Chapter 21 Audit of the Inventory and Warehousing Cycle
Review Questions
21-1 Inventory is often the most difficult and time consuming part of many audit engagements because:
1. 2. 3. 4. 5.
Inventory is generally a major item on the balance sheet and often the largest item making up the accounts included in working capital. The need for organizations to have the inventory in diverse locations makes the physical control and counting of the inventory difficult. Inventory takes many different forms that are difficult for the auditor to fully understand. The consistent application of different valuation methods can be fairly complicated. The valuation of inventory is difficult due to such factors as the large number of different items involved, the need to allocate the manufacturing costs to inventory, and obsolescence.
21-2 The acquisition and payment cycle includes the system for purchasing all goods and services, including raw materials and purchased parts for producing finished goods. Purchase requisitions are used to notify the purchasing department to place orders for inventory items. When inventory reaches a predetermined level or automatic reorder point, requisitions may be initiated by stockroom personnel or by computer. In other systems, orders may be placed for the materials required to produce a customer order, or orders may be initiated upon periodic evaluation of the situation in light of the prior experience of inventory activity. After receiving receiving the materials ordered, as part of the acquisition acquisition and payment cycle, the materials are inspected with a copy of the receiving document used to book perpetual inventory. In a standard cost inventory system, the acquisition and payment cycle computes any inventory purchase variances, which then enter the inventory system. The following audit procedures in the acquisition and payment cycle illustrate the relationship between that cycle and the inventory and warehousing cycle.
1.
2.
Compare the inventory cost entered into the inventory system to the supporting invoice to determine that it was properly recorded and the purchase variance (standard cost system), if any, was properly reflected. Test the purchase cutoff at the physical inventory date and yearend to determine whether or not the physical inventory and yearend inventory cutoffs are proper from a purchase standpoint.
21-1
21-3 Cost accounting records are those which are concerned with the processing and storage of raw materials, work in process, and finished goods, insofar as these activities constitute internal transfers within the inventory and warehousing cycle. These records include computerized files, ledgers, worksheets and reports which accumulate material, labor, and overhead costs by job or process as the costs are incurred. Cost accounting records are important in conducting an audit because they indicate the relative profitability of the various products for management planning and control, and determine the valuation of inventories for financial statement purposes. 21-4 The most important tests of the perpetual records the auditor must make before assessed control risk can be reduced, which may permit a reduction in other audit tests are:
1. 2.
3.
Tests of the purchases of raw materials and pricing thereof. Tests of the cost accounting documents and records by verifying the reduction of the raw material inventory for use in production and the increase in the quantity of finished goods inventory when goods have been manufactured. Tests of the reduction in the finished goods inventory through the sale of goods to customers.
Assuming the perpetuals are determined to be effective, effective, physical inventory tests may be reduced, as well as tests of inventory cutoff. In addition, an effective perpetual inventory will allow the company to test the physical inventory prior to the balance sheet date. 21-5 The continuation of shipping operations during the physical inventory will require the auditor to perform additional procedures to insure that a proper cutoff is achieved. The auditor must conclude that merchandise shipped is either included in the physical count or recorded as a sale, but not both. Since no second count is taken, the auditor must increase the number of test counts to determine that the counts recorded are accurate. 21-6 The auditor must not give the controller a copy of his or her test counts. The auditor's test counts are the only means of controlling the original counts recorded by the company. If the controller knows which items were test counted, he or she will be able to adjust other uncounted items without detection by the auditor. 21-7 The most important audit procedures to test for the ownership of inventory during the observation of the physical counts and as a part of subsequent valuation tests are:
1. 2. 3.
Discuss with the client. Obtain an understanding of the client's operations. Be alert for inventory set aside or specially marked.
21-2
21-7 (continued)
4. 5. 6.
Review contracts with suppliers and customers to test for the possibility of consigned inventory or inventory owned by others that is in the client's shop for repair or some other purpose. Examine vendor invoices indicating that merchandise on hand was sold to the company. Test recorded sales just before and just after the physical inventory to determine that the items were or were not on hand at the physical inventory date and that a proper cutoff was achieved.
21-8 Auditing procedures to determine whether slow-moving or obsolete items have been included in inventory are:
1. 2. 3. 4. 5. 6. 7.
