Chapter 14

Which of the following procedures will best detect the theft of valuable items from an inventory that consists of hundreds of different items selling for $1 to $10 and a few items selling for hundreds of dollars? (1) Maintain a perpetual inventory master file of only the more valuable items with frequent periodic verification of the validity of the perpetuals. (2) Have an independent CPA (Chartered Professional Accountant) firm prepare an internal control report on the effectiveness of the administrative and accounting controls over inventory. (3) Have separate warehouse space for the more valuable items with sequentially numbered tags. (4) Require an authorized officer's signature on all requisitions for the more valuable items.

(1) Maintain a perpetual inventory master file of only the more valuable items with frequent periodic verification of the validity of the perpetuals.

Which of the following sets of duties related to inventory and distribution causes the greatest concern about inadequate segregation of duties? (1) Individuals in charge of approving disbursements related to inventory purchases have the "read-only" ability to view the list of vendors in the preapproved vendor master file. (2) Purchasing agents who arrange for the shipment of raw materials from vendors are responsible for verifying the actual receipt of the inventory items at the receiving dock. (3) The receiving department has access to copies of the purchase orders that exclude information about quantities ordered. (4) Accounts payable personnel have access to receiving reports and purchase orders in addition to vendor invoices for inventory purchases.

(2) Purchasing agents who arrange for the shipment of raw materials from vendors are responsible for verifying the actual receipt of the inventory items at the receiving dock.

Which of the following internal control procedures most likely would be used to maintain accurate inventory records? (1) Perpetual inventory records are periodically compared with the current cost of individual inventory items. (2) A just-in-time inventory ordering system keeps inventory levels to a desired minimum. (3) Requisitions, receiving reports, and purchase orders are independently matched before payment is approved. (4) Periodic inventory counts are used to adjust the perpetual inventory records.

(4) Periodic inventory counts are used to adjust the perpetual inventory records.

Explain why a proper cutoff of purchases and sales is heavily dependent on the physical inventory observation. What information should be obtained during the physical count to make sure cutoff is accurate?

A proper cut-off of purchases and sales is heavily dependent on the physical inventory observation because a proper cut-off 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 cut-off for sales is accurate, the following information should be obtained during the taking of the physical inventory: · 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 cut-off problems. · When prenumbered shipping documents are not used, a careful review of the client's method of getting a proper sales cut-off is the first step in testing the cut-off. · A list of the most recent shipments should be included in the working papers for subsequent follow-up to sales records. For the purchase cut-off, the following information should be noted: · 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.

Assuming that the auditor properly documents receiving report numbers as part of the physical inventory observation procedures, explain how he or she should verify the proper cutoff of purchases, including tests for the possibility of raw materials in transit, later in the audit.

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 the merchandise in transit that would be included in inventory (and accounts payable).

List the audit procedures that could be employed to determine whether slow-moving or obsolete items have been included in inventory.

Auditing procedures to determine whether slow-moving or obsolete items have been included in inventory are: · 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 non-use of inventory items. · Make observations during the physical inventory of 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 physical inventory or included at a reduced cost. · Calculate inventory turnover ratios, by type of inventory if possible, and compare them to previous years or industry standards. · Have a sufficient understanding of the client's business to aid in recognizing inventory that is no longer useful in the client's business. (This item is not an audit procedure but is important as a part of performing the procedures.)

Define what is meant by compilation tests. List several examples of audit procedures to verify compilation.

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: -Tracing 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. -Tracing the test counts recorded in the working papers to the final inventory summary to make sure they are correctly included. -Tracing inventory items on the final inventory list to the tags as a test of the validity of recorded inventory. -Testing the extensions and footings of the physical inventory summary.

One of the final tests an auditor must perform is the determination of lower of cost or market (valuation). For raw materials inventory, how is the test performed? For work in progress and manufactured finished goods inventory, how is the test performed? To answer this question, consider when the test is performed, how market value is determined, and the documents that must be examined.

