acct 320 chap 12

5. Obtain an understanding of internal control over inventories and COGS.

- filling out a questionnaire - writing of descriptive memoranda - flowcharts - physical protection of inventory

4. Use the understanding of the client and its environment to consider inherent risks (including fraud risks) related to inventories, purchases, and COGS.

1. large current asset and very susceptible to major errors and fraud 2. numerous alternative methods for valuation of inventories 3. determination of inventory value directly affects the cost of goods sold and has major impact on net income for the year (motivation to overstate inventory) 4. determination of quality, condition and value is inherently more complex and difficult task

6. Assess the RMM of inventories & COGS and design further audit procedures, including tests of controls and substantive procedures, to address the risks

1. misstatement of inventory costs - Fraud * intentional misstatement of the production costs assigned to inventory * intentional misstatement of inventory prices - Weakness: ineffective board of directions, audit committee or internal audit function - Errors * assignment of direct labor costs, DM or OH to inventory items is inaccurate * erroneous pricing of inventory - Weakness: *ineffective cost accounting system, failure to update stand costs on a timely basis *Ineffective input validation controls on database of inventory costs/ ineffective supervision 2. misstatement of inventory quantities - Fraud * items are stolen with no journal entry reflecting the theft * inventory quantities in locations not visited by auditors are systematically overstated - Weakness * ineffective physical controls over inventories * ineffective board of directions, audit committee or internal audit function - Error * miscounting of inventory by personnel involved in physical inventory -Weakness * ineffective controls or supervision of physical inventory 3. early (late) recognition of purchases ( cutoff problems) - Fraud: intentional recording of purchases in the subsequent period -Weakness: ineffective board of directions, audit committee or internal audit function - Error: recording purchases of the current period in subsequent period -Weakness: ineffective accounting procedures that do not tie recorded purchases to receiving data

relationship of the inventory management process to other accounting processes

1. purchasing process leads to inventory management process leads to revenue process

Examples of Disclosure Items:

1.Cost method (FIFO, LIFO, retail method). 2.Components of inventory. 3.Long-term purchase contracts. 4.Consigned inventory. 5.Purchases from related parties. 6.LIFO liquidations. 7.Pledged or assigned inventory. 8.Disclosure of unusual losses from write-downs or losses on long-term purchase commitments. 9.Warranty obligations.

Observing Physical Inventory During the observation of the physical inventory count, the auditor should do the following:

1.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. 2.Ensure that there is no movement of goods during the inventory count. 3.Make sure that the entity's count teams are following the inventory count instructions. 4.Ensure that inventory tags are issued sequentially to individual departments. 5.Perform test counts and record a sample of counts in the working papers. 6.Obtain tag control information for testing the entity's inventory compilation. 7.Obtain cutoff information, including the number of the last shipping and receiving documents issued. 8.Observe the condition of the inventory for items that may be obsolete, slow moving, or carried in excess quantities. 9.Inquire about goods held on consignment for others or held on a "bill-and-hold" basis.

Possible causes of book-to-physical differences:

1.Inventory cutoff errors. 2.Unreported scrap or spoilage. 3.Pilferage or theft.

evaluating the audit findings- inventory

At the conclusion of testing, the auditor should aggregate all identified misstatements. The total amount of the misstatement is compared to performance materiality allocated to the inventory account Total amount of misstatements < Performance Materiality The auditor may accept the inventory account as fairly presented Total amount of misstatements > Performance Materiality The auditor must conclude the inventory is not fairly presented

Occurrence of Inventory Transactions

Auditor's main concern is determining whether all recorded inventory transactions actually occurred. 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.

McPherson Corporation does not make an annual physical count of year-end inventories, but instead makes weekly test counts on the basis of a statistical plan. During the year, Sara Mullins, CPA, observes such counts as she deems necessary and is able to satisfy herself as to the reliability of the client's procedures. In reporting on the results of her examination, Mullins:

Can issue an unqualified opinion without disclosing that she did not observe year-end inventories.

Substantive Analytical Procedures:

Compare raw material, finished goods, and total inventory turnover to previous years' and industry averages. Compare days outstanding in inventory to previous years' and industry average. Compare gross profit percentage by product line with previous years' and industry data. Compare actual cost of goods sold to budgeted amounts. Compare current-year standard costs with prior years' after considering current conditions. Compare actual manufacturing overhead costs with budgeted or standard overhead costs.

4. Inventory Master File -

Contains all the important information related to the entity's inventory, including the perpetual inventory records.

5. Move ticket-

Contains information about the transfer of goods at each stage of production.

The organization established by Congress to narrow the options in cost accounting that are available under generally accepted accounting principles is the:

Cost Accounting Standards Board.

When a primary risk related to an audit is possible overstated inventory, the assertion most directly related is:

Existence.

Assertions about Account Balances at the Period End:

Existence. Inventory recorded on the books and records actually exists. Rights and obligations. The entity has the legal right to the recorded inventory. Completeness. All inventory related accounts that should have been recorded have been recorded, and all related disclosures that should have been included in the financial statements have been included. Accuracy, valuation, and allocation. Inventory accounts are included in the financial statements at appropriate amounts, any resulting valuation or allocation adjustments are appropriately recorded, and related disclosures have been appropriately measured and described. Classification. All inventory is recorded in the proper accounts. Presentation. Inventory accounts are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.