8.
Obtain a sufficient understanding of the client's business to aid in recognizing inventory inventory that is no longer useful in the client's business. Review the perpetual records for slow-moving items. Discuss the quality of the inventory with management. Ask questions of production personnel during physical inventory observation about the extent of the use or nonuse of inventory items. Make observations during the physical inventory for rust, damaged inventory, inventory in unusual locations, and unusual amounts of dust on the inventory. Be aware of inventory that is tagged obsolete, spoiled, or damaged, or is set aside because it is obsolete or damaged. Examine obsolescence reports, scrap sales, and other records in subsequent periods that may indicate the existence of inventory that should have been excluded from the physical inventory or included at a reduced cost. Calculate inventory ratios, by type of inventory if possible, and compare them to previous years or industry standards.
21-9 The auditor could have uncovered the misstatement if there were adequate controls over the use of inventory tags. More specifically, the auditor should have assured himself or herself that the client had accounted for all used and unused tag numbers by examining all tags, if necessary. In addition, the auditor should have selected certain tags (especially larger items) and had the client show him or her where the goods were stored. The tag numbers used and unused should have been recorded in the auditor's working papers for subsequent follow-up. As part of substantive procedures, the auditor could have performed analytical tests on the inventory and cost of sales. A comparison of ratios such as gross margin percentage and inventory turnover could have indicated that a problem was present.
21-3
21-10 A proper proper cutoff of purchases purchases and sales is heavily dependent on the the physical physical inventory observation because a proper cutoff of sales requires that finished goods inventory included in the physical count be excluded from sales and all inventory received be included in purchases. To make sure the cutoff for sales is accurate, the following information should be obtained during the taking of the physical inventory:
1. 2. 3. 4.
The last shipping document number should be recorded in the working papers for subsequent follow-up to sales records. A review should be made of shipping to test for the possibility of shipments set aside for shipping and not counted or other potential cutoff problems. When prenumbered shipping documents are not used, a careful review of the client's method of getting a proper sales cutoff is the first step in testing the cutoff. A list of the most recent shipments should be included in the working papers for subsequent follow-up to sales records.
For the purchase cutoff, the following information should be noted: 1. 2.
The last receiving report number should be noted in the working papers for subsequent follow-up to purchase records. A review should be made of the receiving department to make sure all inventory has been properly included in the physical inventory.
21-11 Compilation tests are the tests of the summarization of physical counts, the extension of price times quantity, footing the inventory summary, and tracing the totals to the general ledger. Several examples of audit procedures to verify compilation are:
1.
2. 3. 4.
Trace the tag numbers used to the final inventory summary to make sure they were properly included and the numbers not used to the final inventory summary to make sure no tag numbers have been added. Trace the test counts recorded in the working papers to the final inventory summary to make sure they are correctly included. Trace inventory items on the final inventory list to the tags as a test of the existence of recorded inventory. Test the extensions and footings of the physical inventory summary.
21-4
21-12 TYPE OF POTENTIAL MISSTATEMENT
ANALYTICAL PROCEDURE
1. Compare gross margin percentage with previous years.
Overstatement or understatement of inventory amounts (prices and/or quantities).
2. Compare inventory turnover with previous years.
Obsolete inventory.
3. Compare unit costs with previous years.
Overstatement or understatement of unit costs.
4. Compare extended inventory value with previous years.
Errors in compilation, unit costs, or extensions.
5. Compare current year manufacturing costs with previous years.
Misstatement of unit costs of inventory, especially direct labor and manufacturing overhead.
21-13
DATE
11-26-09 12-06-09
PURCHASE QUANTITY
2,400 1,900
PRICE
TO BE INCLUDED IN 12-31-09 INVENTORY
$2.07 $2.28
700 @ $2.07 1,900 @ $2.28
EXTENSION
$1,449.00 4,332.00 $5,781.00
Assuming FIFO inventory valuation, valuation, the 12-31-09 inventory inventory should be valued at $5,781, and is thus currently overstated by $121. If the 1-26-10 purchase was for 2,300 binders at $2.12 each, the 12-3109 inventory should be valued at $5,477.00 (1,900 @ $2.12 + 700 @ $2.07) and is thus currently overstated by $425. The reason is the lower of cost or market rule, with the $2.12 being the replacement cost. 21-14 The direct labor hours for an individual inventory item would be verified by examining engineering specifications or similar information to determine whether the number of hours to complete a unit of finished goods was correctly computed. Ordinarily it is difficult to test the number of hours to an independent source. The manufacturing overhead rate is calculated by dividing the total annual number of labor hours into total manufacturing overhead. These two totals are verified as a part of the payroll and personnel and acquisition and payment cycles. Once these two numbers are verified (overhead rate per direct labor hour and the number of direct labor hours per unit of each type of inventory), it is not difficult to verify the overhead cost in inventory.
