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Chapter 21

Audit of the Inventory and Warehousing Cycle

Review Questions

21-1 Inventory is often the most difficult and time consuming part of manyaudit engagements because:

1. Inventory is generally a major item on the balance sheet and oftenthe largest item making up the accounts included in working capital.

2. The need for organizations to have the inventory in diverse locationsmakes the physical control and counting of the inventory difficult.

3. Inventory takes many different forms that are difficult for the auditorto fully understand.

4. The consistent application of different valuation methods can be fairlycomplicated.5. The valuation of inventory is difficult due to such factors as the

large number of different items involved, the need to allocate themanufacturing costs to inventory, and obsolescence.

21-2 The acquisition and payment cycle includes the system for purchasing allgoods and services, including raw materials and purchased parts for producingfinished goods. Purchase requisitions are used to notify the purchasing depart-ment to place orders for inventory items. When inventory reaches a predeterminedlevel or automatic reorder point, requisitions may be initiated by stockroom

personnel or by computer. In other systems, orders may be placed for the materialsrequired to produce a customer order, or orders may be initiated upon periodicevaluation of the situation in light of the prior experience of inventory activity.

After receiving the materials ordered, as part of the acquisition and paymentcycle, the materials are inspected with a copy of the receiving document used tobook perpetual inventory. In a standard cost inventory system, the acquisition andpayment cycle computes any inventory purchase variances, which then enter theinventory system.

The following audit procedures in the acquisition and payment cycleillustrate the relationship between that cycle and the inventory and warehousingcycle.

1. Compare the inventory cost entered into the inventory system tothe supporting invoice to determine that it was properly recordedand the purchase variance (standard cost system), if any, was properlyreflected.

2. Test the purchase cutoff at the physical inventory date and year-end to determine whether or not the physical inventory and year-end inventory cutoffs are proper from a purchase standpoint.
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21-3 Cost accounting records are those which are concerned with the processingand storage of raw materials, work in process, and finished goods, insofar asthese activities constitute internal transfers within the inventory and warehousingcycle. These records include computerized files, ledgers, worksheets and reportswhich accumulate material, labor, and overhead costs by job or process as thecosts are incurred.

Cost accounting records are important in conducting an audit becausethey indicate the relative profitability of the various products for managementplanning and control, and determine the valuation of inventories for financialstatement purposes.

21-4 The most important tests of the perpetual records the auditor must makebefore assessed control risk can be reduced, which may permit a reduction inother audit tests are:

1. Tests of the purchases of raw materials and pricing thereof.2. Tests of the cost accounting documents and records by verifying

the reduction of the raw material inventory for use in production andthe increase in the quantity of finished goods inventory when goodshave been manufactured.

3. Tests of the reduction in the finished goods inventory through thesale of goods to customers.

Assuming the perpetuals are determined to be effective, physical inventory testsmay be reduced, as well as tests of inventory cutoff. In addition, an effectiveperpetual inventory will allow the company to test the physical inventory prior tothe balance sheet date.

21-5 The continuation of shipping operations during the physical inventory willrequire the auditor to perform additional procedures to insure that a proper cutoffis achieved. The auditor must conclude that merchandise shipped is eitherincluded in the physical count or recorded as a sale, but not both.

Since no second count is taken, the auditor must increase the number oftest counts to determine that the counts recorded are accurate.

21-6 The auditor must not give the controller a copy of his or her test counts. Theauditor's test counts are the only means of controlling the original counts recordedby the company. If the controller knows which items were test counted, he or shewill be able to adjust other uncounted items without detection by the auditor.

21-7 The most important audit procedures to test for the ownership of inventoryduring the observation of the physical counts and as a part of subsequent valuationtests are:

1. Discuss with the client.2. Obtain an understanding of the client's operations.3. Be alert for inventory set aside or specially marked.

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21-7 (continued)

4. Review contracts with suppliers and customers to test for thepossibility of consigned inventory or inventory owned by others thatis in the client's shop for repair or some other purpose.

5. Examine vendor invoices indicating that merchandise on hand was

sold to the company.6. Test recorded sales just before and just after the physical inventory

to determine that the items were or were not on hand at the physicalinventory date and that a proper cutoff was achieved.

21-8 Auditing procedures to determine whether slow-moving or obsolete itemshave been included in inventory are:

1. Obtain a sufficient understanding of the client's business to aid inrecognizing inventory that is no longer useful in the client's business.

