Auditing the Inventory Auditing the Inventory Management ProcessManagement Process

Overview of the Inventory Overview of the Inventory Management ProcessManagement Process

Purchasingprocess

Inventorymanagement

process

Revenueprocess

• Purchase ofraw materials

• Payment ofmanufacturing

overhead

Human resourcemanagement

process

• Assignment ofdirect and indirect

labor costs

• Sale ofgoods

Types of Documents and Types of Documents and RecordsRecords

1.1. Production Schedule Production Schedule 2.2. Receiving Report Receiving Report 3.3. Materials Requisition Materials Requisition 4.4. Inventory Master File Inventory Master File 5.5. Production Data InformationProduction Data Information6.6. Cost Accumulation and Variance ReportCost Accumulation and Variance Report7.7. Inventory Status ReportInventory Status Report8.8. Shipping OrderShipping Order

Production

Schedule

Inventory Master

File

Shipping Order

The Major FunctionsThe Major Functions

Inventory managementAuthorization of production activity and maintenance of inventory at appropriate levels; issuance of purchase requisitions to the purchasing department.

Raw materials stores Custody of raw materials and issuance of raw materials to manufacturing departments.

Manufacturing Production of goods.

Finished goods stores Custody of finished goods and issuance of goods to the shipping department.

Cost accounting Maintenance of the costs of manufacturing and inventory in cost records.

General ledger Proper accumulation, classification, and summarization of inventory and related costs in the general ledger.

Functions in the Inventory Management Process

Key Segregation of DutiesKey Segregation of DutiesSegregation of Duties Possible Errors or Fraud

The inventory management function should be segregated from the cost-accounting function.

If the individual responsible for inventory management also has access to the cost-accounting records, production and inventory costs can be manipulated. This may lead to an over- or understatement of inventory and net income.

The inventory stores function should be segregated from the cost-accounting function.

If one individual is responsible for both controlling and accounting for inventory, unauthorized shipments can be made or theft of goods can be covered up.

The cost-accounting function should be segregated from the general ledger function.

If one individual is responsible for the inventory records and also for the general ledger, it is possible for that individual to conceal unauthorized shipments. This can result in the theft of goods, leading to an overstatement of inventory.

The responsibility for supervising physical inventory should be separated from the inventory management and inventory stores functions.

If the individual responsible for production management or inventory stores functions is also responsible for the physical inventory, it is possible that inventory records to the physical inventory, resulting in an overstatement of inventory.

Inherent Risk AssessmentInherent Risk AssessmentThe auditor should consider industry-related factors

and operating and engagement characteristics when assessing the possibility of a material

misstatement.If industry competition is intense,If industry competition is intense,there may be problems with the there may be problems with the proper valuation of inventory.proper valuation of inventory.Technology changes in certainTechnology changes in certainindustries may also promoteindustries may also promotematerial misstatement due tomaterial misstatement due toobsolescence.obsolescence.

Products that are small and ofProducts that are small and ofhigh value are more susceptiblehigh value are more susceptibleto theft. The auditor must beto theft. The auditor must bealert to related-party transactionsalert to related-party transactionsfor acquiring raw materials andfor acquiring raw materials andselling finished products. Prior-yearselling finished products. Prior-yearmisstatements are good indicatorsmisstatements are good indicatorsof potential misstatements in theof potential misstatements in thecurrent year.current year.

Control Risk AssessmentControl Risk AssessmentMajor steps in setting the control risk in the Major steps in setting the control risk in the

inventory management process.inventory management process.Understand and document the inventory Understand and document the inventory

management process based on a reliance strategy.management process based on a reliance strategy.

Set and document the control risk for the inventory Set and document the control risk for the inventory management process.management process.

Plan and perform tests of controls on inventory Plan and perform tests of controls on inventory transactions.transactions.

Control Activities and Tests of Controls – Control Activities and Tests of Controls – Inventory TransactionsInventory Transactions

Assertion Test of Controls

Occurrence

Observe and evaluate proper segregation of duties. Review and test procedures for transfer of inventory. Review and test procedures for issuing materials to manufacturing departments. Review and test client procedures for account for numerical sequence of materials requisitions.

Completeness Observe the physical safeguards over inventory. Review and test client's procedures for consignment goods.

Authorization Review authorized production schedules. Review and test procedures for developing inventory levels and procedures used to control them.

