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Chapter 13. Auditing the Inventory Management Process. ©2008 The McGraw-Hill Companies, All Rights Reserved. McGraw-Hill/Irwin. Balance Sheet. Assets Cash Investments Receivables Prepaids Inventory PP and E Other assets. Liabilities and Equity Accounts payable Accrued liabilities

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Chapter 13 l.jpg

Chapter 13

Auditing the Inventory Management Process

©2008 The McGraw-Hill Companies, All Rights Reserved

McGraw-Hill/Irwin


Balance sheet l.jpg
Balance Sheet

Assets

Cash

Investments

Receivables

Prepaids

Inventory

PP and E

Other assets

Liabilities and Equity

Accounts payable

Accrued liabilities

Debt

Common stock

Retained earnings


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Inventory Management Process

Major component of the balance sheet

Most complex part of the audit ( typically)

Valuation issues

Obsolescence

LCM ( lower of cost or market)


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LO# 1

Overview of the Inventory Management Process

Inventorymanagementprocess

Purchasingprocess

Revenueprocess

  • Purchase ofraw materials

Human resourcemanagementprocess

  • Sale ofgoods

  • Payment ofmanufacturingoverhead

  • Assignment ofdirect and indirectlabor costs


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Overview ( cont’d)

  • Types of documents and records

  • Major functions

  • Key segregation of duties


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LO# 2

Type of Documents and Records

  • Production Schedule – Based on the expected demand for the entity’s products.

  • Receiving Report – Records the receipt of goods from vendors.

  • Materials Requisition – Used to track materials during the production process.

  • Inventory Master File – Contains all the important information related to the entity’s inventory, including the perpetual inventory records.

Production Schedule

Inventory Master File


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LO# 2

Type of Documents and Records

  • Production Data Information – Contains information about the transfer of goods and related cost accumulation at each stage of production.

  • Cost Accumulation and Variance Report – Material, labor, and overhead costs are charged to inventory as part of the manufacturing process. The variance report compares actual costs to standard or budgeted costs.

  • Inventory Status Report – Shows the type and amount of products on hand.

  • Shipping Order – Used to remove goods from the perpetual inventory records.

Shipping Order


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LO# 3

The Major Functions


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LO# 4

Key Segregation of Duties

Segregation of duties is a particularly important control in the inventory management process because of the potential for theft and fraud.


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LO# 4

Key Segregation of Duties



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LO# 5

Inherent Risk Assessment

The auditor should consider industry-related factors and operating and engagement characteristics when assessing the possibility of a material misstatement.

If industry competition is intense,there may be problems with the proper valuation of inventory.Technology changes in certainindustries may also promotematerial misstatement due toobsolescence.

Products that are small and ofhigh value are more susceptibleto theft. The auditor must bealert to related-party transactionsfor acquiring raw materials andselling finished products. Prior-yearmisstatements are good indicatorsof potential misstatements in thecurrent year.


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Plan and perform tests of controls on inventory transactions.

Set and document the control risk for the inventory management process.

LO# 6

Control Risk Assessment

Major steps in setting the control risk in the inventory management process.

Understand and document the inventory management process based on a reliance strategy.



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LO# 7 transactions.

Control Activities and Tests of Controls – Inventory Transactions


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LO# 7 transactions.

Control Activities and Tests of Controls – Inventory Transactions

Occurrence of Inventory Transactions

The auditor’s main concern is that all recorded inventory exists. The auditor should also be concerned that goods may be stolen. Review and observation are the main tests of controls used by the auditor to test the control procedures.


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LO# 7 transactions.

Control Activities and Tests of Controls – Inventory Transactions

Completeness of Inventory Transactions

The primary control procedure for completeness relates to recording inventory that has been received. Controls are closely related to the purchasing process.


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LO# 7 transactions.

