Chapter 13

1. Chapter 13 Auditing the Inventory Management Process ©2008 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin

2. Balance Sheet Assets Cash Investments Receivables Prepaids Inventory PP and E Other assets Liabilities and Equity Accounts payable Accrued liabilities Debt Common stock Retained earnings

3. Inventory Management Process Major component of the balance sheet Most complex part of the audit ( typically) Valuation issues Obsolescence LCM ( lower of cost or market)

4. LO# 1 Overview of the Inventory Management Process Inventorymanagementprocess Purchasingprocess Revenueprocess • Purchase ofraw materials Human resourcemanagementprocess • Sale ofgoods • Payment ofmanufacturingoverhead • Assignment ofdirect and indirectlabor costs

5. Overview ( cont’d) • Types of documents and records • Major functions • Key segregation of duties

6. LO# 2 Type of Documents and Records • Production Schedule – Based on the expected demand for the entity’s products. • Receiving Report – Records the receipt of goods from vendors. • Materials Requisition – Used to track materials during the production process. • Inventory Master File – Contains all the important information related to the entity’s inventory, including the perpetual inventory records. Production Schedule Inventory Master File

7. LO# 2 Type of Documents and Records • Production Data Information – Contains information about the transfer of goods and related cost accumulation at each stage of production. • Cost Accumulation and Variance Report – Material, labor, and overhead costs are charged to inventory as part of the manufacturing process. The variance report compares actual costs to standard or budgeted costs. • Inventory Status Report – Shows the type and amount of products on hand. • Shipping Order – Used to remove goods from the perpetual inventory records. Shipping Order

8. LO# 3 The Major Functions

9. LO# 4 Key Segregation of Duties Segregation of duties is a particularly important control in the inventory management process because of the potential for theft and fraud.

10. LO# 4 Key Segregation of Duties

11. Inherent Risk Assessment

12. LO# 5 Inherent Risk Assessment The auditor should consider industry-related factors and operating and engagement characteristics when assessing the possibility of a material misstatement. If industry competition is intense,there may be problems with the proper valuation of inventory.Technology changes in certainindustries may also promotematerial misstatement due toobsolescence. Products that are small and ofhigh value are more susceptibleto theft. The auditor must bealert to related-party transactionsfor acquiring raw materials andselling finished products. Prior-yearmisstatements are good indicatorsof potential misstatements in thecurrent year.

13. Plan and perform tests of controls on inventory transactions. Set and document the control risk for the inventory management process. LO# 6 Control Risk Assessment Major steps in setting the control risk in the inventory management process. Understand and document the inventory management process based on a reliance strategy.

14. Internal Control Testing

15. LO# 7 Control Activities and Tests of Controls – Inventory Transactions

16. LO# 7 Control Activities and Tests of Controls – Inventory Transactions Occurrence of Inventory Transactions The auditor’s main concern is that all recorded inventory exists. The auditor should also be concerned that goods may be stolen. Review and observation are the main tests of controls used by the auditor to test the control procedures.

17. LO# 7 Control Activities and Tests of Controls – Inventory Transactions Completeness of Inventory Transactions The primary control procedure for completeness relates to recording inventory that has been received. Controls are closely related to the purchasing process.

18. LO# 7 Control Activities and Tests of Controls – Inventory Transactions Authorization of Inventory Transactions The auditor’s concern with authorization in the inventory system is with unauthorized purchase or production activity that may lead to excess levels of certain types of finished goods.

19. LO# 7 Control Activities and Tests of Controls – Inventory Transactions Accuracy of Inventory Transactions Inventory transactions that are not properly recorded result in misstatements that directly affect the amounts reported in the financial statements. Inventory purchases must be recorded at the correct price and actual quantity received. Inventory shipped must be properly recorded in cost of goods sold and the related revenue recognized.

20. LO# 7 Control Activities and Tests of Controls – Inventory Transactions Classification of Inventory Transactions The client must have control procedures to ensure that inventory is properly classified as raw materials, work in process, or finished goods. By knowing which manufacturing department holds the inventory, the auditor is able to classify it by type.

21. LO# 8 Relating the Assessed Level of Control Risk to Substantive Procedures

22. LO# 8 Relating the Assessed Level of Control Risk to Substantive Procedures

23. LO# 8 Relating the Assessed Level of Control Risk to Substantive Procedures

24. Substantive Analytical Procedures

25. LO# 9 Auditing Inventory Substantive Analytical Procedures

26. Tests of Details

27. LO# 10 Auditing Inventory Auditing Standard Costs MaterialTest the quantity and type of materials included in the product and the price of the materials. LaborGather evidence about the type and amount of labor needed for production and the labor rate. OverheadReview the client’s method of overhead allocation for reasonableness, compliance with GAAP, and consistency.

28. LO# 11 Auditing Inventory Observing Physical Inventory During the observation of the physical inventory count, the auditor should do the following: • Ensure that no production is scheduled. If production is scheduled proper controls must be established for movement between departments in order to prevent double counting. • 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.

29. LO# 11 Auditing Inventory Observing Physical Inventory (continued) • Perform test counts and record a sample of counts in the working papers. • Obtain tag control information for testing the client’s inventory compilation. • Obtain cutoff information, including the number of the last shipping and receiving documents issued. • Observe the condition of the inventory for items that may be obsolete, slow moving, or carried in excess quantities. • Inquire about goods held on consignment for others or held on a “bill-and-hold” basis.

30. LO# 12 Tests of Details of Transactions, Account Balances, and Disclosures

31. LO# 12 Tests of Details of Transactions, Account Balances, and Disclosures

32. LO# 12 Tests of Details of Transactions, Account Balances, and Disclosures

33. LO# 13 Tests of Details of Transactions, Account Balances, and Disclosures • Possible causes of book-to-physical differences: • Inventory cutoff errors. • Unreported scrap or spoilage. • Pilferage or theft.

34. LO# 13 Tests of Details of Transactions, Account Balances, and Disclosures • Examples of Disclosure Items: • 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 write-downs. • Warranty obligations.

35. LO# 14 Evaluating the Audit Findings - Inventory At the conclusion of testing, the auditor should aggregate all identified misstatements. The likely misstatement is compared to the tolerable misstatement allocated to the inventory account. Likely misstatement < Tolerable misstatementThe auditor may accept the inventory account as fairly presented. Likely misstatement > Tolerable misstatementThe auditor may conclude the inventory is not fairly presented.

36. Questions

37. End of Chapter 13