Slide 12- 1 © The McGraw-Hill Companies, Inc., 2006

Inventories andCost of Goods Sold

Slide 12- 2 © The McGraw-Hill Companies, Inc., 2006

Periodic vs Perpetual Inventory

PeriodicValue only known by counting at period’s end.Value of theft, shrinkage can only be estimated

PerpetualContinual “book” value known

Count may not determine B.S. amount if books are not materially different.

“Cycle counts” frequently used to test for accuracy during the period.

Slide 12- 3 © The McGraw-Hill Companies, Inc., 2006

The Special AuditSignificance 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.

Financial reporting fraud has often involved the fraudulent overstatement of inventories.

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Common Internal Controls Over the Conversion Cycle

Segregation of duties - purchases & inventory custody Use of pre-numbered requisitions, purchase orders, and

receiving reports Procedures for authorizing purchase transactions and

verifying them for payment General ledger control A/C 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 security controls over inventories

Slide 12- 5 © The McGraw-Hill Companies, Inc., 2006

Most Likely Misstatements

Inaccurate recording of purchases

Theft of inventory

Duplicate payment for purchases

Fraudulent inflation of purchases cost

Misstatement of inventory unit costs

Misstatement of inventory quantities Failure to accrue receipts of material (before vendor invoices arrive)

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Objectives for the Audit of Inventories and Cost of

Goods Sold Determine the Existence of inventories and occurrence of

the elements of cost of goods sold.

Establish the Completeness of inventories

Establish that the client has Rights to the recorded inventories

Establish the clerical accuracy of records and supporting schedules

Determine that the Valuation of inventories and cost of goods sold is in accordance with GAAP & proper cutoff

Determine that the Presentation and disclosure of inventories and cost of goods sold are appropriate

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Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers

Slide 12- 8 © The McGraw-Hill Companies, Inc., 2006

Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers

Evaluate client’s planning of physical count and plan auditor’s observation

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Planning a Physical Inventory

Count & Observations Thereof

Advising Client: Selecting an appropriate date Suspending production or controlling movement & cutoff Segregating obsolete and defective goods Adequate counting procedures, incl. recoding medium

Auditor Observation Planning: Locations to observe/staff requirements Extent of test counts How to confirm proper cutoff of sales and purchases Arranging for the services of specialists Not telling client where we will observe

GOAL: An Accurate Count & Audit Evidence

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Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers Evaluate client’s planning of physical count and plan observation

Observe(not supervise) taking of physical count

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Observation Audit Procedures

Observe Practices Used Control Tags/Count Sheets

(Whatever Recording Medium Used)

Make Test Counts & Record in W/Ps Take Note of:

Damaged, dusty itemsEnd product in receiving areaItems moving during countLast tag/count sheet used (copy electronic file?)

Slide 12- 12 © The McGraw-Hill Companies, Inc., 2006

Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers Evaluate client’s planning of physical count and plan observation Observe the taking of physical count

Confirm inventories in public warehouses and on consignment

Slide 12- 13 © The McGraw-Hill Companies, Inc., 2006

Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers Evaluate client’s planning of physical count and plan observation Observe the taking of physical inventory Confirm inventories in public warehouses and on consignment

Review the year-end cutoff of purchases and sales transactions

Slide 12- 14 © The McGraw-Hill Companies, Inc., 2006

Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers Evaluate client’s planning of physical count and plan observation Observe the taking of physical inventory Confirm inventories in public warehouses and on consignment Review the year-end cutoff of purchases and sales and transactions

Obtain a copy of completed physical inventory; test its accuracy

Test inventory pricing

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Auditing CompletedInventory Listing

Test math accuracy Quantity:

Compare to W/P recorded test countsLast tag/count sheet or copy of file

Unit cost:Method (LIFO,FIFO) OK per GAAP?Consistent with prior year?Computed accurately?Lower of cost or market?

Evaluate adjustments

Slide 12- 16 © The McGraw-Hill Companies, Inc., 2006

Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers Evaluate client’s planning of physical count and plan observation Observe the taking of physical inventory Confirm inventories in public warehouses and on consignment Review the year-end cutoff of purchases and sales and transactions Obtain a copy of completed physical inventory; test its accuracy Test inventory pricing

Perform analytical procedures

Slide 12- 17 © The McGraw-Hill Companies, Inc., 2006

Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers Evaluate client’s planning of physical count and plan observation Observe the taking of physical inventory Confirm inventories in public warehouses and on consignment Review the year-end cutoff of purchases and sales and transactions Obtain a copy of completed physical inventory; test its accuracy Test inventory pricing Perform analytical procedures

Identify pledged inventories; Review commitments

Slide 12- 18 © The McGraw-Hill Companies, Inc., 2006

Substantive Tests for the Inventories and Cost of

Goods Sold

Obtain listings of inventory and reconcile to ledgers Evaluate client’s planning of physical count and plan observation Observe the taking of physical inventory Confirm inventories in public warehouses and on consignment Review the year-end cutoff of purchases and sales and transactions Obtain a copy of completed physical inventory; test its accuracy Test inventory pricing Perform analytical procedures Identify pledged inventories; Review commitments

Evaluate financial statement presentation and disclosure

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Recap-Inventory Observation

Unless Inventory is Immaterial - We Must Observe a Physical Count.

We Observe to Gain Evidence About the Count - We Do Not Supervise.

Can We Observe Weeks/Months Before Or After B.S. Date?

If so, What Must Exist?Good Perpetual Inventory Records Which

We Must Test During the Intervening Period

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Recap-Inventory Observation (Con’t)

Can We Accept a Stat Sample or is Wall-to-Wall Necessary?If We Can Live with the Added DR in the

Form of Sampling Risk.

Can We Observe Periodic Cycle Counts Rather Than Count Near Yearend?If They Regularly Confirm Reliability of the

Perpetual Inventory Records.

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Added Tests - First Year Clients

Assess if beg. balance is material to F.S. (income statement)

Verify beg. balance to prior client & CPA W/Ps and perform some tests.

or Review procedures, supporting data for physical

count and completed inventory listing to assess potential reliability or

Use analytical procedures to assess reasonableness of beginning balance.

Qualify audit opinion, if necessary.