Audit of the Inventory

and Warehousing
Cycle
Learning Objective 1

Describe the business functions

and the related documents and
records in the inventory and
warehousing cycle.
Flow of Inventory and Costs
Raw Materials Work in Process
Beginning Raw Beginning Cost of
inventory materials inventory goods
used manufactured
Purchases Ending
inventory
Ending
inventory
Cost of
Direct Labor Finished Goods goods sold
Actual Applied Beginning Cost of
inventory goods sold
Manufacturing Overhead
Ending
Actual Applied inventory
 Functions in the Inventory and
Warehousing Cycle
Process Receive Store Process Store Ship
purchase raw raw the finished finished
orders materials materials goods goods goods

Put Put Put

Flow Receive Ship
materials materials completed
of raw finished
in in goods in
inventory materials storage production storage
goods
Learning Objective 2

Describe how e-commerce

affects inventory management.
How E-Commerce Affects
Inventory Management
The Internet enables clients to provide
expanded descriptions of their
inventory on a real-time basis.

The use of the Internet and other e-commerce

applications may lead to financial reporting
risks if access to inventory databases and
systems is not adequately controlled.
Learning Objective 3

Explain the five parts of the audit

of the inventory and warehousing
cycle.
Audit of Inventory
Part of audit Cycle in which tested
Acquire and record Acquisition and
raw materials, labor, payment plus
and overhead. payroll and personnel

Internally transfer Inventory and

assets and costs. warehousing
Audit of Inventory
Part of audit Cycle in which tested
Ship goods and record
Sales and collection
revenue and costs.

Physically observe Inventory and

inventory. warehousing

Price and compile Inventory and

inventory. warehousing
LO 4: Acquisition and Payment Cycle

The acquisition and payment cycle includes identifying

products or services, purchasing, receiving, approving
payments, and paying for goods and services received
Major accounts include inventory, cost of goods sold, accounts
payable, and expenses
Acquisition and payment cycle consists of five distinct activities:
Requisition for goods or services
Purchase of goods or services according to company policies
Receipt of goods and services
Approval of items for payment
Cash disbursements
Automated Purchasing System

Networked software system linking to vendors whose

offerings and prices have been preapproved by
appropriate management
Automated purchasing system will perform the following
beneficial tasks:
Apply preloaded specifications and materials lists to the system to
start the process
Automatically flag invoices that don’ t reconcile with purchase orders
Create change orders and variance purchase orders
Integrated Audit of the Acquisition and
Payment Cycle
Phases I and II of the Audit Opinion
Formulation Process
Continually update information on business risk
Analyze potential motivations to misstate accounts in the acquisition
and payment cycle
Perform preliminary analytical procedures to determine if unexpected
relationships exist in the accounts
Develop an understanding of the internal controls in the acquisition and
payment cycle that are designed to address the risks identified in the
three previous steps
Integrated Audit of the Acquisition and
Payment Cycle
Phases III and IV of the Audit
Opinion Formulation Process
Determine the important controls that need to be tested
Develop a plan for testing internal controls and perform the tests
of key controls in the acquisition and payment cycle
Analyze the results of the tests of controls
Perform planned substantive procedures based on the potential
for misstatement and the information gathered
Risks Related to the Acquisition and
Payment Cycle
Acquisition cycle deals with receipt of all goods and
services
Misstatements may occur just because of the volume of
transactions
Frauds that have taken place include the following:
Employee theft of inventory
Employee schemes involving fictitious vendors as means to transfer
payments to themselves
Executives misusing travel and entertainment accounts and charging
them as company expense
Schemes to classify expenses as assets
Manipulation of “ restructuring reserves” to manage future income
Risks Related to the Acquisition and
Payment Cycle
Number of potential fraud indicators that
affect the cycle include:
Inventory growing at a rate greater than sales
Expenses significantly above or below industry norms
Capital assets growing faster than the business and for
which there are not strategic plans
Significant reduction of “ reserves”
Risks Related to the Acquisition and
Payment Cycle (continued)
Expense accounts that have significant credit entries
Travel and entertainment expense accounts that do not
have documentation
Inadequate follow-up to auditor recommendations on
needed controls
Payments made to senior officers in the form of loans
that are subsequently forgiven
Preliminary Analytical Procedures for
Possible Misstatements
Analytical procedures to identify potential misstatements:
Calculate and analyze dollar and percentage change in inventory,
cost of goods sold, and expense accounts
Compute and analyze ratios like inventory turnover and number of
day’ s sales in inventory
Prepare common sized income statement to identify cost of good
sold or expense accounts that are out of line
Auditor compares client analytics to past client
performance, industry results, and auditor’ s
expectations
Linking Internal Controls and
Financial Statement Assertions
Requisition of goods and services
Need identified
Pre-numbered requisition form completed and sent to
purchasing
Purchase goods or services
Purchase order shows quantity and price of goods ordered,
quality specifications, shipping terms
Purchase orders are pre-numbered to establish completeness
Linking Internal Controls and Financial
Statement Assertions (continued)
Purchase orders must be properly authorized
Many companies have separate purchasing department:
Promotes efficiency and effectiveness
Eliminates potential favoritism
Reduces the opportunity for fraud
Centralizes control in one function

