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Inventories and Cost
of Goods Sold
Chapter 12
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
12-2
The Special Significance of
Audit of Inventories
The valuation of goods on hand and in process often
presents complex and difficult issues
Determining the quantities of inventories may require
specialized techniques
Inventories often represent the largest current asset
of a company
Misstatements of inventories directly affect cost of
goods sold and, therefore, net income
Management fraud has often involved the fraudulent
overstatement of inventories
12-3
Source of Inventories
Includes
Goods on hand ready for sale
Goods in the process of production
Goods to be consumed directly or indirectly in
production such as raw materials, purchased
parts and supplies
12-4
Objectives
1. Use the understanding of the client and its environment to consider inherent risks,
including fraud risks, related to inventories and cost of goods sold.
2. Obtain an understanding of internal control over inventories and cost of goods sold.
3. Assess the risks of material misstatement and design tests of controls and substantive
procedures that:
a. Substantiate the existence of inventories and the occurrence
of transactions affecting cost of goods sold.
b. Establish the completeness of recorded inventories.
c. Verify the cutoff of transactions affecting cost of goods sold.
d. Determine that the client has rights to the recorded inventories.
e. Establish the proper valuation of inventories and the accuracy of transactions
affecting cost of goods sold.
f. Determine that the presentation and disclosure of information about inventories
and cost of goods sold are appropriate, including disclosure of the classification
of inventories, accounting methods used, and inventories pledged as collateral
for debt.
12-5
McKesson & Robbins
Fraud Case Significant impact on responsibility of auditors
with respect to validity of inventories
Case: 1939 – the audited financial statements
contained $19 million of fictitious assets
including $10 million of nonexistent inventories Auditors followed customary auditing practice which limited audit
work on inventories to examining records only
Statements on Auditing Procedures 1 and 2 – first formal
auditing standards issued by AICPA affirmed the importance of
auditors’ observation of physical inventories although other
auditing procedures could be substituted
12-6
Inventory Methods
Periodic inventory system
Determine inventory quantities solely by an
annual physical count
Perpetual inventory records
Inventory updated constantly
Strong internal control over inventories
May use test counts throughout the year
12-7
Internal Control (1 of 3)
Control environment
Commitment to competence and human resource
policies and practices
• Appropriately qualified and trained personnel assigned to
inventory
Integrity and ethical values
• Company purchasing agents do not accept ―kickbacks‖
Organizational structure and assignment of authority
and responsibility
• Purchasing, receiving and production understand roles
12-8
Internal Control (2 of 3)
Risk assessment; risks related to • Availability of a supply of goods, services, and
skilled labor
• Stability of prices and labor rates
• Generation of sufficient cash flow to pay for
purchases
• Changes in technology that affect manufacturing
processes
• Obsolescence of inventory
12-9
Internal Control (3 of 3)
Monitoring
Observations by production supervisors of
performance of various activities and
functions
Quality and performance reviews
Formal program to consider improvements in
purchasing and production noted by internal
auditors
12-10
Functions related to inventories
Purchasing
Receiving
Storing
Issuing
Processing
Shipping
12-11
Purchasing Function
Internal control
Segregation of purchasing, receiving and recording
Cycle
Purchase requisition form completed by department
Purchasing prepares purchase order
• May obtain bids but need approval
• Item description and quantity
• Copy forwarded to accounting
• Copy forwarded to receiving should not include
quantity
12-12
Receiving and Storing
Receiving
Determines quantity of goods received
Detects damaged or defective merchandise
Prepares receiving report
Prompt transmittal of goods received to stores
department
Storing
Counts, inspects and receives goods
Notifies accounting of receipt
Physically secures inventory
12-13
Issuing and Production
Stores department issues goods to
requesting department
Prenumbered requisition
Production
Controlled with master production schedule
Production orders
Materials requisitions and move tickets
Job time tickets
12-14
Shipping
Shipment upon authorized sales order
approved by credit department
Generates a prenumbered shipping document
• One copy in shipping
• One copy to billing
• Third copy used as packing slip
• For goods shipped common carrier – fourth copy
services as bill of lading
12-15
Cost Accounting
Accounts for usage of raw materials
Determines content and value of
goods in progress
Compute finished inventory
12-16
Other functions
Perpetual inventory system
Provide information essential to purchasing,
sales and production-planning policies
Allows companies to control high costs of
holding excessive inventory
IT systems
Easier to control inventories
EDI to coordinate production and purchasing
12-17
Controls Over the
Conversion Cycle
Segregation of duties over purchases and custody of inventory
Use of pre-numbered requisitions, purchase orders, and receiving reports
Procedures for authorizing purchase transactions and verifying them for payment
General ledger control of inventories and reconciliation to production records
Cost accounting controls
Analysis of variances from standard costs
Use of perpetual records for inventories
Use of appropriate procedures for taking inventory
Appropriate physical controls over inventories
12-18
Relating Controls to Assertions
12-19
Audit Steps (1 of 3)
A. Use the understanding of the client and its environment to
consider inherent risks, including fraud risks, related to
inventories and cost of goods sold.