2. Review the perpetual records for slow-moving items.

3. Discuss the quality of the inventory with management.4. Ask questions of production personnel during physical inventory

observation about the extent of the use or nonuse of inventory items.5. Make observations during the physical inventory for rust, damaged

inventory, inventory in unusual locations, and unusual amounts ofdust on the inventory.

6. Be aware of inventory that is tagged obsolete, spoiled, or damaged,or is set aside because it is obsolete or damaged.

7. Examine obsolescence reports, scrap sales, and other records insubsequent periods that may indicate the existence of inventory thatshould have been excluded from the physical inventory or included

at a reduced cost.8. Calculate inventory ratios, by type of inventory if possible, and

compare them to previous years or industry standards.

21-9 The auditor could have uncovered the misstatement if there were adequatecontrols over the use of inventory tags. More specifically, the auditor should haveassured himself or herself that the client had accounted for all used and unusedtag numbers by examining all tags, if necessary. In addition, the auditor shouldhave selected certain tags (especially larger items) and had the client show himor her where the goods were stored. The tag numbers used and unused shouldhave been recorded in the auditor's working papers for subsequent follow-up. As

part of substantive procedures, the auditor could have performed analytical testson the inventory and cost of sales. A comparison of ratios such as gross marginpercentage and inventory turnover could have indicated that a problem waspresent.

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21-10 A proper cutoff of purchases and sales is heavily dependent on the physicalinventory observation because a proper cutoff of sales requires that finishedgoods inventory included in the physical count be excluded from sales and allinventory received be included in purchases.

To make sure the cutoff for sales is accurate, the following informationshould be obtained during the taking of the physical inventory:

1. The last shipping document number should be recorded in theworking papers for subsequent follow-up to sales records.

2. A review should be made of shipping to test for the possibility ofshipments set aside for shipping and not counted or other potentialcutoff problems.

3. When prenumbered shipping documents are not used, a carefulreview of the client's method of getting a proper sales cutoff is thefirst step in testing the cutoff.

4. A list of the most recent shipments should be included in the workingpapers for subsequent follow-up to sales records.

For the purchase cutoff, the following information should be noted:

1. The last receiving report number should be noted in the workingpapers for subsequent follow-up to purchase records.

2. A review should be made of the receiving department to make sureall inventory has been properly included in the physical inventory.

21-11 Compilation tests are the tests of the summarization of physical counts,the extension of price times quantity, footing the inventory summary, and tracingthe totals to the general ledger.

Several examples of audit procedures to verify compilation are:

1. Trace the tag numbers used to the final inventory summary to makesure they were properly included and the numbers not used to thefinal inventory summary to make sure no tag numbers have beenadded.

2. Trace the test counts recorded in the working papers to the finalinventory summary to make sure they are correctly included.

3. Trace inventory items on the final inventory list to the tags as a testof the existence of recorded inventory.

4. Test the extensions and footings of the physical inventory summary.

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ANALYTICAL PROCEDURETYPE OF

POTENTIAL MISSTATEMENT

1. Compare gross margin percentage

with previous years.

Overstatement or understatement of

inventory amounts (prices and/orquantities).

2. Compare inventory turnover withprevious years.

Obsolete inventory.

3. Compare unit costs with previousyears.

Overstatement or understatement of unitcosts.

4. Compare extended inventory valuewith previous years.

Errors in compilation, unit costs, orextensions.

5. Compare current year manufacturingcosts with previous years.

Misstatement of unit costs of inventory,especially direct labor and

manufacturing overhead.

21-13

DATEPURCHASEQUANTITY PRICE

TO BE INCLUDED IN12-31-09 INVENTORY EXTENSION

11-26-09

12-06-09

2,400

1,900

$2.07

$2.28

700 @ $2.07

1,900 @ $2.28

$1,449.00

4,332.00

$5,781.00

Assuming FIFO inventory valuation, the 12-31-09 inventory should be

valued at $5,781, and is thus currently overstated by $121.If the 1-26-10 purchase was for 2,300 binders at $2.12 each, the 12-31-

09 inventory should be valued at $5,477.00 (1,900 @ $2.12 + 700 @ $2.07) andis thus currently overstated by $425. The reason is the lower of cost or market rule,with the $2.12 being the replacement cost.