21-5
21-15 With a job cost system, labor charged to a specific job is accumulated on a job cost sheet. The direct labor dollars included on the job cost sheet can be traced to the employee "job time sheet" to make sure the hours are correctly included on the job cost sheet. The labor rate can be verified by comparing it to the amount on the employee's earnings record. 21-16 Assuming the auditor properly documents receiving report numbers as a part of the physical inventory observation procedures, the auditor should verify the proper cutoff of purchases as a part of subsequent tests by examining each invoice to see if a receiving report is attached. If the receiving report is dated on or before the inventory date and the last recorded number, the received inventory must have been included in the physical inventory; therefore the invoice should be included in accounts payable. Those invoices that are received after the balance sheet date but shipped F.O.B. shipping point on or before the close of the year would indicate merchandise in transit.
Multiple Choice Questions From CPA Examinations
21-17
a.
(4)
b.
(2)
c.
(1)
21-18
a.
(1)
b.
(2)
c.
(2)
21-19
a.
(4)
b.
(3)
c.
(2)
Discussion Questions and Problems
21-20 POTENTIAL FINANCIAL MISSTATEMENT
SUBSTANTIVE AUDIT PROCEDURE
PURPOSE OF INTERNAL CONTROL
TEST OF CONTROL
1. For a proper valuation of inventory. (Accuracy)
Examine receiving and requisition documents, trace to perpetual records.
Misstatement of inventory.
Compare physical count to perpetual inventory record.
2. To ensure inventory is recorded when received, payments made are for goods received, and quantities and descriptions are accurate. (Completeness, existence and accuracy)
Account for a numerical sequence of receiving reports and observe matching invoices received from vendors.
Understatement of inventory or payment for goods not received.
Trace quantity and description on vendor's invoice to receiving report.
21-6
21-20 (continued) POTENTIAL FINANCIAL MISSTATEMENT
SUBSTANTIVE AUDIT PROCEDURE
PURPOSE OF INTERNAL CONTROL
TEST OF CONTROL
3. To minimize theft or unrecorded shipments of inventory. (Existence)
Discuss with client and observe whether personnel prepare shipping documents.
Overstatement of inventory.
Compare physical count to perpetual records.
4. To ensure inventory shipments are recorded as sales. (Completeness)
Account for a numerical sequence of shipping orders.
Understatement of sales.
Trace quantity and description on bills of lading to recorded sales.
5. To make sure physical inventory counts are accurate. (Accuracy, existence and completeness)
Observe counting personnel and discuss with client.
Misstatement of inventory.
Compare physical count to perpetual inventory record.
6. To assure reasonable costs are used for inventory and cost of goods sold. (Accuracy)
Review procedures for determining standard costs.
Misstatement of inventory.
Trace costs from supporting documents to development of standards.
7. To make sure obsolete obsolete goods are classified as such. (Accuracy)
Read policy and discuss procedures with client.
Misstatement of inventory.
Analytical procedures for inventory.
8. To make sure inventory inventory compilation is accurate. (Accuracy)
Observe who compiles the inventory and discuss with client.
Misstatement of inventory.
Reperform clerical tests of inventory compilation.
21-7
21-21 a. TRANSACTIONRELATED AUDIT OBJECTIVE
b.
c.
RELATED RISK
TEST OF CONTROL
1. Recorded transactions represent valid, approved purchases (Occurrence).
If purchasing agents can make purchases from any vendor, there is a risk that purchasing agents may make unauthorized purchases of items not approved (for personal use).
Enter non-valid vendor numbers into the purchasing system to see if the related transaction is rejected.