Which of the following is the best audit procedure for the discovery of damaged merchandise in a client's ending inventory? Compare the physical quantities of slow-moving items with corresponding quantities in the prior year. Observe merchandise and raw materials during the client's physical inventory taking. Review the management's inventory representations letter for accuracy. Test overall fairness of inventory values by comparing the company's turnover ratio with the industry average.

Observe merchandise and raw materials during the client's physical inventory taking.

Control Activities and Tests of Controls - Inventory Transactions

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 entity procedures for account for numerical sequence of materials requisitions. Observe the physical safeguards over inventory. Completeness Review and test entity'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. Cutoff Review 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. Presentation Review inventory reports, general ledger and chart of accounts for proper aggregation or disaggregation. Review procedures and forms used to develop inventory disclosures; if IT application, testing of application controls for proper codes. Review disclosure checklist and related disclosures for relevance and completeness.

Tests of Details of Disclosures

Occurrence and rights and obligations. Inquire of management and review any loan agreements and board of directors' minutes for any indication that inventory has been pledged or assigned. Inquire of management about issues related to warranty obligations. Completeness. Complete financial reporting checklist to ensure that all financial statement disclosures related to inventory are made. Classification and understandability. Review inventory compilation for proper classification among raw materials, work in process, and finished goods. Read footnotes to ensure that required disclosures are understandable. Accuracy and valuation.Determine if the cost method is accurately disclosed. Inquire of management about issues related to LIFO liquidations. Read footnotes and other information to ensure that the information is accurate and properly presented at the appropriate amounts.

Assertions about Classes of Transactions and Events:

Occurrence. All inventory transactions and events that have been recorded or disclosed have occurred and are valid, and such transactions and events pertain to the entity. Completeness. All inventory transactions and events that should have been recorded have been recorded, and all related disclosures that should have been included in the financial statements have been included. Authorization. All inventory transactions and events have been properly authorized. Accuracy. Amounts and other data relating to inventory transactions and events have been recorded appropriately, and related disclosures have been appropriately measured and described. Cutoff. All inventory transactions and events have been recorded in the correct accounting period. Classification. All inventory transactions and events have been recorded in the proper accounts. Presentation: All inventory transactions and events are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.

Tests of Details of Transactions Substantive Tests of Transactions

Occurrence. Vouch a sample of inventory additions to receiving reports and purchase requisitions. Completeness. Trace a sample of receiving reports to the inventory records. Authorization. Test a sample of inventory shipments to ensure there is an approved shipping ticket and customer sales. Accuracy. Recomputed the mathematical accuracy of a sample of inventory transactions. Audit standard costs or other methods used to price inventory. Cutoff. Trace a sample of time cards before and after period end to the appropriate weekly inventory report. Classification. Examine a sample of inventory checks for proper classification into expense accounts. Presentation. Review disclosure checklist and related disclosures for relevance and completeness Classification. Review inventory compilation for proper classification among raw materials, work in process, and finished goods. Presentation. Review disclosure checklist and related disclosures for relevance and completeness. Review inventory purchase contracts for proper disclosure of long-term contracts, related party transactions, assigned and consigned inventory. Determine if cost method is accurately disclosed (e.g., LIFO). Inquire of management about issues related to LIFO liquidations. Read the financial statements and evaluate that disclosures are relevant and understandable.

The receiving department is least likely to be responsible for the: Determination of quantities of goods received. Detection of damaged or defective merchandise. Preparation of a shipping document. Transmittal of goods received to the store's department.

Preparation of a shipping document.

2. Receiving Report -

Records the receipt of goods from vendors.

Instead of taking a physical inventory count on the balance-sheet date, the client may take physical counts prior to the year-end if internal control is adequate and:

Well-kept records of perpetual inventory are maintained.

Presentation of Inventory Transactions

What could go wrong? •Auditor's tests of controls around management's use of a chart of accounts, proper codes for recording inventory transactions, and the financial reporting process, including the use of a disclosure checklist, should provide adequate assurance for the presentation assertion. •Controls over the aggregation or disaggregation of transactions are important to properly allocate costs to appropriate classes of inventory.

3. Materials Requisition -

authorizes and records the issue of materials for use.

evaluate the clients planning of physical inventory

existence occurrence completeness rights valuation cutoff

Obtain listings of inventory and reconcile to ledgers

existence occurrence rights

review the year-end cutoff of sales transactions

existence occurrence rights valuation cutoff

perform analytical procedures or date analytics

existence rights valuation accuracy

obtain a copy of the completed physical inventory, test its clerical accuracy, and trace test counts

exitance occurrence completeness rights valuation cutoff

evaluate financial statement presentation of inventories and cost of goods sold including adequacy of disclosure

presentation

1. Describe the nature of inventories and cost of goods sold (COGS).

sources of inventories ¡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 - controls found in purchasing cycle - affected by inflation

evaluate the bases and methods of inventory pricing

valuation

test the pricing of inventories

valuation accuracy

determine whether any inventories have been pledged and review purchase and sales commitments

valuation presentation

IT Systems

¡Easier to control inventories ¡EDI to coordinate production and purchasing

perpetual inventory system

¡Provide information essential to purchasing, sales and production-planning policies ¡Allows companies to control high costs of holding excessive inventory

3. Describe the documents, records, and accounts that are involved in the purchases and production (conversion) cycles and the fundamental controls over inventories, purchasing, and production.