21-14 The direct labor hours for an individual inventory item would be verifiedby examining engineering specifications or similar information to determine whetherthe number of hours to complete a unit of finished goods was correctly computed.

Ordinarily it is difficult to test the number of hours to an independent source.The manufacturing overhead rate is calculated by dividing the totalannual number of labor hours into total manufacturing overhead. These two totalsare verified as a part of the payroll and personnel and acquisition and paymentcycles.

Once these two numbers are verified (overhead rate per direct laborhour and the number of direct labor hours per unit of each type of inventory), it isnot difficult to verify the overhead cost in inventory.

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21-15 With a job cost system, labor charged to a specific job is accumulated ona job cost sheet. The direct labor dollars included on the job cost sheet can betraced to the employee "job time sheet" to make sure the hours are correctlyincluded on the job cost sheet. The labor rate can be verified by comparing it tothe amount on the employee's earnings record.

21-16 Assuming the auditor properly documents receiving report numbers as apart of the physical inventory observation procedures, the auditor should verifythe proper cutoff of purchases as a part of subsequent tests by examining eachinvoice to see if a receiving report is attached. If the receiving report is dated onor before the inventory date and the last recorded number, the received inventorymust have been included in the physical inventory; therefore the invoice shouldbe included in accounts payable. Those invoices that are received after thebalance sheet date but shipped F.O.B. shipping point on or before the close ofthe year would indicate merchandise in transit.

Multiple Choice Questions From CPA Examinations

21-17 a. (4) b. (2) c. (1)

21-18 a. (1) b. (2) c. (2)

21-19 a. (4) b. (3) c. (2)

Discussion Questions and Problems

21-20

PURPOSE OFINTERNAL CONTROL

TEST OFCONTROL

POTENTIALFINANCIAL

MISSTATEMENT

SUBSTANTIVEAUDIT

PROCEDURE

1. For a proper valuationof inventory.(Accuracy)

Examine receivingand requisitiondocuments, traceto perpetualrecords.

Misstatement ofinventory.

Comparephysical countto perpetualinventoryrecord.

2. To ensure inventoryis recorded whenreceived, payments

made are for goodsreceived, and quantitiesand descriptions areaccurate.(Completeness,existence andaccuracy)

Account for anumericalsequence of

receiving reportsand observematching invoicesreceived fromvendors.

Understatementof inventory orpayment for

goods notreceived.

Trace quantityand descriptionon vendor's

invoice toreceivingreport.

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21-20 (continued)

PURPOSE OFINTERNAL CONTROL

TEST OFCONTROL

POTENTIALFINANCIAL

MISSTATEMENT

SUBSTANTIVEAUDIT

PROCEDURE

3. To minimize theft orunrecorded shipmentsof inventory.(Existence)

Discuss withclient andobserve whetherpersonnelprepare shippingdocuments.

Overstatementof inventory. Comparephysical countto perpetualrecords.

4. To ensure inventoryshipments arerecorded as sales.(Completeness)

Account fora numericalsequence ofshipping orders.

Understatementof sales.

Trace quantityand descrip-tion on bills oflading torecorded sales.

5. To make sure physicalinventory counts areaccurate.(Accuracy, existenceand completeness)

Observe countingpersonnel anddiscuss withclient.


Comparephysical countto perpetualinventoryrecord.

6. To assure reasonablecosts are used forinventory and costof goods sold.(Accuracy)

Reviewproceduresfor determiningstandard costs.


Trace costsfrom supportingdocuments todevelopmentof standards.

7. To make sure obsoletegoods are classifiedas such.(Accuracy)

Read policyand discussprocedures withclient.


Analyticalprocedures forinventory.

8. To make sure inventorycompilation is accurate.(Accuracy)

Observe whocompiles theinventory anddiscuss withclient.


Reperformclerical testsof inventorycompilation.

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a.TRANSACTION-RELATED AUDIT

OBJECTIVE

b.

RELATED RISK

c.

TEST OF CONTROL

1. Recorded transactionsrepresent valid,approved purchases(Occurrence).

If purchasing agents canmake purchases from anyvendor, there is a risk thatpurchasing agents maymake unauthorizedpurchases of items notapproved (for personaluse).

Enter non-valid vendornumbers into thepurchasing system tosee if the relatedtransaction is rejected.

2. Recorded inventorymay not be recorded at

appropriate amounts,due to obsolescence(Accuracy).

