Audit Ch. 12

If an excessive number of errors are found during auditor test counts...

The entire inventory should be recounted

McKesson & Robbins fraud case

1939 case that revealed a drug company had $19 million of fictitious assets Prompted auditing standards that emphasized the importance of physical inventory observation

Copies of the purchase order should be sent to...

1. Accounting department 2. Receiving department (blind copy w/o quantity)

Inventory pricing questions

1. What method of pricing is used? 2. Is the method the same as used in prior years? 3. Has the method been applied consistently and accurately?

What is the auditor's responsibility in inventory counting?

1. Attend physical inventory count 2. Inspect inventory to determine existence and condition 3 Make test counts 4. Observe compliance with instructions 5. Obtain audit evidence about reliability of count procedures 6. Determine all inventory is included 7. Be aware of inclusion of obsolete or damaged merchandise

Inventory risks

1. Availability of supply of goods, services, and skilled labor 2. Stability of prices and labor rates 3. Sufficient cash flow to pay for purchases 4. Changes in manufacturing technology 5. Obsolescence of inventory

Control environment aspects relevant to inventory

1. Commitment to competence and HR (qualified and trained personnel assigned to inventory) 2. Integrity and ethical values (appropriate purchasing, no "kickbacks") 3. Organizational structure and assignment of authority and responsibility (everyone understands their role)

If goods held by the client are on consignment, auditors may...

1. Compare physical inventory with records, contracts, and correspondence with consignors 2. Communicate directly with consignor to confirm quantity and value of goods and client liability

What should auditors do if they are unable to observe the inventory taking at year end? (hired after year-end)

1. Conclude that sufficient appropriate evidence cannot be obtained to express an opinion 2. Perform alternative auditing procedures to obtain satisfaction

Using a perpetual inventory system allows companies to...

1. Control costs of holding excessive inventory 2. Minimize risks of running out of stock

Once goods are delivered to the warehouse, the warehouse should...

1. Count and inspect received goods 2. Record receipt (accepting responsibility for goods) 3. Notify accounting of receipt

Factors to consider in planning a physical inventory

1. Date 2. Suspension of production 3. Segregation of obsolete and defective goods 4. Counting process controls (tags, sheets, etc.) 5. Proper cutoff of sales/purchases 6. Use of specialists

Receiving department responsibilities

1. Determine quantities of goods received 2. Detect damaged or defective merchandise 3. Prepare receiving report 4. Transfer goods received to stores department

How should auditors verify inventories held in public warehouses?

1. Direct confirmation 2. Supplementary procedures (if amounts are significant)

If there was not a satisfactory audit in the prior year, what should auditors do to investigate beginning inventories?

1. Discuss with person who supervised physical inventory 2. Study written instructions 3. Trace items from inventory tags to summary sheets 4. Test perpetual inventory records 5. Test overall reasonableness of beginning inventory

Tests of controls for inventory

1. Examine a sample of purchase transactions 2. Perform tests of the cost accounting system

Perform analytical procedures for inventory - primary audit objectives

1. Existence 2. Rights 3. Completeness 4. Valuation 5. Accuracy

Reconcile listings of inventory to ledgers - primary audit objectives

1. Existence/occurrence

Observe taking of physical inventory - primary audit objectives

1. Existence/occurrence 2. Completeness 3. Valuation 4. Cutoff

Review year-end cutoff of purchase and sales transactions - primary audit objectives

1. Existence/occurrence 2. Completeness 3. Valuation 4. Cutoff

Test accuracy of completed physical inventory - primary audit objectives

1. Existence/occurrence 2. Completeness 3. Valuation 4. Cutoff

Evaluate client's planning of physical inventory - primary audit objectives

1. Existence/occurrence 2. Rights 3. Completeness 4. Valuation 5. Cutoff

What should be documented in the working papers related to observation of inventory?

1. Extent of test counts 2. Discrepancies notes 3. Conclusions on whether inventory was properly taken

Inventory includes...

