4

MODULE
AUD 4

Inventory Cycle AUD 4

1 Controls Related to the Inventory Cycle

Controls over inventory purchases and sales were covered in the sections on the revenue cycle
and the expenditure cycle. For inventory held by the entity, a proper system of internal control
includes adequate safeguarding of inventory and proper segregation of duties.
The following duties should be segregated:

1. Purchasing
Serially numbered, properly approved purchase orders should be prepared and issued to
the accounting and receiving departments.

2. Receiving
The receiving department is solely responsible for the receipt of goods. This department is
responsible for verification of quantities received, detection of damaged goods, preparation
of a receiving report, and delivery of goods received to the warehouse department. The
receiving department should receive a copy of the purchase order that does not indicate the
quantity ordered so the receiving department is forced to count the goods upon arrival.

3. Warehouse
The warehouse department acts as custodian for the verified quantity of goods received.

4. Shipping
The shipping department is responsible for shipment of goods after authorization (in the
form of an approved sales order from the credit department).

2 Performing Specific Procedures to Obtain Evidence:

The Inventory Cycle

2.1 Auditing the Inventory Balance

The observation of the beginning and ending physical inventory counts is a required generally
accepted auditing procedure. Attendance by the auditor at the physical inventory count involves
the following dual-purpose tests:
1. evaluating management's instructions and procedures for the inventory count;
2. observing the performance of management's count procedures;
3. inspecting the inventory to ascertain its existence and condition; and
4. performing test counts.
An auditor who is not present to observe the physical inventory must use alternative procedures
to justify any opinion expressed. This is acceptable when it is impractical or impossible to
observe physical inventory, or when inventories are not material.

© Becker Professional Education Corporation. All rights reserved. Module 4 A4–25

4 Inventory Cycle AUD 4

If the company maintains a well-kept perpetual inventory system and performs physical cycle
counts throughout the year to ensure accuracy, the auditor may observe the inventory before
or after year-end if necessary. If inventory counting is done at a date other than the date of the
financial statements, the auditor should obtain evidence about whether changes in inventory
between the count date and the financial statement date are recorded properly. If the assessed
level of control risk is high, the observation procedures should be performed at year-end.
The auditor should observe the physical inventory count of goods held off-site in public
warehouses or on consignment if the inventory held therein is significant; otherwise,
confirmation of such inventory is sufficient.

Pass Key

Candidates sometimes believe that "inventory observation" implies that the auditor counts
the client's inventory. This is not the case—the client counts the inventory, and the auditor
simply observes. The auditor may make test counts of certain items, but generally the
auditor would not count the client's entire inventory.

Auditing the Inventory Cycle

Company Ex
ce Inventory ist
en en
Com
ist ess report c
leten ple
te e
Ex

p n
m
es
Co

CPA Company
Test Prenumbered
counts inventory tags
Accuracy

Completeness: In conjunction with the inventory observation, the auditor should test
A4_Fig.5
the physical inventory report by tracing test counts to the report, thereby verifying its
completeness. The auditor should also select from a sample of prenumbered inventory tags
and trace to the physical inventory report sheets to test their completeness.
Valuation, Allocation, and Accuracy: The auditor should perform the following procedures:
1. Test the mathematical accuracy of the inventory report and reconcile it to the general
ledger inventory accounts.
2. Inquire about obsolete or damaged goods, scan the perpetual records for slow-moving
items, and be alert during the inventory observation for damaged goods or signs of
obsolescence.
3. Examine vendor invoices, review direct labor rates, test the computation of standard
overhead rates, and examine standard cost variance analyses. These prices and rates
can then be applied to a sample of inventory items to determine whether the inventory
is valued appropriately.

A4–26 Module 4 Inventory

© Becker Professional Education Corporation. All rights reserved. Cycle
AUD 4 4 Inventory Cycle

Existence and Occurrence: The primary purpose of the observation of the client's
inventory count is to establish the existence of inventory. During the observation, the
auditor should verify the existence of a sample of items in the physical inventory report by
locating and performing test counts of the items. The auditor should also test the existence
of the items on the client's inventory report sheets by vouching a sample of items from the
inventory report sheet to the corresponding prenumbered inventory tags.
Rights and Obligations: The auditor should ascertain that consigned inventory on hand
is excluded from the physical inventory count, whereas consigned goods in the hands of
consignees are included in inventory balances. The auditor should also confirm that any
inventory held off-site is properly accounted for at year-end. In addition, inventory in transit
at year-end should be properly accounted for based on shipping terms.

2.2 Auditing Inventory Transactions

Inventory sales and purchases should be audited as part of the audits of the revenue cycle and
the expenditure cycle.

2.3 Auditing Presentation and Disclosure

Completeness: The auditor should ensure that all required disclosures related to inventory
have been included in the notes to the financial statements. Inventory disclosures include:
y Cost method (LIFO, FIFO, weighted average) and valuation method (net realizable value
or lower of cost or market).
y Raw materials, work-in-process, and finished goods inventory balances.
y Consigned inventory.
y Pledged or assigned inventory.
y Significant losses from inventory write-downs or purchase commitments.
y Warranty obligations.
Valuation, Allocation, and Accuracy: The auditor should read the footnotes and other
information related to inventory to determine whether the information is accurate and
presented at the appropriate amounts.
Rights and Obligations, and Occurrence: The auditor should determine that inventory-
related obligations have been properly disclosed by inquiring of management and reviewing
loan agreements and minutes for evidence that inventory has been pledged or assigned.
The auditor should also inquire about warranty obligations. The auditor should compare
disclosures to other audit evidence to ensure that all disclosed information related to
inventory has occurred.
Understandability of Presentation and Classification: The auditor should read all
inventory-related disclosures to ensure that they are understandable. The auditor should
review inventory records for proper classification between raw materials, work in process,
and finished goods.

© Becker Professional Education Corporation. All rights reserved. Module 4 A4–27

4 Inventory Cycle AUD 4

NOTES

A4–28 Module 4 Inventory

© Becker Professional Education Corporation. All rights reserved. Cycle