Without information aboutthe amount of time

inventory is in the ware-house, management isless likely to identify slowmoving items that shouldbe recorded at the lowerof cost or market.

Select a sample ofinventory items from

the perpetual inventorysystem and recalculatethe number of days eachitem has been present inthe warehouse.

3. Actual shipments ofinventory are recordedin the perpetualinventory records(Completeness).

Shipments of inventorymay occur but not berecorded.

Select a sample of itemsin the warehouse andphysically move them tothe shipping areas to seeif the microchip correctlyremoves those items fromthe perpetual inventoryrecords.

4. Inventory recorded inthe perpetual recordsphysically exists(Occurrence).

Non-inventory warehouseindividuals may removeinventory withoutauthorization.

Observe client personnelin the inventory ware-house and determine ifeach person is authorizedto be in the warehouse.

5. Inventory transactionsare properly classified(Classification).

Equipment or suppliesmay be inaccuratelyclassified as inventory if

they are not physicallyseparated from theinventory.

Observe whetherequipment or suppliesare stored in the same

physical space asinventory.

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21-21 (continued)

a.TRANSACTION-RELATED AUDIT

OBJECTIVE

b.

RELATED RISK

c.

TEST OF CONTROL

6. Recorded inventoryitems are physicallypresent (Occurrence)and recorded atcorrect amounts(Accuracy).

If periodic reconciliationsof inventory records tophysical counts are notperformed, there is a riskthat items may beremoved from thewarehouse withoutknowledge, which wouldresult in overstatedinventory amounts.

Inspect the clients testsamples for accuracy andreasonableness. Inquireabout the nature ofdiscrepancies identified.

7. Actual inventory on

hand may not berecorded in theperpetual inventorylisting (Completeness).

There is a risk that

inventory on hand is notincluded in the inventoryrecords.

Inspect the clients test

samples for accuracy andreasonableness. Inquireabout the nature ofdiscrepancies identified.

8. The perpetualinventory records areaccurately summarizedand posted to thegeneral ledgeraccounts (Posting andSummarization)

There could be errors inthe mathematicalformulas of the inventoryrecords.

Recalculate the inventoryamounts and determinethat the totals agree to thegeneral ledger balances.

9. Recording inventorytransactions representactual receipts ofinventory items(Occurrence).

Inventory could be addedto the inventory accountbalance before actualgoods are received.

Enter an addition to theperpetual inventorysystem without a validreceiving report number todetermine if the systemrejects the transaction.

10. Recording of inventoryin the clients recordsis valid (Occurrence)

Inventory held onconsignment may berecorded as the clientsinventory.

Observe whetherinventory held onconsignment is stored inthe same physical spaceas inventory.

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21-22 a. It is important to review the cost accounting records and test theiraccuracy for the following reasons:

1. The cost accounting records determine unit costs that areapplied to derive inventory values. Since inventory is usuallymaterial, unit costs must be verified.

2. In many companies, there are many types of inventory itemswith complex cost structures. The potential for misstatementis great in determining costs. The auditor would need to goto an extreme effort to verify such costs without being able torely on the cost accounting records which provides the costs,(i.e., it is far more efficient to test the cost accounting recordsthan the costs themselves).

3. The cost accounting records also deal with transferringinventories through the production cycle and then from finishedgoods for sales. These transfers must be handled accuratelyfor inventory to be properly stated.

b. 1. Examine engineering specifications for expected (standard)labor hours. Examine time records for hours worked on partduring measured period. Divide by units produced to testreasonableness of standard.

2. Review specifications for types of labor required to produceparts, or observe production. Review union contracts orearnings records to develop reasonable rate for this labor mix.

3. Identify appropriate overhead accounts, paying carefulattention to consistent application. Determine amounts forthese accounts for a measured period. Determine direct labor

hours from payroll records from the same period. Computethe overhead rate per direct labor hour.