2. Recorded inventory may not be recorded at appropriate amounts, due to obsolescence (Accuracy).
Without information about the amount of time inventory is in the warehouse, management is less likely to identify slow moving items that should be recorded at the lower of cost or market.
Select a sample of inventory items from the perpetual inventory system and recalculate the number of days each item has been present in the warehouse.
3. Actual shipments of inventory are recorded in the perpetual inventory records (Completeness).
Shipments of inventory may occur but not be recorded.
Select a sample of items in the warehouse and physically move them to the shipping areas to see if the microchip correctly removes those items from the perpetual inventory records.
4. Inventory recorded in the perpetual records physically exists (Occurrence).
Non-inventory warehouse individuals may remove inventory without authorization.
Observe client personnel in the inventory warehouse and determine if each person is authorized to be in the warehouse.
5. Inventory transactions are properly classified (Classification).
Equipment or supplies may be inaccurately classified as inventory if they are not physically separated from the inventory.
Observe whether equipment or supplies are stored in the same physical space as inventory.
21-8
21-21 (continued) a. TRANSACTIONRELATED AUDIT OBJECTIVE
b.
c.
RELATED RISK
TEST OF CONTROL
6. Recorded inventory items are physically present (Occurrence) and recorded at correct amounts (Accuracy).
If periodic reconciliations of inventory records to physical counts are not performed, there is a risk that items may be removed from the warehouse without knowledge, which would result in overstated inventory amounts.
Inspect the client’s test samples for accuracy and reasonableness. Inquire about the nature of discrepancies identified.
7. Actual inventory on hand may not be recorded in the perpetual inventory listing (Completeness).
There is a risk that inventory on hand is not included in the inventory records.
Inspect the client’s test samples for accuracy and reasonableness. Inquire about the nature of discrepancies identified.
8. The perpetual inventory records are accurately summarized and posted to the general ledger accounts (Posting and Summarization)
There could be errors in the mathematical formulas of the inventory records.
Recalculate the inventory amounts and determine that the totals agree to the general ledger balances.
9. Recording inventory transactions represent actual receipts of inventory items (Occurrence).
Inventory could be added to the inventory account balance before actual goods are received.
Enter an addition to the perpetual inventory system without a valid receiving report number to determine if the system rejects the transaction.
Inventory held on consignment may be recorded as the client’s inventory.
Observe whether inventory held on consignment is stored in the same physical space as inventory.
10. Recording of inventory in the client’s records is valid (Occurrence)
21-9
21-22
a.
It is important to review the cost accounting records and test their accuracy for the following reasons: 1. 2.
3.
b.
1.
2. 3.
4. 5. 6.
The cost accounting records determine unit costs that are applied to derive inventory values. Since inventory is usually material, unit costs must be verified. In many companies, there are many types of inventory items with complex cost structures. The potential for misstatement is great in determining costs. The auditor would need to go to an extreme effort to verify such costs without being able to rely on the cost accounting records which provides the costs, (i.e., it is far more efficient to test the cost accounting records than the costs themselves). The cost accounting records also deal with transferring transferri ng inventories through the production cycle and then from finished goods for sales. These transfers must be handled accurately for inventory to be properly stated. Examine engineering specifications for expected (standard) labor hours. Examine time records for hours worked on part during measured period. Divide by units produced to test reasonableness of standard. Review specifications for types of labor required to produce parts, or observe production. Review union contracts or earnings records to develop reasonable rate for this labor mix. Identify appropriate overhead accounts, paying careful attention to consistent application. Determine amounts for these accounts for a measured period. Determine direct labor hours from payroll records from the same period. Compute the overhead rate per direct labor hour. Review engineering specifications. Review material usage variance. Trace to vendor's invoices. Review material price variance. Sum individual components.
