Audit of the Inventory and Distribution Cycle

1. Audit of the Inventory and Distribution Cycle CAS 240 – The auditor’s responsibilities relating to fraud in an audit of financial statements CAS 501 – Audit evidence: specific considerations for selected items

2. The Complexity of Inventory • Why? • A major item • Inventory items could • Very diverse items are included • Valuation needs to consider • One client may use several methods

3. Functions in the Inventory and Warehousing Cycle • Process purchase orders • Receive new materials • Store materials • Process goods • Store finished goods • Ship finished goods

4. An Overview of Functions, Documents, and Accounting Systems • Starting point • E.g. Stockroom Purchase details Purchase Requisition N Prepare prenumbered Purchase Requisition Accounts Payable Purchasing

5. Purchasing Department Purchase Requisition Originating Department Determine Vendor, Prepare prenumbered Purchase Order N Purchase Order Originating Department Receiving Accounts Payable Vendor

6. Receive New Materials Blind copy of Purchase Order Purchasing Filed until goods received along with invoice copy A Count goods, match with Purchase Order, and prepare Receiving Report Blind copy of Purchase Order A Receiving Report Originating Department with goods Purchasing Accounts Payable

7. Vendors Invoice Purchase Requisition Originating Department Purchase Order Purchasing Voucher Register to General Accounting Compare. Then prepare Voucher and enter in Voucher Register Receiving Report Receiving Vendor’s Invoice Purchase Requisition Vendor Purchase Order Receiving Report Vendor’s Invoice Voucher To Cash Disbursements when due D

8. Storage Production Cost Accounting Raw Materials Requisition Goods are placed in storage. Raw materials perpetual inventory updated Raw Materials Requisition Raw Materials Requisition Goods from Receiving N Inventory Master file Goods are placed in production Production

9. Manufacturing Raw Materials Requisition Storage N Goods are placed in storage in production Finished Goods to storage Goods Cost Accounting Records

10. Finished Goods Storage Update Perpetual Inventory Master File. Update Cost Accounting Records Finished Goods to shipment Finished Goods from Production Finished Goods Master File Cost Accounting Records

11. Customer Common Carrier Finished Goods Shipment Part of Sales and Collection cycle Order Entry Approved Sales Order Sales Order Bill of Lading Bill of Lading Billing and A/R Bill of Lading Prepare Multi-Part Bill of Lading. Update Perpetual Inventory Master File on shipment Bill of Lading Finished Goods Master File Any shipment must be authorized by having an approved shipping document

12. The Audit of Inventory Audit area Cycle Acquire and record raw materials, labour, and overhead Acquisition and Payments, Payroll and Personnel Internally transfer assets and costs Inventory and warehousing Ship goods and record revenue and costs Sales and Collections Physically observe inventory Inventory and warehousing Price and compile inventory Inventory and warehousing

13. Cost Accounting Typical Controls • Good controls are essential • Physical controls • Inventory must be protected from theft and misuse • What does the auditor look for? • If auditor assesses the physical controls and inadequate?

14. Documents and Records • If testing internal controls • Auditor examines • Testing a series of documents • Does the auditor always test the controls around inventory production? .

15. Inventory files • When does the auditor examine the Perpetual Inventory system? • If level of control risk is low

16. Analytical Procedures • Compare gross margin percentage with previous years • Compare inventory turnover with previous years • Compare unit costs of inventory with previous years • Compare extended inventory value with previous years • Compare current-year manufacturing costs with previous year

17. Inventory Tests of Details of Balances Set materiality. Assess Audit Risk and Inherent Risk for Inventory and Warehousing Assess Control Risk for the applicable cycles Identify assertions where substantive testing is insufficient, and/or there is risk of material misstatement Design and perform test of control for the applicable cycles. Assess control risk The type of audit procedures? What is the sample size? Items to be selected? Timing – when to do the procedures? Design and perform substantive tests of inventory.

18. Physical Inventory Observation: Existence • Remember McKesson & Robbins 1937 • Select a random sample of tag numbers • If inventory is not tagged • Movement of inventory

19. Physical Inventory Observation: Completeness • Tagging inventory • If tags are not used • Enquire as to inventory in other locations.

20. Physical Inventory Observation: Accuracy • Recount client’s counts • Should also trace inventory in both directions. • Perpetual inventory master file • Record client counts test-counted for subsequent testing.

21. Physical Inventory Observation: Classification • Examine inventory tags: • What to look for? • How about percentage of completion for work-in-process?

22. Physical Inventory Observation: Cutoff • Record for subsequent follow-up • Inventory for that shipment • Review shipping area for inventory • The receiving process

23. Physical Inventory Observation: Valuation • What is the auditor looking for? • What else should the auditor do?

24. Physical Inventory Observation: Rights and Obligations • Ownership of inventory is the prime focus in this instance • About what type of item is the auditor concerned?

25. Tests for Compilation and Detail tie-in • What about accounting principles? • What does compilation mean? • What items should be used in this test? • What else should be done? • Detail tie-in?