4. Review engineering specifications. Review material usagevariance.

5. Trace to vendor's invoices. Review material price variance.6. Sum individual components.

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AUDITPROCEDURE TYPE OF TEST PURPOSE

1 Test of Control To make sure that proper

controls exist and are beingfollowed in the taking of thephysical inventory.(Existence, completeness,accuracy and classification)

2 Substantive Test To ensure that all inventoryrepresented by an inventorytag actually exists.(Existence)

3 Substantive Test To test the accuracy of theclient's perpetual inventory

records.(Existence, completeness,and accuracy)

4 Substantive Test To test client's final inventorycompilation.(Existence, completeness,accuracy and classification)

5 Substantive Test To test that the final inventorywas valued at its proper cost.(Accuracy)

6 Test of Control To ensure that no raw materialwas issued without properapproval.(Existence)

7 Test of Control orSubstantive Test

To ensure that additionsrecorded on the finished goodsperpetual records wererecorded on the books ascompleted production.(Accuracy and classification)

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MISSTATEMENT

a.CONTROL THATSHOULD HAVE

PREVENTED

THE MISSTATEMENTFROM OCCURRING

b.SUBSTANTIVE

AUDIT PROCEDURETHAT COULD BE

USED TO UNCOVERTHE MISSTATEMENT

1 Internal verification byanother person.

Examine vendors' invoices insupport of prices used.

2 Keep a record of the lastshipping report numbershipped before the inventorycount.

Examine bills of lading for firstshipments recorded after thephysical inventory to determinethat they were shipped afteryear-end.

3 Perform independent

second counts on allmerchandise. All personsresponsible for inventorytags and compilation ofphysical inventory should beindependent of custody ofperpetual inventory records.

Record test counts and trace to

compiled inventory.

4 Use of prenumbered tagsand accounting fornumerical sequence.

Account for all prenumberedtags during the physicalexamination and duringcompilation tests.

5 Internal verification ofperpetual inventory prices.

Compare vendor invoice pricesto perpetual inventory prices.

6 Segregation of obsoleteinventory.

Perform net realizable valueand lower of cost or markettests of inventory, includingtests of the perpetual inventory.

7 Periodic review ofreasonableness ofmanufacturing overheadrate.

Test reasonableness ofmanufacturing overhead rate.

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21-25 a.

Internal Controls Tests of Controls

1. Inventory purchases areused to update the

perpetual Atlanta inventoryrecords.

Trace inventory quantities for a sampleof purchase transactions to the perpetual

inventory records as a part of tests ofcontrols and substantive tests ofacquisition transactions.

2. Transfers of inventory areused to update the Atlantaand local distribution centerperpetual inventory records.

Trace inventory quantities for a sampleof shipments from Atlanta to localdistribution centers to the perpetualinventory records.

3. Inventory sales are used toupdate the local distributioncenter perpetual inventory

records.

Trace inventory quantities for a sampleof sales transactions to the perpetualinventory records as a part of tests of

controls and substantive tests of salestransactions.

4. Local distribution centersaccess to perpetual recordsis restricted to processingsales transactions.

Test the effectiveness of the perpetualrecords access restrictions using theCPA firms computer audit specialists.

5. Quarterly physical inventoryis taken for comparison toand adjustment of perpetualrecords.

Examine local distribution center physicalinventory count records and adjustmentsto the perpetual records.

6. Internal auditors test theperpetual recordscontinuously.

Examine internal auditor audit programsand working papers for their tests of theperpetual records and the findings.

7. Internal auditors sampleinventory counts and testinventory adjustments.

Examine internal auditor audit programsand working papers for their tests of thephysical observation of inventory and thefindings.

b. There are four ways to reduce physical observation of inventory.Auditors will use their judgment to decide which combination of these

to use.

1. Reduce the number of local warehouses to observe inventorycounting and do test counts of inventory.

2. Reduce the number of auditors who observe the inventorycounting at each location.

3. Reduce the sample sizes for test counts inventory.4. Perform the physical observation of inventory at an interim date.

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21-26 a. When the inventory is a material item in the financial statementsthat the CPA is auditing, his or her observation of the taking of thephysical inventory is in compliance with the auditing standardpertaining to field work that requires obtaining sufficient appropriateevidence to afford a reasonable basis for an opinion regarding thefinancial statements. Observation is a generally accepted auditing

procedure applied in the audit of the physical inventory.By observing the taking of the physical inventory, the CPA is

seeking to satisfy himself or herself as to the effectiveness andapplication of the methods of inventory taking and as to the measureof reliance which may be placed upon the client's inventory recordsand its representations as to inventory quantities. He or she mustascertain that the physical inventory actually exists, that theinventory quantities are being determined by reasonably accuratemethods, that the inventory is in a salable or usable condition, andthat consigned goods are not commingled with owned goods.

b. The CPA makes test counts of inventory quantities duringobservation of the taking of the physical inventory to satisfy himselfor herself that an accurate count is being made by the individualstaking the inventory. The extent of test counting will be determinedby the inventory taking procedures; for example, the number of testcounts would be reduced if there were two teams, one checking theother, taking the inventory. On the other hand, the test counts wouldbe expanded if misstatements were found in the inventory counts.

