Chapter 12: Inventories & COGS

Objectives of Inventories Audit

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

Cost accounting

Accounts for usage of raw materials Determines content and value of goods in progress Compute finished inventory

Auditing inventories: Step 3

Assess risks of material misstatement and design further audit procedures

Documentation of Physical Inventory

Auditor doesn't have to be present for inv count, but has to have documentation that client has done it in appropriate manner Client's plan should be documented and communicated in form of written instructions to personnel taking physical inventory - Letter from client reviewed by auditors - Auditors consider nature and materiality of inventories - Date is typically near/at balance sheet date unless internal control is effective

Audit of inv after year-end

Auditor: - May conclude that sufficient appropriate evidence cannot be obtained to express an opinion, or - Could obtain satisfaction with alternative auditing procedures -- Existence of strong internal control -- Perpetual inventory records -- Documentation of well-planned and executed physical inventory -- Making of test counts

Internal control risks for inventories

Availability of a supply of goods, services, and skilled labor - To determine whether mgt has understanding of econ environment affecting inherent risk & develops sufficient controls -- ie - Not auditor's job to determine whether sufficient supply exists, just that mgt has accted for it Stability of prices and labor rates Generation of sufficient cash flow to pay for purchases Changes in technology that affect manufacturing processes Obsolescence of inventory

Inventory observation

Client counts and supervises inventory Auditors observe - Determine all items included - Employees comply with instructions - Be alert for inclusion of obsolete or damaged merchandise - Record numbers of final receiving and shipping documents issued before inventory taking - Make test counts - Tag control

Inventories control environment

Commitment to competence and human resource policies and practices - Appropriately qualified and trained personnel assigned to inventory Integrity and ethical values - Company purchasing agents do not accept "kickbacks" Organizational structure and assignment of authority and responsibility - Purchasing, receiving and production understand roles

Production function

Controlled with master production schedule Production orders Materials requisitions and move tickets Job time tickets

Storing function

Counts, inspects and receives goods Notifies accounting of receipt Physically secures inventory

Periodic inventory system

Determine inventory quantities solely by an annual physical count

Objectives for the Audit of Inventories and Cost of Goods Sold

Determine the existence of inventories Establish the completeness of inventories Establish that the client has rights to the recorded inventories Determine that the valuation of inventories and cost of goods sold is in accordance with GAAP Determine that the presentation and disclosure of inventories and cost of goods sold are appropriate

Substantive tests for presentation & disclosure of inventories

Determine whether any inventories have been pledged - Review commitments Evaluate FS presentation & disclosure

Receiving function

Determines quantity of goods received Detects damaged or defective merchandise Prepares receiving report Prompt transmittal of goods received to stores department

Substantive tests for completeness of inventories

Evaluate client's planning of physical inv Observe taking of physical inv Review year-end cutoff of purchase & sales transactions Obtain copy of completed physical inv - Test accuracy Perform analytical procs

Substantive tests for existence & rights of inventories

Evaluate client's planning of physical inv Observe taking of physical inv Review year-end cutoff of purchase & sales transactions Obtain copy of completed physical inv - Test accuracy Perform analytical procs

Proper cut-off of inventory

Examine on a test basis the purchase invoices and receiving reports for several days before and after the inventory date. - Determine that liab has been recorded for all goods in inventory - Make sure shipments and purchases recorded in proper period

Source of Inventories

Goods on hand ready for sale Goods in the process of production Goods to be consumed directly or indirectly in production - Ex: Raw materials, purchased parts and supplies

TOC for using perpetual records to control inventories

Inquire about perpetual inv procs - Test records by reference to purchase invoices, receiving reports, and prod records Tests: - Existence & occurrence - Completeness - Cutoff - Valuation & accuracy - Presentation & disclosure

TOC for establishing GL control of inventories of raw mats, goods in process, and finished goods & periodically reconciling these to production records

Inspect accting & prod records & selected reconciliations Tests: - Existence & occurrence - Rights & obligations - Valuation & accuracy - Presentation & disclosure

TOC for establishing controls for cost accting system that accumulate appropriate inv costs on job order/process cost basis - Ex: Independent review of cost accumulations

Inspect evidence of independent reviews of cost accumulations - Recompute mats costs by reference to requisitions & purchase invoices - Recompute direct labor costs by reference to time & payroll records & overhead application rates Tests: - Valuation & accuracy

TOC for analyzing & following up on variances from standard costs

Inspect inventory reports - Examine evidence of follow-up on variances Tests: - Existence & occurrence - Completeness - Valuation & accuracy

Risks of Material Misstatements in Inventories

Inventories constitute a large asset and very susceptible to major errors and fraud. The accounting profession allows numerous alternative methods for valuation of inventories, and different methods may be used for various classes of inventories. Determination of inventory value directly affects the cost of goods sold and has a major impact on net income for the year. Determination of inventory quality, condition, and value is inherently a more complex and difficult task than is the case with most other elements of financial position.

Disclosures required for inventories

Inventory pricing methods/methods in use Other important disclosures: - Changes in methods - Classifications of inventory - Details of pledged inventory - Deduction of valuation allowance for inventory losses - Existence and terms of inventory purchase commitments.

