Audit of the Inventory
and Warehousing Cycle
Chapter 2D
2D - 1
OVERVIEW OF THE
INVENTORY
MANAGEMENT PROCESS
Figure
13-1 shows how other processes
interact with the inventory management
process.
Figure 13-2 presents a flowchart for a
reasonably complex inventory
management process.
2D - 2
DOCUMENTS AND
RECORDS
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Production schedule.
Receiving report.
Material requisition.
Inventory master file.
Production data information.
Cost accumulation and variance report.
Inventory status report.
Shipping order.
2D - 3
Flow of Inventory and Costs
Raw Materials
Beginning Raw
inventory materials
Purchases used
Ending
inventory
Manufacturing
Direct Labor
Actual Applied
Work in Process
Manufacturing
Overhead
Actual Applied
2D - 4
Flow of Inventory and Costs
Work in Process
Beginning
inventory
Cost of goods
manufactured
Ending
inventory
Finished Goods
Beginning
inventory Cost of
goods sold
Ending
inventory
Cost of Goods Sold
2D - 5
Functions in the Inventory and
Warehousing Cycle
Process
purchase
orders
Store
raw
materials
Receive raw
materials
Process the materials
2D - 6
Functions in the Inventory and
Warehousing Cycle
Store
finished
goods
Ship
finished
goods
Perpetual inventory
master file
2D - 7
Audit of Inventory
Part of audit
Cycle in which tested
Acquire and record
raw materials, labor,
and overhead.
Acquisition and
payment plus
payroll and personnel
Internally transfer
assets and costs.
Inventory and
warehousing
2D - 8
Audit of Inventory
Part of audit
Cycle in which tested
Ship goods and record
revenue and costs.
Sales and
collection
Physically observe
inventory.
Inventory and
warehousing
Price and compile
inventory.
Inventory and
warehousing
2D - 9
SEGREGATION OF DUTIES
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The inventory management function should be
segregated from the cost accounting function.
The inventory stores function should be
segregated from the cost-accounting function.
The cost-accounting function should be
segregated from the general ledger function.
The responsibility of supervising physical
inventory taking should be separated from the
inventory management and inventory stores
functions.
2D - 10
INHERENT RISK
ASSESSMENT
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Industry-related factors
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Competition
Inventory valuation issues
Rapid technology changes
Engagement and Operating
Characteristics
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Types of product
Valuation can lead to disagreements with
client
Possible related-parties transactions
2D - 11
CONTROL RISK
ASSESSMENT
Understanding and documenting
the inventory management process based
on the planned level of control risk
Planning and performing tests of controls
on inventory transactions
Assessing and documenting the
control risk for the
inventory management process
2D - 12
AUDITING INVENTORY
Substantive tests of transactions
 Analytical procedures
 Tests of account balances
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2D - 13
SUBSTANTIVE TESTS OF
TRANSACTIONS
Because the inventory management process
interacts with the revenue, purchasing, and
payroll processes, control procedures over
the receipt of raw materials, shipment of
goods, and assignment of labor costs are
normally tested as part of those processes.
 If the auditor intends to obtain substantive
evidence on the perpetual inventory
records, the tests of receipt and shipment of
goods can be extended by tracing the
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2D - 14
ANALYTICAL
PROCEDURES
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Compare raw material, finished goods, and total
inventory turnover to previous years’ and
industry averages.
Compare days outstanding in inventory to
previous years’ and industry averages.
Compare gross profit percentage by product line
with previous years and industry data.
Compare actual cost of goods sold to budgeted
amounts.
2D - 15
ANALYTICAL
PROCEDURE (continued)
Compare current year standard costs with
prior years’ after considering current
conditions.
 Compare actual manufacturing overhead
costs with budgeted or standard
manufacturing overhead costs.

2D - 16
Analytical Procedures for
Manufacturing Equipment
Analytical Procedure
Possible Misstatement
Compare unit costs of
inventory with those of
previous years.
Compare extended
inventory value with that
of previous years.
Overstatement or
understatement of
unit costs
Misstatements in
compilation, unit
costs, or extensions
2D - 17
Analytical Procedures for
Manufacturing Equipment
Analytical Procedure
Possible Misstatement
Compare current year
manufacturing costs with
those of previous years
(variable costs should be
adjusted for changes in
volume).
Misstatement of unit
costs of inventory,
especially direct
labor and
manufacturing
overhead
2D - 18
Cost Accounting Controls
1. Physical Controls
Raw materials
WIP
Finished goods
2. Controls over the related costs
2D - 19
Tests of Cost Accounting
Physical Controls
Documents and records for
transferring inventory
Perpetual inventory master files
Unit cost records
2D - 20
OBSERVATION OF
PHYSICAL INVENTORY
The auditor's observation of inventory is
a generally accepted auditing procedure.
 The observation of the physical inventory
provides evidence primarily on the
validity audit objective (also ownership
and valuation).
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2D - 21
OBSERVATION
PROCEDURES
Insure that no production is scheduled.
 Ensure that there is no movement of goods
during the inventory count.
 Make sure that the client's count teams are
following the inventory count instructions.
 Ensure that inventory tags are issued
sequentially to individual departments.
 Perform test counts and record a sample of
counts in the working papers.

2D - 22
OBSERVATION
PROCEDURES
(continued)
Obtain tag control information for
testing the client's inventory
compilation.
 Obtain cutoff information.
 Observe the condition of the inventory
for items that may be obsolete, slow
moving, or in excess quantities.
 Inquiry about goods held on
consignment for others or held on a "bill

2D - 23
Controls
Proper instructions for the physical count
Supervision by responsible personnel
Independent interval verification of the counts
Independent reconciliations of the physical
counts with perpetual inventory master files
Adequate control over count sheets or tags
2D - 24
Audit of Pricing and
Compilation
Inventory price tests
Inventory compilation tests
2D - 25
Audit of Pricing and
Compilation
Pricing and
compilation
controls
Pricing and
compilation
procedures
Valuation
of inventory
2D - 26
Valuation (Pricing)
of Inventory
Pricing Purchased Inventory
Pricing Manufactured Inventory
Cost or Market
2D - 27
TESTS OF ACCOUNT
BALANCES
Table 13-8 summarizes the tests of the inventory
account balance for each audit objective.
2D - 28
POSSIBLE CAUSES OF
BOOK-TO-PHYSICAL
DIFFERENCES
Inventory cutoff errors.
 Unreported scrap or spoilage.
 Pilferage or theft.
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2D - 29
SAMPLE DISCLOSURE ITEMS
FOR INVENTORY AND
RELATED ACCOUNTS
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Cost method (FIFO, LIFO, retail method).
Components of inventory.
Long-term purchase contracts.
Consigned inventory.
Purchases from related parties.
LIFO liquidations.
Pledged or assigned inventory.
Disclosure of unusual losses from writedowns of
inventory or losses on long-term purchase
commitments.
Warranty obligations.
2D - 30
Interrelationship of
Various Audit Tests
Tests of acquisition
and payment cycle
Raw materials
Acquisitions of
raw materials
Work in process
Other manufacturing
overhead
2D - 31
Interrelationship of
Various Audit Tests
Tests of payroll
and personnel cycle
Work in process
Direct labor
Work in process
Indirect labor
2D - 32
Interrelationship of
Various Audit Tests
Inventory tests
Raw materials
Ending inventory
Work in process
Ending inventory
Finished goods
Ending inventory
2D - 33
Interrelationship of
Various Audit Tests
Tests of sales and
collection cycle
Finished goods
Cost of goods sold
2D - 34