21-10
21-23 AUDIT PROCEDURE
TYPE OF TEST
1
Test of Control
To make sure that proper controls exist and are being followed in the taking of the physical inventory. (Existence, completeness, accuracy and classification)
2
Substantive Test
To ensure that all inventory represented by an inventory tag actually exists. (Existence)
3
Substantive Test
To test the accuracy of the client's perpetual inventory records. (Existence, completeness, and accuracy)
4
Substantive Test
To test client's final inventory compilation. (Existence, completeness, accuracy and classification)
5
Substantive Test
To test that the final inventory was valued at its proper cost. (Accuracy)
6
Test of Control
To ensure that no raw material was issued without proper approval. (Existence)
7
Test of Control or Substantive Test
To ensure that additions recorded on the finished goods perpetual records were recorded on the books as completed production. (Accuracy and classification)
21-11
PURPOSE
21-24
MISSTATEMENT
a. CONTROL THAT SHOULD HAVE PREVENTED THE MISSTATEMENT FROM OCCURRING
b. SUBSTANTIVE AUDIT PROCEDURE THAT COULD BE USED TO UNCOVER THE MISSTATEMENT
1
Internal verification by another person.
Examine vendors' invoices in support of prices used.
2
Keep a record of the last shipping report number shipped before the inventory count.
Examine bills of lading for first shipments recorded after the physical inventory to determine that they were shipped after year-end.
3
Perform independent second counts on all merchandise. All persons responsible for inventory tags and compilation of physical inventory should be independent of custody of perpetual inventory records.
Record test counts and trace to compiled inventory.
4
Use of prenumbered tags and accounting for numerical sequence.
Account for all prenumbered tags during the physical examination and during compilation tests.
5
Internal verification of perpetual inventory prices.
Compare vendor invoice prices to perpetual inventory prices.
6
Segregation of obsolete inventory.
Perform net realizable value and lower of cost or market tests of inventory, including tests of the perpetual inventory.
7
Periodic review of reasonableness of manufacturing overhead rate.
Test reasonableness of manufacturing overhead rate.
21-12
21-25
a. Internal Controls
Tests of Controls
1.
Inventory purchases are used to update the perpetual Atlanta inventory records.
Trace inventory quantities for a sample of purchase transactions to the perpetual inventory records as a part of tests of controls and substantive tests of acquisition transactions.
2.
Transfers of inventory are used to update the Atlanta and local distribution center perpetual inventory records.
Trace inventory quantities for a sample of shipments from Atlanta to local distribution centers to the perpetual inventory records.
3.
Inventory sales are used to update the local distribution center perpetual inventory records.
Trace inventory quantities for a sample of sales transactions to the perpetual inventory records as a part of tests of controls and substantive tests of sales transactions.
4.
Local distribution centers access to perpetual records is restricted to processing sales transactions.
Test the effectiveness of the perpetual records access restrictions using the CPA firm’s computer audit specialists.
5.
Quarterly physical inventory is taken for comparison to and adjustment of perpetual records.
Examine local distribution center physical inventory count records and adjustments to the perpetual records.
6.
Internal auditors test the perpetual records continuously.
Examine internal auditor audit programs and working papers for their tests of the perpetual records and the findings.
7.
Internal auditors sample inventory counts and test inventory adjustments.
Examine internal auditor audit programs and working papers for their tests of the physical observation of inventory and the findings.
b.
There are four ways to reduce physical observation of inventory. Audito Auditors rs will will use their their judgme judgment nt to decid decide e which which combina combinatio tion n of these these to use. 1. 2. 3. 4.
Reduce the number of local warehouses to observe inventory counting and do test counts of inventory. Reduce the number of auditors who observe the inventory counting at each location. Reduce the sample sizes for test counts inventory. Perform the physical observation of inventory at an interim date.
21-13
21-26
a.
When the inventory is a material item in the financial statements that the CPA is auditing, his or her observation of the taking of the physical inventory is in compliance with the auditing standard pertaining to field work that requires obtaining sufficient appropriate evidence to afford a reasonable basis for an opinion regarding the financial statements. Observation is a generally accepted auditing procedure applied in the audit of the physical inventory. By observing the taking of the physical inventory, the CPA is seeking to satisfy himself or herself as to the effectiveness and application of the methods of inventory taking and as to the measure of reliance which may be placed upon the client's inventory records and its representations as to inventory quantities. He or she must ascertain that the physical inventory actually exists, that the inventory quantities are being determined by reasonably accurate methods, that the inventory is in a salable or usable condition, and that consigned goods are not commingled with owned goods.
b.