1. Goods on hand ready for sale 2. Goods in the process of production 3. Goods to be consumed in production (directly or indirectly)

Analytical procedures for inventory

1. Gross profit margins 2. Inventory turnover 3. Volume of purchase transactions 4. Scan COGS accounts 5. COGS analysis by month

Misstatements of inventory costs - errors

1. Inaccurate assignment of labor, materials, and overhead costs 2. Erroneous pricing of inventory

Misstatements of inventory quantities - internal control weaknesses

1. Ineffective physical controls over inventory 2. Poor "tone at the top" 3. Ineffective supervision of physical inventory

Misstatements of inventory costs - fraud

1. Intentional misstatement of production costs 2. Intentional misstatement of inventory prices

Early/late recognition of purchases - fraud

1. Intentional recording of purchases in subsequent period

Disclosures related to inventory

1. Inventory pricing methods 2. Changes in methods 3. Classifications of inventory 4. Details of pledged inventory 5. Deduction of valuation allowance for inventory losses 6. Existence and terms of inventory purchase commitments

Misstatement of inventory quantities - fraud

1. Items stolen with no journal entry 2. Inventory quantities in locations not visited by auditors are overstated

Inventory factors related to risk of material misstatements

1. Large current asset 2. Susceptible to major errors and fraud 3. Numerous alternative valuation methods are allowed 4. Directly affects COGS (major impact on net income) 5. Determination of inventory quality, condition, and value is inherently complex

Monitoring controls for purchases cycle

1. Management review of purchase reports, inventory, and accounts payable 2. Feedback from suppliers 3. Software to monitor purchase transactions

Misstatement of inventory quantities - errors

1. Miscounting of inventory

What errors should auditors be alert for when testing final inventory listing?

1. Misplaced decimal points 2. Incorrect units or pricing 3. Altered or fictious inventory tags 4. Omitted or additional inventory items 5. Discrepancies between physical count and inventory records

Potential misstatements related to inventory

1. Misstatement of inventory costs 2. Misstatement of inventory quantities 3. Early/late recognition of purchases (cutoff problems)

Monitoring controls for production cycle

1. Observation by production supervisors 2. Quality and performance reviews 3. Internal auditor recommendations and improvements

How should auditors verify goods on consignment?

1. Obtain list of and review all consignees and contracts 2. Communicate with and obtain written information from consignees

Substantive tests for inventory

1. Obtain listings of inventory and reconcile to ledgers 2. Evaluate client's planning of physical inventory 3. Observe taking of physical inventory and make test counts 4. Review year-end cutoff of purchases and sales transactions 5. Test clerical accuracy of completed physical inventory count and test counts 6. Evaluate bases and methods of inventory pricing 7. Test pricing of inventories 8. Perform analytical procedures 9. Determine whether inventories have been pledged and review purchase and sales commitments 10. Evaluate financial statement presentation and disclosure of inventories and COGS

Early/late recognition of purchases - internal control weaknesses

1. Poor "tone at the top" 2. Ineffective accounting procedures

Misstatements of inventory costs - internal control weaknesses

1. Poor "tone at the top" 2. Ineffective input validation controls in database

Internal control for purchasing should segregate...

1. Purchasing 2. Receiving 3. Recording

Functions related to inventories

1. Purchasing 2. Receiving 3. Storing 4. Issuing 5. Processing 6. Shipping

The receiving department should be independent of...

1. Purchasing department 2. Storing department 3. Shipping department

In comparing their test counts to tags, auditors should be alert for errors in...

1. Quantity 2. Part numbers 3. Descriptions 4. Units of measure 5. % of completion

Early/late recognition of purchases - errors

1. Recording purchases of current period in subsequent period

What conversion cycle documents should be prenumbered?

1. Requisitions 2. Purchase orders 3. Receiving reports

Copies of the shipping document should be...

