Importance of Inventory

1. Importance of Inventory • Typically the largest asset on balance sheet • High inherent risk • Net realizable value • Complex calculations • Importance of physical observation

2. F.G. Inventory • Beg. Inventory • 3. Transfer from 4. Transfer to Cost • WIP (Purchases) of Sales • (BTP if count 6. Physical • > books) inventory • adjustment • Ending Inventory

3. Cost of Sales • 4. COS - Transfer • from FG • 5. Underapplied (overapplied) • overhead • 6. Book to (BTP adj. if count • physical inventory > books) • adjustment

4. Analytical ProceduresGross Margin • Convert change in ratio to dollars • Trends - look at changes in ratio over time considering industry, expectations • Disaggregate data • Use turnover as supporting information • (inventory turnover is primarily used to assess net realizable value)

5. Disaggregation Example • OtherShoes Shoes Total Total • Sports Rep. Corr. Rep. Corr. • Sales 10,000 5,000 5,000 15,000 15,000 • COS 6,000 3,000 3,200 9,000 9,200 • GM 4,000 2,000 1,800 6,000 5,800 • GM% 40% 40% 36% 40% 38.7%

6. Explanations for Increase in GP • Error Non-error explanations explanations

7. Explanations for Increase in GP • Error Non-error explanations explanations • Sales cutoff Mix change • Purchase cutoff Price increase • Fictitious sale Cost decrease • Inventory • misstated

8. MC • Substantive tests for inventories include comparison to prior years, budgets, and industry averages. Which of the following would cause an abnormally low gross profit rate? • a. Overstatement of ending inventory. • b. Overstatement of sales. • c. Understatement of ending inventory. • d. Overstatement of variable selling costs.

9. Problem 21-29 Part a: • 2009 2008 2007 2006 • Gross Margin % 26.3 22.6 22.4 22.4 • Inventory • Turnover6.6 7.6 7.6 7.9 • Turnover computed as COS/Ave. Inv • 2009 2008 • Sales 23.2 21.7 • COS 17.1 16.8 • EI 2.9 2.3

10. Prob. 21-29 - Part c: • Materiality of change in gross profit: • Materiality of change in turnover:

11. Part c: • Change in gross profit x sales = • 3.7% x 23.2 million = $858,000 • 2009 CGS / 2008 turnover = • 17.1 million / 7.6 = 2.25 million EI. • 2009 EI - estimated based on 2008 turnover = 2.9 million - 2.25 million = $650,000. • The possible misstatement indicated by each ratio is material.

12. Part b: • Logical causes of increase in gross profit for 2009: • Logical causes of decrease in inventory turnover:

13. Part b: • Logical causes of increase in gross profit for 2009: • 1. Increase in sales price. • 2. Change in inventory method. • 3. Improper sales cutoff (2010 sale recorded in 2009), or purchase cutoff error (2009 purchases recorded in 2010). • 4. Change in sales mix. • 5. Overstated inventory

14. Logical causes of decrease in inventory turnover: • 1. Increase in selling prices also lowered demand for product. • 2. Company building inventory supplies. • 3. Change in inventory method • 4. Increase in obsolete or unsalable inventory. • 5. Overstated inventory.

15. Physical Inventory Observation • Required by SAS # 1 • Client controls are important

16. Inventory Observation • Physical inventory can be taken off year-end • Client should not know exact locations to be visited • No year-end physical is necessary if client has adequate perpetual records • Cycle counts should be taken to test accuracy of perpetual records

17. Inventory Tags • Evidence that inventory was counted (completeness) • Record for internal verification • Prenumbered document facilitates existence test

18. Test Counts • Client should not know items selected • Record quantity, description and unit of measure • control sequence of tags (critical control of existence)

19. Perpetual System • Counts perpetual records • Counts perpetual records • Which is the existence test?

20. Direction of Tests • Counts perpetual records Completeness • Counts perpetual records • Existence

21. Existence for Physical Inventory • Valid tags • Reasonable quantities • Test counts agree • Analytical Procedures • Key point: can’t test from records to inventory, unless a detailed inventory listing exists

22. The physical count for a retailer is higher than the perpetual records. Which of the following could explain the difference? • Inventory items had been counted but the tags had not been removed and added to the compilation sheets. • Credit memos for returned goods had not been recorded. • No journal entry had been made for goods returned to suppliers. • An item purchased FOB shipping pt. had not arrived and was not in the perpetual records.

23. Inventory Compilation • Tags should be valid tag sequences noted during observation (existence) • Test summarization of quantities, price extensions, and summary value should equal trial balance/adjusted general ledger (detail tie-in) • Scan entire listing for reasonableness of quantities, prices, extensions

24. Inventory Pricing • Usually priced at FIFO initially • LIFO recorded in a reserve account based on calculations • Client may use both methods

25. Additional Pricing Issues • Layering- Goods may have been purchased as several prices. • Obsolescence (LCM) - Primarily determined by movement and prices of goods. • Manufacturing overhead - Over/underapplied overhead usually closed to COS. If material, some relates to ending inventory.

26. Sales Cutoff • January sale ($10,000; GP = 25%) recorded in December • Goods included in Goods excluded from • inv. (phys. taken) inv. (perp. system) • Sales 10,000Sales 10,000 • Inv. 7,500 • AR 10,000 AR 10,000 • COS 7,500

27. Purchases Cutoff • December purchase of $10,000 recorded in January • Goods included in Goods excluded from • inv. (phys. taken) inv. (perp. system) • COS 10,000Inv. 10,000 • Accts. Pay 10,000 Accts. Pay. 10,000