Some test counts are recorded by the CPA for the purpose ofsubsequent comparison with the client's compilation of the inventory.The comparison procedure goes beyond the mere determination that

quantities have been accurately transcribed. The CPA also seeksassurance that the description and condition of the inventory itemsis accurate for pricing purposes and that the quantity information,such as dozen, gross, cartons, etc., is proper.

Another reason for recording test counts in the working papersis to provide evidence of the extent of tests in the event that auditprocedures are questioned at some future date.

c. 1. The CPA does not regard the inventory certificate as asatisfactory substitute for his or her own audit of the inventory.The service company has merely assumed the client's functionof taking the physical inventory, pricing it, and making the

necessary extensions. To the extent that the service companyis competent, the system of internal control with regard tothe inventory has been strengthened. Nevertheless, as theCPA would under other strong systems of internal control, heor she would investigate the system to determine that it isoperating in a satisfactory manner. The CPA's investigationwould necessarily entail an observation of the taking of theinventory and testing the pricing and calculation of the inventory.

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21-26 (continued)

2. The inventory certificate of the outside specialists would haveno effect upon the CPA's report. The auditor must be satisfiedthat the inventory was fairly stated by observing the taking ofthe inventory and testing the pricing and compilation of the

inventory.On the other hand, if the taking of the inventory was not

observed and no audit tests were applied to the computationof the inventory, the CPA would be compelled to disclaim anopinion on the financial statements as a whole if the amountof the inventory is material.

If it is impractical or impossible for the CPA to observethe taking of the physical inventory, but he or she is able todetermine that inventory is fairly stated by the application ofother auditing procedures, the CPA would be able to issue anunqualified opinion.

3. The CPA would make no reference to the certificate of theoutside specialists in his report. The outside specialists areserving as adjuncts of the company's staff of permanentemployees. The outside specialists are not independent.

21-27 a. The auditor in this situation should observe the recording of theshipments on the day of occurrence and record these details in theworking papers so a determination can be made as to whether theshipments affected the physical inventory count.

b. 1. There is no clear-cut answer to sample size for inventorycounts. The answer to the question depends on additionalfactors, such as the randomness of your test counts andwhether the values of the merchandise are relatively stratified.It also depends on inherent risk for inventory physical countsand the materiality of inventory compared to total assets.

2. Request a recount by the client or greatly expand your teststo determine whether a material misstatement exists.

c. The auditor should determine how this inventory is valued and afterdiscussion with the client it may be well to classify it as obsolete. In

all cases, the auditor must specifically identify the merchandise inthe working papers for subsequent evaluation. The auditor shouldalso be aware that this could be an indication of widespreadobsolescence problems in other parts of the inventory.

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21-27 (continued)

d. One of the important tasks the auditor undertakes during theobservation is to determine that inventory tags are physicallycontrolled. This assures that the inventory is not understated becausetags are lost, or overstated because falsified tags are added. In this

situation, the auditor should recover the discarded tags and requestthat the practice be stopped, and that control of tags be establishedunder the auditors direct observation.

21-28 The following procedures should be established to insure that theinventory count includes all items that should be included and that nothing iscounted twice:

1. All materials should be cleared from the receiving area and storedin the appropriate space before the count.

2. Incoming shipments of unassembled parts and supplies should beheld in the receiving area until the end of the day and then inventoried.

3. If possible, the day's shipments of finished appliances should betaken to the shipping area before the count. (Unshipped itemsremaining in the shipping area should be inventoried at the end ofthe day.)

4. Great care must be exercised over goods removed from thewarehouse itself. These may be unassembled parts and suppliesrequisitioned on an emergency basis or unscheduled shipments of

finished appliances. Alternative methods for recording these removalsare:

a) Keep a list of all items removed and indicate on the list whetherthe item had been counted.

b) Record the removal on the inventory tag if the item has beeninventoried.

c) Indicate on the material requisition or the shipping order thatthe item had been inventoried. For any of these alternatives,a warehouse employee or the perpetual inventory clerk mustadjust the recorded counts.