Perpetual inventory records

Inventory updated constantly Strong internal control over inventories May use test counts throughout the year

Monitoring of inventories

Observations by production supervisors of performance of various activities and functions Quality and performance reviews Formal program to consider improvements in purchasing and production noted by internal auditors

TOC for establishing appropriate physical controls over inventories

Observe & inquire about physical control policies & procedures Tests: - Existence & occurrence - Rights & obligations

TOC for segregating duties over purchases & custody of inventories

Observe & make inquiries about performance of various functions Tests: - Existence & occurrence - Completeness - Rights & obligations - Valuation & accuracy

TOC for establishing procs for - Authorizing purchase transactions - Reconciling purchase invoices to PO's & receiving reports - Verifying clerical accuracy of purchase invoices

Observe & make inquiries about purchase procs - Test sample of purchase transactions by: -- Inspecting evidence of authorizations & reconciliations --- Comparing details to authorized POs & receiving reports ---- Recomputing invoice amts Tests: - Existence & occurrence - Rights & obligations - Valuation & accuracy

TOC for using prenumbered requisitions, PO's, receiving reports & accounting for sequence of docs

Observe & make inquiries about use of prenumbered docs - Inspect evidence of accting for sequence Tests: - Completeness - Cutoff

Auditing inventories: Step 2

Obtain an understanding of internal control over inventories and cost of goods sold

Substantive tests for valuation of inventories

Obtain listings of inv - Reconcile to ledgers Evaluate client's planning of physical inv Observe taking of physical inv Review year-end cutoff of purchase & sales transactions Obtain copy of completed physical inv - Test accuracy Evaluate bases & methods of inv pricing Test pricing of inv Perform analytical procs Determine whether any inventories have been pledged - Review commitments

Separation of prenumbered shipping documents used in shipping function

One copy in shipping One copy to billing Third copy used as packing slip Fourth copy services as bill of lading - For goods shipped common carrier

Auditing inventories: Step 5

Perform further audit procedures—substantive procedures for inventories and cost of goods sold 1. Obtain listings of inventory and reconcile to ledgers. 2. Evaluate the client's planning of physical inventory. 3. Observe the taking of physical inventory and make test counts. 4. Review the year-end cutoff of purchases and sales transactions. 5. Obtain a copy of the completed physical inventory, test its clerical accuracy, and trace test counts. 6. Evaluate the bases and methods of inventory pricing. 7. Test the pricing of inventories. 8. Perform analytical procedures. 9. Determine whether any inventories have been pledged and review purchase and sales commitments. 10. Evaluate financial statement presentation of inventories and cost of goods sold, including the adequacy of disclosure.

Auditing inventories: Step 4

Perform further audit procedures—tests of controls - If necessary, revise the risks of material misstatement based on the results of tests of controls

Purchasing Cycle

Purchase requisition form completed by department -= Request for new item -- Approved by superior Purchasing prepares purchase order May obtain bids but need approval Item description and quantity Copy forwarded to accounting Copy forwarded to receiving should not include quantity

Functions related to inventories

Purchasing Receiving Storing Issuing Processing Shipping

TOC for using appropriate procs for taking physical inventory

Review inv instructions - Observe inv-taking process Tests: - Existence & occurrence - Completeness - Cutoff - Rights & obligations - Valuation & accuracy

Procedures to obtain evidence that beginning inventory is fairly stated for first-year clients

Review predecessor's working papers Discuss with person who supervised physical inventory at beginning Study written instructions in planning Trace numerous items from inventory tags to final summary sheets Test perpetual inventory records for previous year Test overall reasonableness of beginning inventory

Controls Over Conversion Cycle

Segregation of duties over purchases and custody of inventory Use of pre-numbered requisitions, purchase orders, and receiving reports Procedures for authorizing purchase transactions and verifying them for payment General ledger control of inventories and reconciliation to production records Cost accounting controls Analysis of variances from standard costs Use of perpetual records for inventories Use of appropriate procedures for taking inventory Appropriate physical controls over inventories

Internal control over purchasing function

Segregation of purchasing, receiving and recording

Considerations in Planning a Physical Inventory

Selecting appropriate date Suspending production Segregating obsolete and defective goods Establishing control over the counting process Achieving proper cutoff of sales and purchases Arranging for services of specialists

Shipping function

Shipment upon authorized sales order approved by credit department - Generates a prenumbered shipping document

Issuing function

Stores department issues goods to requesting department - Prenumbered requisition

Goals of Inventories TOC & Substantive Tests

Substantiate the existence of inventories and the occurrence of transactions affecting cost of goods sold. Establish the completeness of recorded inventories. Verify the cutoff of transactions affecting cost of goods sold. Determine that the client has rights to the recorded inventories. Establish the proper valuation of inventories and the accuracy of transactions affecting cost of goods sold. 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.

Auditing inventories: Step 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

Significance of Audit of Inventories

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 Management fraud has often involved the fraudulent overstatement of inventories

Considerations in auditing inventory pricing

What method of pricing does the client use? Is the method of pricing the same as that used in prior years? Has the method selected by the client been applied consistently and accurately in practice? - Test pricing of inventories