Receipt of Goods and Services

Receiving department should ensure
Linking Internal Controls and Financial
Statement Assertions (continued)
Only authorized goods are received
The goods meet order specifications
An accurate count of goods received is taken
All receipts of goods are recorded
Receiving reports are pre-numbered to establish
completeness
Receiving department records quantity of goods received
Goods also inspected for quality
Receiving reports sent to accounting
Linking Internal Controls and Financial
Statement Assertions (continued)
Approve payment
Accounting matches vendor invoice, purchase order, and
receiving reports - If quality and quantity match,
account payable is recorded
The match can occur as:
Traditional Manual Matching
Automated Matching

Cash disbursement
Linking Internal Controls and Financial
Statement Assertions (continued)

Supporting documentation is reviewed and approved

for payment
Documents are marked “ paid” to avoid duplicate
payment
Design, Perform and Analyze Results
of Tests of Controls
The primary risk is that Accounts Payable and expenses will
be understated
Therefore, controls related to the following are usually
significant:
Proper authorization
Completeness of recording
Timeliness of recording
Correctness of valuation
Attribute sampling may be used to test control operation
The level of assessed control risk will impact the rigor of the
subsequent substantive testing of Accounts Payable and
expenses
Substantive Tests of Accounts Payable

The auditor’ s main concern is that

Accounts Payable will be understated
Therefore, emphasis is placed on testing
the completeness assertion
Typical substantive tests include:
Analytical review of related accounts
Tests of subsequent disbursements
Reconcile vendor statements or confirm accounts payable
Analytical Review of Related Expense
Accounts
Used to determine if accounting data
indicates understatement of expenses
If understatement likely, auditor expands
tests of accounts payable
Analytics used on clients with low control
risk
Testing Subsequent Disbursements

Auditor samples cash disbursements after the end

of the year
Determines if disbursements are for audit year
transactions by vouching back to source
documents (purchase order, vendor invoice,
receiving report)
If disbursement is for audit year transaction,
auditor reprocesses the transaction to see if it
was properly recorded as a payable
Reconciling Vendor Statements or
Confirmations with Payables

Auditor requests vendors’ monthly

statements or sends confirmation to
major vendors
Auditor reconciles vendor statement or
confirmation with client balance in the
accounts payable subsidiary ledger
Substantive Tests of Expense Accounts

Auditing payables and cash disbursements

provides indirect evidence about expense
accounts
Additional analysis of selected expense accounts
is usually merited
The auditor should consider management is
more likely to
Understate rather than overstate expenses
Classify expenses as assets rather than vice versa
Substantive Tests of Expense Accounts
(continued)

Substantive audit procedures include:

Detailed tests of transactions
Analytical review
Review of unusual entries
Learning Objective 5

Design and perform audit tests

of cost accounting.
Cost Accounting Controls

1. Physical controls over raw

materials, work in process,
and finished goods inventory

2. Controls over the related costs

Methodology for Designing Tests of
Balances – Accounts Receivable
Understand internal Assess planned control
control – cost risk – cost
accounting system. accounting system.

Determine extent of testing controls.

Design tests of controls and substantive tests of

transactions for the cost accounting system
to meet transaction-related audit objectives.