Accuracy

Review and test procedures for taking physical inventory. Review and test procedures used to develop standard costs. Review and test cost accumulation and variance reports. Review and test procedures for identifying obsolete, slow-moving, and excess quantities. Review the reconciliation of perpetual inventory to general ledger control account.

CutoffReview and test procedures for processing inventory included on receiving reports into the perpetual records. Review and test procedures for removing inventory from perpetual records based on shipments of goods.

Classification Review the procedures and forms used to classify inventory.

Relating the Assessed Level of Relating the Assessed Level of Control Risk to Substantive Control Risk to Substantive ProceduresProcedures

Assertions about Classes of Transactions and Events

Assertions about Account Balances at the Period End

Assertions about Presentation and Disclosure

Auditing InventoryAuditing Inventory

Substantive Analytical ProceduresSubstantive Analytical ProceduresSubstantive Analytical Procedure Possible Misstatement DetectedCompare raw material, finished goods, and total inventory turnover to previous years' and industry averages.

Obsolete, slow-moving, or excess inventory

Compare days outstanding in inventory to previous years' and industry average.

Obsolete, slow-moving, or excess inventory

Compare gross profit percentage by product line with previous years' and industry data. Unrecorded or fictitious inventory

Compare actual cost of goods sold to budgeted amounts. Over- or understated inventoryCompare current-year standard costs with prior years' after considering current conditions. Over- or understated inventory

Compare actual manufacturing overhead costs with budgeted or standard overhead costs. Inclusion or exclusion of overhead costs

Auditing InventoryAuditing InventoryAuditing Standard CostsAuditing Standard Costs

MaterialMaterialTest the quantity and Test the quantity and

type of materials type of materials included in the product included in the product

and the price of the and the price of the materials.materials.

LaborLaborGather evidence about Gather evidence about the type and amount of the type and amount of

labor needed for labor needed for production and the labor production and the labor

rate.rate.

OverheadOverheadReview the client’s method of Review the client’s method of

overhead allocation for overhead allocation for reasonableness, compliance reasonableness, compliance with GAAP, and consistency.with GAAP, and consistency.

Auditing InventoryAuditing InventoryObserving Physical InventoryObserving Physical Inventory

During the observation of the physical inventory count, the auditor should do the following:1. Ensure that no production is scheduled.

2. Ensure that there is no movement of goods during the count.

3. Make sure that the client’s count teams are following instructions.

4. Ensure that inventory tags are issued sequentially to individual departments.

5. Perform test counts.

6. Obtain tag control information.

7. Obtain cutoff information.

8. Observe the condition of the inventory – excess, obsolete, slow moving.

9. Inquire about goods held on consignment.

Tests of Details of Transactions, Tests of Details of Transactions, Account Balances, and DisclosuresAccount Balances, and Disclosures

OccurrenceCompletenessAuthorizationAccuracyCutoffClassification

Substantive Tests of Transactions Existence

Rights and obligationsCompleteness Valuation and allocation

Test of Details of Account Balances

Accuracy and Valuation

Test of Details of Disclosures

Occurrence, Rights and ObligationsCompletenessClassification and Understandability

Tests of Details of Transactions, Tests of Details of Transactions, Account Balances, and DisclosuresAccount Balances, and Disclosures

Examples of Disclosure Items:Examples of Disclosure Items:1.1. Cost method (FIFO, LIFO, retail method).Cost method (FIFO, LIFO, retail method).2.2. Components of inventory.Components of inventory.3.3. Long-term purchase contracts.Long-term purchase contracts.4.4. Consigned inventory.Consigned inventory.5.5. Purchases from related parties.Purchases from related parties.6.6. LIFO liquidations.LIFO liquidations.7.7. Pledged or assigned inventory.Pledged or assigned inventory.8.8. Disclosure of unusual losses from write-downs Disclosure of unusual losses from write-downs

or losses on long-term purchase commitments.or losses on long-term purchase commitments.9.9. Warranty obligations.Warranty obligations.

Evaluating the Audit Findings - Evaluating the Audit Findings - InventoryInventory

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 Likely misstatement < < Tolerable misstatementTolerable misstatementThe auditor may accept the inventory account as The auditor may accept the inventory account as fairly fairly presentedpresented..

Likely misstatement Likely misstatement >> Tolerable misstatement Tolerable misstatementThe auditor must conclude the inventory is The auditor must conclude the inventory is not fairly not fairly

presentedpresented..