The CPA makes test counts of inventory quantities during observation of the taking of the physical inventory to satisfy himself or herself that an accurate count is being made by the individuals taking the inventory. The extent of test counting will be determined by the inventory taking procedures; for example, the number of test counts would be reduced if there were two teams, one checking the other, taking the inventory. On the other hand, the test counts would be expanded if misstatements were found in the inventory counts. Some test counts are recorded by the CPA for the purpose of subsequent comparison with the client's compilation of the inventory. The comparison procedure goes beyond the mere determination that quantities have been accurately transcribed. The CPA also seeks assurance that the description and condition of the inventory items is accurate for pricing purposes and that the quantity information, such as dozen, gross, cartons, etc., is proper. Anothe Anotherr reason reason for for recor recordin ding g test test counts counts in in the work working ing pape papers rs is to provide evidence of the extent of tests in the event that audit procedures are questioned at some future date.
c.
1.
The CPA does not regard the inventory certificate as a satisfactory substitute for his or her own audit of the inventory. The service company has merely assumed the client's function of taking the physical inventory, pricing it, and making the necessary extensions. To the extent that the service company is competent, the system of internal control with regard to the inventory has been strengthened. Nevertheless, as the CPA would under other strong systems of internal control, he or she would investigate the system to determine that it is operating in a satisfactory manner. The CPA's investigation would necessarily entail an observation of the taking of the inventory and testing the pricing and calculation of the inventory. 21-14
21-26 (continued)
21-27
2.
The inventory certificate of the outside specialists would have no effect upon the CPA's report. The auditor must be satisfied that the inventory was fairly stated by observing the taking of the inventory and testing the pricing and compilation of the inventory. On the other hand, if the taking of the inventory was not observed and no audit tests were applied to the computation of the inventory, the CPA would be compelled to disclaim an opinion on the financial statements as a whole if the amount of the inventory is material. If it is impractical or impossible for the CPA to observe the taking of the physical inventory, but he or she is able to determine that inventory is fairly stated by the application of other auditing procedures, the CPA would be able to issue an unqualified opinion.
3.
The CPA would make no reference to the certificate of the outside specialists in his report. The outside specialists are serving as adjuncts of the company's staff of permanent employees. The outside specialists are not independent.
a.
The auditor in this situation should observe the recording of the shipments on the day of occurrence and record these details in the working papers so a determination can be made as to whether the shipments affected the physical inventory count.
b.
1.
2. c.
There is no clear-cut answer to sample size for inventory counts. The answer to the question depends on additional factors, such as the randomness of your test counts and whether the values of the merchandise are relatively stratified. It also depends on inherent risk for inventory physical counts and the materiality of inventory compared to total assets. Request a recount by the client or greatly expand your tests to determine whether a material misstatement exists.
The auditor should determine how this inventory is valued and after discussion with the client it may be well to classify it as obsolete. In all cases, the auditor must specifically identify the merchandise in the working papers for subsequent evaluation. The auditor should also be aware that this could be an indication of widespread obsolescence problems in other parts of the inventory.
21-15
21-27 (continued)
d.
One of the important tasks the auditor undertakes during the observation is to determine that inventory tags are physically controlled. This assures that the inventory is not understated because tags are lost, or overstated because falsified tags are added. In this situation, the auditor should recover the discarded tags and request that the practice be stopped, and that control of tags be established under the auditor’s direct observation.
21-28 The following following procedures procedures should should be established to insure that the inventory count includes all items that should be included and that nothing is counted twice:
1.
All materials should be cleared from the receiving area and stored in the appropriate space before the count.
2.
Incoming shipments of unassembled parts and supplies should be held in the receiving area until the end of the day and then inventoried.
3.
If possible, the day's shipments of finished appliances should be taken to the shipping area before the count. (Unshipped items remaining in the shipping area should be inventoried at the end of the day.)
4.
Great care must be be exercised exercised over goods removed from the warehouse itself. These may be unassembled parts and supplies requisitioned on an emergency basis or unscheduled shipments of finished appliances. Alternative methods for recording these removals are: a) b) c)
Keep a list of all items removed and indicate on the list whether the item had been counted. Record the removal on the inventory tag if the item has been inventoried. Indicate on the material requisition or the shipping order that the item had been inventoried. For any of these alternatives, a warehouse employee or the perpetual inventory clerk must adjust the recorded counts.
5.