¨Purchasing - purchase requestion - purchase order ¨Receiving - receiving report ¨Storing - notifies the accounting department of the amount received and placed in stock ¨Issuing ¨Production - master production schedule - production orders -move tickets - materials requisitions - job time ticket ¨Shipping -shipping document - bill of lading

functions related to inventories

¨Purchasing ¨Receiving ¨Storing ¨Issuing ¨Production ¨Shipping

Completeness of Inventory Transactions

•Auditor's main concern is determining whether all inventory that has been received has been recorded. •Primary control procedure for completeness relates to the recording of inventory that has been received. Controls are closely related to the purchasing process.

Auditors' objectives in the audit of inventories & COGS

•risk of fraud, related to inventories & COGS •Obtain an understanding of I/C over inventories & COGS •Assess RMM and design tests of controls and substantive procedures to determine whether the following assertions have been violated (should also refer to Figure 12.1, course textbook): -Existence of recorded inventory/occurrence of inventory transactions -Proper valuation of inventory and accuracy of inventory transactions (large focus on inventory pricing & obsolescence reserve) -Completeness of recorded inventory and inventory transactions -Cutoff of purchase and sales transactions -Rights (and obligations) to recorded inventory -Presentation & disclosure of information about inventories, including classification, adequate disclosure of pledged inventory as collateral, and purchase/sales commitments.

Major steps in setting the control risk in the inventory management process.

- Understand and document the inventory management process based on a reliance strategy. - Plan and perform tests of controls on inventory transactions. - Set and document the control risk for the inventory management process.

Production Schedule -

Based on the expected demand for the entity's products.

The document issued by a common carrier acknowledging the receipt of goods and setting forth the provisions of the transportation agreement is the:

Bill of lading.

Possible Misstatement Detected:

Obsolete, slow-moving, or excess inventory Obsolete, slow-moving, or excess inventory Unrecorded or fictitious inventory Over- or understated inventory Over- or understated inventory Inclusion or exclusion of overhead costs

The primary objective of a CPA's observation of a client's physical inventory count is to:

Obtain direct knowledge that the inventory exists and has been properly counted.

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.

Which of the following should be included as a part of inventory costs of a manufacturing company?

Direct Labor: Yes, Raw Materials: Yes, Factory Overhead: Yes

Which of the following is least likely to be among the auditors' objectives in the audit of inventories and cost of goods sold? Determine that the valuation of inventories and cost of goods sold is arrived at by appropriate methods. Determine the existence of inventories and the occurrence of transactions affecting cost of goods sold. Establish that the client includes only inventory on hand at year-end in inventory totals. Establish the completeness of inventories.

Establish that the client includes only inventory on hand at year-end in inventory totals.

Cutoff of Inventory Transactions

Inventory transactions recorded in the improper period could affect a number of accounts, including inventory, purchases, and cost of goods sold.

Accuracy of Inventory Transactions

Inventory transactions that are not properly recorded result in misstatements that directly affect the amounts reported in the F/S. 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.

6. 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.

Auditing Standard Costs:

Materials Test the quantity and type of materials included in the product and the price of the materials. Overhead Review the entity's method of overhead allocation for reasonableness, compliance with GAAP, and consistency Labor Gather evidence about the type and amount of labor needed for production and the labor rate.

7. Inventory Status Report -

Shows the type and amount of products on hand.

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 certain industries may also promote material misstatement due to obsolescence. Products that are small and of high value are more susceptible to theft. The auditor must be alert to related-party transactions for acquiring raw materials and selling finished products. Prior-year misstatements are good indicators of potential misstatements in the current year.

Classification of Inventory Transactions

The entity must have control procedures to ensure that inventory is properly classified as RM, WIP, or FG. By knowing which manufacturing department holds the inventory, the auditor is able to classify it by type.

8. Shipping Document -

Used to remove goods from the perpetual inventory records.

The auditor's analytical procedures will be facilitated if the client:

Uses a standard cost system that produces variance reports.

When perpetual inventory records are maintained in quantities and in dollars, and internal control over inventory is weak, the auditor would probably:

Want the client to schedule the physical inventory count at the end of the year.

Observe the taking of physical inventory and make test counts

existence occurrence completeness rights valuation cutoff

standard costs

materials labor overhead

2. Describe the auditors' objectives in the audit of inventories and COGS.

¨Management fraud has often involved the fraudulent overstatement 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 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 will also obtain evidence about the related purchases, sales, purchase returns and sales returns accounts