B. Obtain an understanding of internal control over inventories and
cost of goods sold.
C. Assess the risks of material misstatement and design further
audit procedures.
D. Perform further audit procedures—tests of controls.
1. Examples of tests of controls:
a. Examine significant aspects of a sample of purchase
transactions.
b. Perform tests of the cost accounting system.
2. If necessary, revise the risks of material misstatement based
on the results of tests of controls.
12-20
Audit Steps (2 of 3)
E. Perform further audit procedures—substantive
procedures for inventories and cost of goods sold.
1. Obtain listings of inventory and reconcile to ledgers.
2. Evaluate the client’s planning of physical inventory.
3. Observe the taking of physical inventory and make test
counts.
4. Review the year-end cutoff of purchases and sales
transactions.
12-21
Audit Steps (3 of 3)
E. Perform further audit procedures
5. Obtain a copy of the completed physical inventory, test its
clerical accuracy, and trace test counts.
6. Evaluate the bases and methods of inventory pricing.
7. Test the pricing of inventories.
8. Perform analytical procedures.
9. Determine whether any inventories have been pledged and
review purchase and sales commitments.
10. Evaluate financial statement presentation of inventories
and cost of goods sold, including the adequacy of disclosure.
12-22
Figure 12.1 Objectives of Major Substantive
Procedures for Inventories and Cost of Goods Sold
12-23
Risks of Material Misstatements
1. Inventories constitute a large asset and very
susceptible to major errors and fraud.
2. The accounting profession allows numerous alternative
methods for valuation of inventories, and different
methods may be used for various classes of
inventories.
3. The determination of inventory value directly affects the
cost of goods sold and has a major impact on net
income for the year.
4. The determination of inventory quality, condition, and
value is inherently a more complex and difficult task
than is the case with most other elements of financial
position.
12-24
12-25
Relating
Controls
to
Assertions
12-26
Considerations in
Planning a Physical Inventory
Selecting of the appropriate date
Suspending production
Segregating obsolete and defective
goods
Establishing control over the counting
process
Achieving proper cutoff of sales and
purchases
Arranging for the services of specialists
12-27
Documentation of
Physical Inventory Plan should be documented and
communicated in form of written
instructions to personnel taking physical
inventory
Letter from client reviewed by auditors
Auditors consider nature and materiality of
inventories
Date is typically at or near balance sheet date
unless internal control is effective
12-28
Inventory Observation
Client counts and supervises inventory
Auditors observe
Determine all items included
Employees comply with instructions
Be alert for inclusion of obsolete or damaged
merchandise
Record numbers of final receiving and shipping
documents issued before inventory taking
Make test counts
Tag control
12-29
When the Auditors are Engaged
after Year-End
Inventory verification when auditor unable to observe
taking of inventory at close of year.
May conclude that sufficient appropriate evidence
cannot be obtained to express an opinion
Or could obtain satisfaction with alternative auditing
procedures
• Existence of strong internal control
• Perpetual inventory records
• Documentation of well-planned and executed
physical inventory
• Making of test counts
12-30
Proper Cut-off of Inventory
Examine on a test basis the purchase
invoices and receiving reports for several
days before and after the inventory date.
Determine that liability has been recorded for
all goods in inventory
Make sure shipments and purchases
recorded in proper period
12-31
Inventory Pricing
Emphasize:
What method of pricing does the client use?
Is the method of pricing the same as that
used in prior years?
Has the method selected by the client been
applied consistently and accurately in
practice?
• Test the pricing of inventories
12-32
12-33
Presentation and Disclosure
Disclosure of inventory pricing methods or
methods in use
Other important disclosures: Changes in methods
Classifications of inventory
Details of pledged inventory
Deduction of valuation allowance for inventory losses
Existence and terms of inventory purchase
commitments.
12-34
Problems with First Year Clients
Procedures to obtain evidence that beginning
inventory is fairly stated
Review predecessor’s working papers
Discuss with person who supervised physical
inventory at beginning
Study written instructions in planning
Trace numerous items from inventory tags to final
summary sheets
Test perpetual inventory records for previous year
Test overall reasonableness of beginning inventory