Emphasis should be on those items that have the greatest risk of material misstatement larger dollar amounts, products that are known to have wide price fluctuations, and slow-moving inventory i. Inventory is reduced, when appropriate, to net realizable value or replacement cost ii. For purchased finished goods and raw materials, the most recent vendor's invoice of the subsequent period is a useful and straightforward means of testing for replacement cost iii. Obsolescence can be tested by reviewing documents supporting the most recent sales made by the client, such as payments made by customers.

What are some additional procedures that could be performed if there was a suspicion of fraudulent activity in the inventory cycle?

Perform surprise visits and inventory counts. Perform additional procedures at the count. An expert may be required. Use audit software and audit data analytics to further test compilation of inventory counts to check for possible omissions or duplications. Ensure that the audit plan is confidential and not discussed with the client. Perform nonfinancial analytics to determine unusual relationships. Inquire of personnel in the shipping department about recent shipments between inventory warehouse locations close to the physical inventory count date.

During the physical inventory count, the controller intentionally withheld several inventory tags from the employees responsible for the physical count. After the auditor left the client's premises at the completion of the inventory observation, the controller recorded nonexistent inventory on the tags and thereby significantly overstated earnings. How could the auditor have uncovered the misstatement, assuming there are no perpetual records?

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 him/herself that the client had accounted for all used and unused tag numbers by examining all tags him/herself, if necessary. In addition, the auditor should have selected certain tags (especially larger items) and had the client show him 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 his/her 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.

At the completion of an inventory observation, the controller requested a copy of all recorded test counts from the auditor to facilitate the correction of all discrepancies between the client's and the auditor's counts. Should the auditor comply with the request? Why or why not?

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 non-counted items without detection by the auditor.

Ruswell Manufacturing Ltd. applied manufacturing overhead to inventory at December 31, 2020, on the basis of $3.47 per direct labour hour. Explain how you would evaluate the reasonableness of total direct labour hours and manufacturing overhead in the ending inventory of finished goods.

The direct labour 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 labour 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 labour hours and the number of direct labour hours per unit of each type of inventory), it is not difficult to verify the overhead cost of inventory.

What major audit procedures are involved in testing for the ownership of inventory during the observation of the physical counts and as part of subsequent valuation tests?

The most important audit procedures employed in testing for the ownership of inventory during the observation of the physical counts and as a part of subsequent valuation tests are: -discussions with the client. -an understanding of the client's operations. -an alertness for inventory set aside or specially marked. -review of 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. -examination of vendor invoices indicating that merchandise on hand was sold to the company. -testing of sales recorded 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.

What is the purpose of attending the inventory count performed by the client? Why is planning so important before the auditor is in attendance for an inventory count? What are some of the decisions an auditor must make before attending the inventory count? Why?

The purpose of attendance is to observe that the inventory exists and to assess its condition (this provides some evidence for the valuation objective). The auditor should have a thorough understanding of the controls before the inventory taking begins. i. The auditor cannot evaluate the effectiveness of count procedures without understanding the system ii. Enables the auditor to discuss potential issues such as valuation, potential obsolescence and consignment inventory intermingled with owned inventory The auditor must also review the process of pricing and compilation to make sure the physical counts were properly priced and compiled.

1. What are some of the business functions in the inventory and distribution cycle? What are some of the records in use? What are some of the key controls that are put in place? (See Figure 14-4 and Table 14-1)

a. Acquisition and payment i. Raw Materials b. Human resources & payroll cycle i. DL, MOH c. Revenue cycle i. WIP, FG, COGS

1. What are some of the major risks of error or fraud in the inventory and distribution cycle? (See Table 14-3)

a. Different locations make physical control and counting difficult b. Inventory is easily transportable and is easy to steal c. The auditor may need specialist assistance d. Obsolescence due to technological innovation in the marketplace e. Returns cause problems: accuracy, timing, and cut-off f. Several acceptable inventory valuation methods under ASPE and IFRS g. The company has or is attempting to obtain financing secured by inventory h. The inventory is difficult to count or value i. The company is a manufacturer or has a complex system to determine the value of inventory j. The company is involved in technology or another volatile or rapidly changing industry