26. Tests for Existence • What items should be used for this test? • What type of test is performed?

27. Tests for Completeness • What about unused tags? • How about the tags sequence? • Hand-held computers

28. Tests for Accuracy • Want to ensure that the counts are accurate. What type of test? • Perform pricing tests. Type of tests? • Manufacturing • Non-Manufacturing

29. Tests for Classification • Want to inventory is classified correctly as to the type of inventory

30. Tests of Valuation • Remember the physical inventory observation. What was performed in this regard? • Perform test of lower of cost or market, selling price, and obsolescence

31. Tests for Rights and Obligations • The auditor is concerned about what type of inventory? • What type of test?

32. Tests for Presentation and Disclosure • What document should be examined here?

33. Interrelationship of Various Audit Tests Tests of acquisition and payments cycle Tests of payroll and personnel cycle Work in process Raw materials Beginning inventory + Acquisitions of raw materials - Ending inventory = Raw material used Beginning inventory + Direct labour + Raw material used + Indirect labour and other manufacturing overhead - Ending inventory = Cost of goods manufactured Tests of cost accounting: Perpetual inventory records Unit cost records Finished goods Beginning inventory + Cost of goods manufactured - Ending inventory = Cost of goods sold Tests of physical inventory observation Compilation and pricing Tests of sales and collection cycle

34. Problem 14-20, p. 481 For each audit procedure commonly performed in the inventory and warehousing cycle for a manufacturing company, identify whether each of the procedures is primarily a test of control or substantive test.

35. Problem 14-21, p. 482 In connection with examination of the financial statements of Knutson Products Co. Ltd, an assembler of home appliances, for the year ended May 31, 2015, Raymonde Mathieu, public accountant, is reviewing with Knutson’s controller the plans for the physical inventory at the company’s warehouse on May 31, 2015. Finished appliances, unassembled parts, and supplies are stored in the warehouse, which is attached to Knutson’s assembly plant. The plant will operate during the count. On May 30, the warehouse will deliver to the plant the estimated quantities of unassembled parts and supplies required for May 31 production, but there may be emergency requisitions on May 31. During the count, the warehouse will continue to receive parts and supplies and to ship finished appliances. However, appliances completed on May 31 will be held in the plant until after the physical inventory. REQUIRED: What procedures should the company establish to ensure that the inventory count includes all items that should be included and that nothing is counted twice? (Adapted from AICPA)

36. Problem 14-22, p. 482 Items 1 through 8 are selected questions typically found in questionnaires used by auditors to obtain an understanding of internal controls in the inventory and distribution cycle. In using the questionnaires for a particular client, a ‘yes’ response to a question indicates a possible internal control, whereas a ‘no’ response indicates a potential weakness. • Does the receiving department prepare prenumbered receiving reports and account for the numbers periodically for all inventory received, showing the description and quantity of materials? • Is all inventory stored under the control of a custodian in areas where access is limited? • Are all shipments to customers authorized by prenumbered shipping documents? • Is a detailed perpetual inventory master file maintained for raw materials inventory? • Are physical inventory counts made by someone other than storekeepers and those responsible for maintaining the perpetual inventory master file? • Are standard cost records used for raw materials, direct labour, and manufacturing overhead? • Is there a stated policy with specific criteria for writing off obsolete or slow moving inventory? • Is the clerical accuracy of the final inventory compilation checked by a person independent of those responsible for preparing it? REQUIRED: • For each of the preceding questions, state the purpose of the internal control. • For each internal control, list a test of controls to test its effectiveness. • For each of the preceding questions, identify the nature of the potential financial misstatement(s) if the control is not in effect. • For each of the potential misstatements in part (c), list a substantive audit procedure to determine whether a material misstatement exists.

37. Problem 14-27, p. 484 In an annual audit at December 31, 2015, you find the following transactions near the closing date: • Merchandise costing $625 was received on December 28, 2015, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was marked “on consignment.” • A packing case containing products costing $816 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked “Hold for shipping instructions.” Your investigation revealed that the customer’s order was dated December 18, 2015, but that the case was shipped and the customer billed on January 10, 2016. The product was a stock item of your client. • Merchandise received on January 6, 2016, costing $720 was entered in the acquisitions journal on January 7, 2016. The invoice showed shipment was made FOB supplier's warehouse on December 31, 2015. Because it was not on hand December 31, it was not included in inventory. • Merchandise costing $1822 was received on January 3, 2016, and the related acquisition invoice recorded on January 5. The invoice showed the shipment was made on December 29, 2015, FOB destination. • A special machine, fabricated to order for a customer, was finished and in the shipping room on December 31, 2015. This customer was billed on that date and the machine excluded from inventory, although it was shipped January 4, 2016. REQUIRED Assume that each of the amounts is material. • State whether the merchandise should be included in the client’s inventory. • Give your reason for your decision on each item. (AICPA adapted)