The finished appliances remaining in the warehouse should be inventoried at the end of the day.
6.
The warehouse should be instructed to date all documents as of the day the materials are received, issued, or shipped.
21-16
21-28 (continued)
7.
The inventory clerk should post the May 31 production and shipment of finished goods to the inventory record based upon the dates shown on the plant production report and the shipping report. This will provide a proper cutoff because provisions have been made to adjust all counts for goods manufactured and shipped on May 31.
8.
The listing of inventory differences should be reviewed by the controller and warehouse supervisor prior to booking the adjustment. Abnormal differences should be investigated, and recounts (with appropriate reconciliation) should be made where appropriate.
a.
Ratios are calculated as follows
21-29
Gross margin % Inventory turnover b.
c. d. e.
52% 5.6
52% 5.9
51% 5.9
This ratio should be compared against industry averages. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations. This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. Inquiry with management, review supporting documentation There are no wide swings in the ratios, and the ratios are close to industry average. Assuming there is no other reason to expect changes (major changes within the company structure, major changes to the economy), the analytical procedures seem reasonable and most likely do no warrant changes to the overall audit plan.
21-17
21-30
a.
b.
1. 2. 3. 4. 5.
Exclude Exclude Include Include Exclude
1.
This merchandise would be excluded because title does not pass to buyer on an F.O.B. destination shipment until delivery to the buyer. Since it was not received until January 2010, there is no basis for including it in inventory. Goods held "on consignment" do not belong to the consignee, and should not be included in inventory. Normally title to a stock item does not pass to the customer until shipment, even though it has been set aside. Therefore it should be included in inventory. Title to goods shipped F.O.B. shipping point normally passes to the buyer on delivery to the transportation agency, and in this instance the goods belong to your client at December 31, 2009. There is an error in recording the acquisition. Since this machine is fabricated to the customer's order, title to customer made-merchandise passes to the buyer as materials and labor are appropriated to the job. When the job is completed and ready for shipment as in this case, it may be considered as a completed sale.
2. 3. 4.
5.
21-18
21-31
a.
Inventory observation locations are unannounced so that the client does not have the opportunity to move inventory around in order to present a more favorable situation, if they were inclined to do so.
b.
Sheet to Floor tests for existence, floor to sheet tests for completeness. Existence tests that items recorded on the F/S physically exist on the floor; completeness tests that all items on the floor are recorded on the F/S. Generally existence is the more relevant assertion for assets such as inventory, but there are always exceptions to the rule.
c.
Exceptions noted: a)
d.
e.
Client count differs from client records. Will be adjusted by client b) Auditor count differs materially from client count. Auditor will will request client recount. recount. c) Auditor count differs not materially from client count. No recount or adjustment needed. Task 2 is satisfied appropriately. Although subjective, if there are 10 counters, I would speak to at least 3 counters if not more. The exceptions found in Task 3 could result in incorrect counts as the purpose of having two people count the same section is to verify – if they count at the same time this feature is lost. Also, if the counters don’t remove the objects from the shelves, they may miscount the items in the back – sometimes the shelf is not full or there are obstructions in the back which mean there will be gaps in the stacks. It is more important that the count is performed in accordance with instructions rather than the physical count is absolutely correct because you can’t check all of the results, but you can check the process. If the process is not correct you are much more likely to have errors in the results. If the process is sound, you are more likely to have more accurate results. To follow up, you would speak to the Count Manager to ensure that the count procedures are being followed properly. Once this has occurred, you would continue to observe count procedures to be sure that the procedures are being followed correctly.
21-19
21-32
a.
Inventory per Schedule to Inventory Observed During Audit. Existence testing tells you that all items listed in inventory, per the books, actually exist on the lot. The risk is that inventory will be overstated with inventory that does not actually exist. This is way for companies to improve their balance sheets fraudulently.
b.
Inventory Observed During Audit to Inventory per Schedule. Completeness testing tells you that all items seen on the lot are recorded in the financial statements. The risk is that inventory will be understated as inventory may be left off the financial statements. This is generally considered a lower risk than existence, which is the same for all other assets.
c.
See chart below:
Item number
Item Description
Tag No.
Item appears on lot?