Audit Sample Items to

Timing
procedures size select
Tests of Cost Accounting

Physical Controls

Documents and records for

transferring inventory

Perpetual inventory master files

Unit cost records

Learning Objective 6

Apply analytical procedures to

the accounts in the inventory
and warehousing cycle.
 Analytical Procedures for
Manufacturing Equipment
Analytical procedure Possible misstatement
Overstatement or
Compare gross margin
understatement of
percentage with that of
inventory and cost
previous years.
of goods sold
Obsolete inventory
Compare inventory turnover
(cost of goods sold divided by
Overstatement or
average inventory) with that
understatement
of previous year.
of inventory
 Analytical Procedures for
Manufacturing Equipment
Analytical procedure Possible misstatement
Overstatement or
Compare unit costs of understatement of unit
inventory with those costs, which affect
of previous years. inventory and cost of
goods sold
Misstatements in
Compare extended inventory compilation, unit costs, or
value with that of previous extensions, which affect
years. inventory and cost of
goods sold
 Analytical Procedures for
Manufacturing Equipment
Analytical procedure Possible misstatement
Misstatements of unit costs
Compare current year
of inventory, especially
manufacturing costs with those
direct labor and
of previous years (variable
manufacturing overhead,
costs should be adjusted for
which affect inventory and
changes in volume).
cost of goods sold
Methodology for Designing Tests
of Balances – Other Accounts
Phase I

Identify client risks affecting the inventory and

warehousing cycle.

Set tolerable misstatement and assess inherent

risk for the inventory and warehousing cycle.

Assess control risk for several cycles.

Methodology for Designing Tests
of Balances – Other Accounts
Phase II

Design and perform tests of controls and

substantive tests of transactions
for several cycles.
Methodology for Designing Tests
of Balances – Other Accounts
Phase III

Design and perform analytical procedures

for the inventory and warehousing cycle.

Design tests of details of inventory to satisfy

balance-related audit objectives.
Audit Sample Items to
Timing
procedures size select
Learning Objective 7

Design and perform physical

observation audit tests
for inventory.
Controls

Proper instructions for the physical count

Supervision by responsible personnel

Independent interval verification of the counts

Independent reconciliations of the physical

counts with perpetual inventory master files

Adequate control over count sheets or tags

Audit Decisions

Timing
Sample
size

Selection
of items
Physical Observation Tests

The most important part of the observation of

inventory is determining whether the physical
count is being taken in accordance with the
client’s instructions.
Balance-Related Audit Objectives:
Physical Inventory Observation
Inventory as recorded
Existence
on tags exist.

Existing inventory is
Completeness
counted and tagged.

Inventory is counted
Accuracy
accurately.
Balance-Related Audit Objectives:
Physical Inventory Observation
Inventory is classified
Classification
correctly on the tags.

Transactions are recorded

Cutoff
in the proper period.
Balance-Related Audit Objectives:
Physical Inventory Observation
Obsolete and unusable
Realizable
inventory items are
Value
excluded or noted.

The client has rights

Rights to inventory recorded
on tags.
Learning Objective 8

Design and perform audit tests

of pricing and compilation
for inventory.
Audit of Pricing and Compilation

Inventory price tests

Inventory compilation tests

Audit of Pricing and Compilation

Pricing and compilation controls

Pricing and compilation procedures

Valuation of inventory
Balance-Related Objectives:
Inventory Pricing and Compilation

Detail tie-in Existence

Completeness Accuracy
Balance-Related Objectives:
Inventory Pricing and Compilation

Realizable
Classification
value

Presentation
Rights
and disclosure
Valuation of Inventory

Pricing purchased inventory

Pricing manufactured inventory

Cost or market
Learning Objective 9

Integrate the various parts of

the audit of the inventory
and warehousing cycle.
Interrelationship of Various
Audit Tests
Tests of acquisition
and payment cycle

Raw materials Work in process

Acquisitions of Other manufacturing
raw materials overhead

Raw material used Raw material used

Interrelationship of Various
Audit Tests
Tests of payroll and
personnel cycle

Work in process Work in process

Direct labor Indirect labor
Interrelationship of Various
Audit Tests
Inventory tests
• Tests of cost accounting records
• Tests of physical inventory observation
• Tests of pricing and compilation

Raw materials Work in process

Ending inventory Ending inventory

Finished goods
Ending inventory
Interrelationship of Various
Audit Tests
Work in process Finished goods
Cost of goods Cost of goods
manufactured manufactured

Finished goods
Tests of sales
and Cost of goods sold
collection cycle
End of Presentation