Control Activities and Tests of Controls – Inventory Transactions

Authorization of Inventory Transactions

The auditor’s concern with authorization in the inventory system is with unauthorized purchase or production activity that may lead to excess levels of certain types of finished goods.


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LO# 7 transactions.

Control Activities and Tests of Controls – Inventory Transactions

Accuracy of Inventory Transactions

Inventory transactions that are not properly recorded result in misstatements that directly affect the amounts reported in the financial statements. Inventory purchases must be recorded at the correct price and actual quantity received. Inventory shipped must be properly recorded in cost of goods sold and the related revenue recognized.


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LO# 7 transactions.

Control Activities and Tests of Controls – Inventory Transactions

Classification of Inventory Transactions

The client must have control procedures to ensure that inventory is properly classified as raw materials, work in process, or finished goods. By knowing which manufacturing department holds the inventory, the auditor is able to classify it by type.


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LO# 8 transactions.

Relating the Assessed Level of Control Risk to Substantive Procedures


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LO# 8 transactions.

Relating the Assessed Level of Control Risk to Substantive Procedures


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LO# 8 transactions.

Relating the Assessed Level of Control Risk to Substantive Procedures



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LO# 9 transactions.

Auditing Inventory

Substantive Analytical Procedures


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Tests of Details transactions.


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LO# 10 transactions.

Auditing Inventory

Auditing Standard Costs

MaterialTest the quantity and type of materials included in the product and the price of the materials.

LaborGather evidence about the type and amount of labor needed for production and the labor rate.

OverheadReview the client’s method of overhead allocation for reasonableness, compliance with GAAP, and consistency.


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LO# 11 transactions.

Auditing Inventory

Observing Physical Inventory

During the observation of the physical inventory count, the auditor should do the following:

  • Ensure that no production is scheduled. If production is scheduled proper controls must be established for movement between departments in order to prevent double counting.

  • Ensure that there is no movement of goods during the inventory count.

  • Make sure that the client’s count teams are following the inventory count instructions.

  • Ensure that inventory tags are issued sequentially to individual departments.


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LO# 11 transactions.

Auditing Inventory

Observing Physical Inventory (continued)

  • Perform test counts and record a sample of counts in the working papers.

  • Obtain tag control information for testing the client’s inventory compilation.

  • Obtain cutoff information, including the number of the last shipping and receiving documents issued.

  • Observe the condition of the inventory for items that may be obsolete, slow moving, or carried in excess quantities.

  • Inquire about goods held on consignment for others or held on a “bill-and-hold” basis.


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LO# 12 transactions.

Tests of Details of Transactions, Account Balances, and Disclosures


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LO# 12 transactions.

Tests of Details of Transactions, Account Balances, and Disclosures


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LO# 12 transactions.

Tests of Details of Transactions, Account Balances, and Disclosures


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LO# 13 transactions.

Tests of Details of Transactions, Account Balances, and Disclosures

  • Possible causes of book-to-physical differences:

  • Inventory cutoff errors.

  • Unreported scrap or spoilage.

  • Pilferage or theft.


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LO# 13 transactions.

Tests of Details of Transactions, Account Balances, and Disclosures

  • Examples of Disclosure Items:

  • Cost method (FIFO, LIFO, retail method).

  • Components of inventory.

  • Long-term purchase contracts.

  • Consigned inventory.

  • Purchases from related parties.

  • LIFO liquidations.

  • Pledged or assigned inventory.

  • Disclosure of unusual losses from write-downs.

  • Warranty obligations.


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LO# 14 transactions.

Evaluating the Audit Findings - Inventory

At the conclusion of testing, the auditor should aggregate all identified misstatements. The likely misstatement is compared to the tolerable misstatement allocated to the inventory account.

Likely misstatement < Tolerable misstatementThe auditor may accept the inventory account as fairly presented.

Likely misstatement > Tolerable misstatementThe auditor may conclude the inventory is not fairly presented.


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Questions transactions.


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End of Chapter 13 transactions.