1001-08 1002-08 1003-08 1004-08 1005-08 1006-08
Earth mover, 1988, yellow Front loader, 2002, green Backhoe, 2000, yellow Earth mover, 2004, green Dump Truck, 2000, yellow Steam Roller, 1997, yellow
AU05 AU06 AU03 AU02 AU04 AU01
Yes Yes Yes Yes Yes Yes
d.
Auditor notes that no items with tag AU07 are found in records. Auditor notes notes that all items appear appear to exist exist and list list appears appears complete. Auditor would follow up on possible obsolescence of old inventory. No material changes noted, no changes to the audit plan deemed necessary.
21-20
Case
■
21-33
a.
Assertion is accuracy. Audit purpose is to check that inventory is properly valued. Risk is overstatement of asset.
b.
All items appear to be valued properly except for the bumpers. It appears that the last price ($210) was applied to the entire 1,000 bumpers instead of applying 500 @ $200 and 500 @ $210 as per the FIFO method. qty per invoice
$ per invoice
qty FIFO
need
$ FIFO
Struts 3,000
$ 35.00
2,000
$ 40.00
Tires
4,000
$ 25.00
fastners
4,000
$
2.00
4,000
$
4,000 4,000
3,000
$ 35.00
1,000
$ 40.00
4,000
4,000
$ 25.00
10,000
4,000
$
2.00
2.10
4,000
$
2.10
$
2.50
2,000
$
2.50
$
2.60
-
$
2.60
500
$ 200.00
500
$ 210.00
bumpers 500
$ 200.00
500
$ 210.00
c.
4,000
1,000
ext
$ 105,000 $ 40,000 $ 100,000 $ 8,000 $ 8,400 $ 5,000 $ $ 100,000 $ 105,000
The variance for the error found is $5,000, since this amount is below tolerable misstatement, no changes to the audit plan are deemed necessary. Had the variance been material, the auditor would have to re-evaluate the audit plan, possibly perform alternative procedures, expand the scope of testing, or request that the client to reconcile and adjust the inventory pricing.
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Internet Problem Solution: Using Inventory Count Specialists
21-1 Since 1938 when auditors failed to uncover fictitious inventory recorded by the McKesson & Robbins Company, auditors have been ordinarily required to physically observe the counting of inventory. It is important to recognize that auditors are not required to actually count the inventory for inclusion on the balance sheet, but they are required to observe the inventory being counted. Occasionally, companies employ inventory specialists to perform their inventory counts. One very large inventory counting specialist is Retail Grocery Inventory Service, now known as RGIS. Visit RGIS’s [www.rgisinv.com] Web site and answer the following questions.
1.
Does an auditor’s responsibility for observing the physical inventory differ if a company hires an inventory specialist such as RGIS to perform counts as opposed to having its own employees perform inventory counts? (Hint: Read AU Section 331.) Answer: No, the auditor’s responsibility is unchanged by who does the counting of the client’s inventory. The auditor must be present during the physical counting of the inventory.
2.
Would your expectations of the physical observation of a client’s inventory change if a client hired a company such as RGIS? Answer: Student responses will likely vary based upon their experience with companies such as RGIS and whether they have participated in a physical inventory. This question is meant to encourage students to consider whether the hiring of an outside company such as RGIS affects how the auditor executes his/her responsibilities during a physical inventory. Most students have very likely never considered who actually counts a company’s inventory let alone the significance of hiring another company to do the work. For example, the instructor might ask the students to explain the difference between hiring temporary employees to help with the counting of inventory and hiring a company such as RGIS to count the inventory.
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Internet Problem 21-1 (continued)
3.
What are the advantages and disadvantages of hiring an inventory specialist such as RGIS? Answer: Student responses will vary. However, advantages and disadvantages include the following: Advantages: Experienced inventory specialists; No or very limited management time required to train employees on inventory procedures; Ability to continue business while the counting proceeds; Company employees are free to continue with their daily tasks, etc. Disadvantages : Company may lose control over the counting process; Management may experience a disconnect from the inventory counting process which might lead to a loss of information; Inventory specialists may not be familiar with inventory if the company is in a unique industry; etc.
(Note : Internet problems address current issues using Internet sources. Because Internet sites are subject to change, Internet problems and solutions may change. Current information on Internet problems is available at www.pearsonglobaleditions.com/arens.)
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