1. What are the two separate systems within the inventory cycle?

a. Inventory - related costs b. Distribution - actual physical flow of goods

1. What are some of the controls that can be put into place to ensure controls over the costs of inventory?

a. Perpetual inventory master and transaction files b. Unit cost records

1. What are some of the tests of controls that can be performed by the auditor to ensure physical controls over inventory, documents and records for the transferring of inventory are appropriate, perpetual inventory files are accurate, and unit cost records are accurate.

a. Physical controls over inventory - The auditor's tests of physical controls over raw materials, work in process, and finished goods are usually limited to observation and inquiry. b. Documents and records for transferring inventory - The auditor's primary concerns in verifying the transfer of inventory from one location to another are that recorded transfers exist, all actual transfers are recorded, and the quantity, description, and date of all recorded transfers are accurate (e.g., using bar coded products and scanning technology to track inventory movement). c. Perpetual inventory master and transaction files - the reliability of perpetual inventory master files affects the timing and extent of the auditor's physical examination of inventory. When perpetual inventory master files are accurate, auditors can test the physical inventory before the balance sheet date. d. Unit cost records - Obtaining accurate cost data for raw materials, direct labour, and manufacturing overhead is an essential part of cost accounting. The valuation of ending inventory depends on the proper design and use of these records.

What are some of the procedures an auditor must undertake when observing the physical inventory count? What audit assertions are addressed when performing these procedures?

a. Physical observations i. Existence: 1. Select tags or count sheets and vouch to items on floor 2. Enquire as to inventory not held on premises ii. Completeness: 1. Observe inventory to ensure it was tagged, 2. Ensure client accounts for numerical sequence of tags, 3. Count items on floor and trace to tags or count sheets iii. Cut-off: 1. Record in the working papers / photocopy for subsequent follow up, the last 5 shipping and receiving documents used at year end. 2. Make sure the inventory for shipments made on last day of year are excluded from the physical count. 3. Make sure inventory received on last day of year are included in the physical count. 4. Review shipping area for inventory set aside for shipment but not counted. 5. Examine inventory descriptions and compare with the actual inventory counted. i. Valuation & Allocation 1. Recount client's counts to make sure the recorded counts are accurate on the count sheets. 2. Compare physical counts with perpetual inventory file. 3. Document items test counted for fieldwork testing. 4. Evaluate whether the percent of completion recorded on job cost records for work in process is reasonable. 5. Inquire on obsolete inventory. 6. Look for items that are damaged, rust or dust covered, or located in inappropriate places.

1. What are some of the controls that can be put into place to ensure physical controls over inventory?

a. Segregation of duties, physical access. b. Documents and records for transferring inventory

What are some of the procedures an auditor must undertake when performing tests of details of balances for inventory pricing and compilation? What audit assertions are addressed when performing these procedures?

a. Substantive tests - In addition to examining the relationship of the inventory account with other financial accounts, auditors often use nonfinancial information to assess the reasonableness of inventory. i. Pricing - includes the tests of the client's unit prices to determine whether they are correct. (Valuation & allocation) 1) the method must be in accordance with an acceptable financial accounting framework 2) the application of the method must be consistent from year to year, and 3) cost versus market value must be considered ii. Compilation - includes the tests of the summarization of the physical counts, the extension of price times quantity, footing the inventory summary, and tracing the totals to the general ledger. (Existence, completeness)

1. What are the four broad categories of cost accounting controls?

a. physical controls - over assets to prevent loss from misuse and theft. b. perpetual records - data files maintained by persons who do not have custody of or access to assets are another important cost accounting control. c. physically counting inventory - Regardless of the inventory recordkeeping method, the client must make a periodic physical count of inventory to ensure accuracy in the perpetual inventory master files, and d. pricing and compiling inventory - to provide assurance that clients use reasonable costs for valuing ending inventory.