1. Retained by shipping department 2. Sent to billing department 3. Enclosed as a packing slip If goods are shipped using a common carrier: 4. Used as a bill of lading

Business considerations related to inventory

1. Seasonality 2. Inventory on hand 3. Counting measurements 4. Spoilage 5. Ordering 6. Technology

Steps to test a sample of purchase transactions

1. Select sample 2. Examine related purchase requisition (or other authorization) 3. Examine related invoice, receiving report, and paid check 4. Trace transactions to voucher and check register 5. Inspect vendor's invoices for approval of terms 6. Compare quantities and prices in invoice, purchase order, and receiving report 7. Trace postings from voucher register to general and subsidiary ledgers

Circumstances to allow auditors to be satisfied with alternative auditing procedures if unable to observe inventory taking

1. Strong internal control 2. Perpetual inventory records 3. Well-planned and executed physical inventory 4. Making of test counts

In order to accept beginning inventory counts from a competent, predecessor auditor, the new auditors should...

1. Study the inventory valuation methods used 2. Review the inventory records 3. Review the inventory sheets used 4. Compare beginning and ending inventories

Evaluate bases and methods of inventory pricing - primary audit objectives

1. Valuation

Test pricing of inventories - primary audit objectives

1. Valuation 2. Accuracy

Determine whether inventories have been pledged and review commitments - primary audit objectives

1. Valuation 2. Presentation and disclosure

Why is the audit of inventories significant?

1. Valuation of goods on hand is complex 2. Determining quantities may require specialized techniques 3. Inventory is the largest current asset 4. Misstatements directly affect COGS (and net income) 5. Management fraud often involved overstatement of inventories

A purchase requisition should include...

A description of the type and quantity of goods needed

When should inventory be counted?

At or near the balance sheet date

Periodic inventory system

Determines quantities solely by an annual physical count

If the client hires an outside firm to take physical inventory, the auditor should...

Evaluate the effectiveness of the procedures used by the outside firm and perform other procedures as appropriate Counts made are not sufficient, appropriate evidence by themselves

How can auditors determine proper cutoff of inventory?

Examine on a test basis purchase invoices and receiving reports for several days before and after inventory date Make sure that... 1. Liability has been recorded for all inventory 2. Shipments and purchases are recorded in the proper period

How should auditors test the pricing of inventories?

For raw materials: verify with purchase invoices For goods in process and finished: verify with cost accounting records

When can inventory counts be performed during the year?

If auditor is satisfied that client has effective internal control and perpetual records

How should employees count inventory?

In teams of two

Perpetual inventory system

Inventory is updated constantly Verifies records with occasional test counts throughout the year Typically have strong internal control over inventories

IT-based inventory system

Makes it easier to control inventory Can use electronic data interchange (EDI) to coordinate production and purchasing Automatically generates purchase requisition when inventory levels reach reorder points

Kickback

Payments from suppliers from purchasing agents to influence them in choosing a specific supplier

After receiving a purchase requisition, the purchasing department should...

Prepare a serially numbered purchase order

Shipping document

Prepared by shipping department, indicates goods were shipped Should be prenumbered

Purchase requisition

Request prepared by department needing supplies Marks start of purchase transaction

Who should have the authority to make purchases?

Separate purchasing department should have exclusive authority for all purchases

Inventory tags

Serially numbered tags attached to goods during taking of physical inventory Used to avoid: 1. Omission of goods from the count 2. Double counting of goods

Physical inventory documentation

Should be documented and communicated in written instructions Drafted by client, reviewed by auditors, and given to personnel performing count

Prenumbered requisition

Should be issued for all items passing from storage to a department Acts as a signed receipt from department accepting the goods

How can auditors determine accuracy of cutoff of inventory counts?

Should record serial number of final receiving and shipping documents issued by the the taking of inventory

Who has responsibility for the physical inventory count?

The client

If auditor test counts show errors...

The client will recount the goods immediately and correct the error

The purchase requisition should be sent to....

The purchasing department

How should auditors determine whether any inventory on hand is the property of others?

Through inquiry

What is the goal of reconciling inventory listings to ledgers?

To make sure that inventory records agree with the financial statements

Why should auditors record test counts and tag numbers?

To trace them later to the client's inventory summary sheets

How can auditors detect pledging of inventories?

When confirming bank balances and debts