8.3
7.3
6.6
5.5
4.1
3.3
.
.
.
.
19.0
17.0
15.4
14.0
12.9
11.1
9.7
8.7
7.8
6.6
4.9
4.0
.
.
.
.
.
19.6
17.8
16.2
14.9
12.8
11.3
10.1
9.1
7.6
5.7
4.6
.
.
.
.
.
.
.
18.4
16.9
14.6
12.8
11.4
10.3
8.6
6.5
5.2
.
.
.
.
.
.
.
.
18.8
16.2
14.3
12.7
11.5
9.6
7.2
5.8
18.6
16.6
15.0
12.5
9.5
7.6
Inventory Cycle-44