5. The finished appliances remaining in the warehouse should beinventoried at the end of the day.

6. The warehouse should be instructed to date all documents as ofthe day the materials are received, issued, or shipped.

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21-28 (continued)

7. The inventory clerk should post the May 31 production and shipmentof finished goods to the inventory record based upon the datesshown on the plant production report and the shipping report. Thiswill provide a proper cutoff because provisions have been made to

adjust all counts for goods manufactured and shipped on May 31.

8. The listing of inventory differences should be reviewed by the controllerand warehouse supervisor prior to booking the adjustment. Abnormaldifferences should be investigated, and recounts (with appropriatereconciliation) should be made where appropriate.

21-29

a. Ratios are calculated as follows

Gross margin % 52% 52% 51%

Inventory turnover 5.6 5.9 5.9

b. This ratio should be compared against industry averages. Thegross margin represents the percent of total sales revenue that thecompany retains after incurring the direct costs associated withproducing the goods and services sold by a company. The higher

the percentage, the more the company retains on each dollar ofsales to service its other costs and obligations.

c. This ratio should be compared against industry averages. A lowturnover implies poor sales and, therefore, excess inventory. A highratio implies either strong sales or ineffective buying.

d. Inquiry with management, review supporting documentatione. There are no wide swings in the ratios, and the ratios are close to

industry average. Assuming there is no other reason to expectchanges (major changes within the company structure, majorchanges to the economy), the analytical procedures seemreasonable and most likely do no warrant changes to the overall

audit plan.

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21-30 a.

1. Exclude2. Exclude

3. Include4. Include5. Exclude

b. 1. This merchandise would be excluded because title does notpass to buyer on an F.O.B. destination shipment until deliveryto the buyer. Since it was not received until January 2010,there is no basis for including it in inventory.

2. Goods held "on consignment" do not belong to the consignee,and should not be included in inventory.

3. Normally title to a stock item does not pass to the customer

until shipment, even though it has been set aside. Thereforeit should be included in inventory.

4. Title to goods shipped F.O.B. shipping point normally passesto the buyer on delivery to the transportation agency, and inthis instance the goods belong to your client at December31, 2009. There is an error in recording the acquisition.

5. Since this machine is fabricated to the customer's order, titleto customer made-merchandise passes to the buyer asmaterials and labor are appropriated to the job. When the jobis completed and ready for shipment as in this case, it maybe considered as a completed sale.

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21-31 a. Inventory observation locations are unannounced so that theclient does not have the opportunity to move inventoryaround in order to present a more favorable situation, if theywere inclined to do so.

b. Sheet to Floor tests for existence, floor to sheet tests forcompleteness. Existence tests that items recorded on theF/S physically exist on the floor; completeness tests that allitems on the floor are recorded on the F/S. Generallyexistence is the more relevant assertion for assets such asinventory, but there are always exceptions to the rule.

c. Exceptions noted:

a) Client count differs from client records. Will be

adjusted by clientb) Auditor count differs materially from client count.

Auditor will request client recount.c) Auditor count differs not materially from client count.

No recount or adjustment needed.d. Task 2 is satisfied appropriately. Although subjective, if there

are 10 counters, I would speak to at least 3 counters if notmore.

e. The exceptions found in Task 3 could result in incorrectcounts as the purpose of having two people count the same

section is to verify if they count at the same time thisfeature is lost. Also, if the counters dont remove the objectsfrom the shelves, they may miscount the items in the back sometimes the shelf is not full or there are obstructions in theback which mean there will be gaps in the stacks. It is moreimportant that the count is performed in accordance withinstructions rather than the physical count is absolutelycorrect because you cant check all of the results, but youcan check the process. If the process is not correct you aremuch more likely to have errors in the results. If the processis sound, you are more likely to have more accurate results.

To follow up, you would speak to the Count Manager toensure that the count procedures are being followedproperly. Once this has occurred, you would continue toobserve count procedures to be sure that the procedures arebeing followed correctly.

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21-32 a. Inventory per Schedule to Inventory Observed During Audit.Existence testing tells you that all items listed in inventory, per thebooks, actually exist on the lot. The risk is that inventory will beoverstated with inventory that does not actually exist. This is way forcompanies to improve their balance sheets fraudulently.

b. Inventory Observed During Audit to Inventory per Schedule.Completeness testing tells you that all items seen on the lot arerecorded in the financial statements. The risk is that inventory willbe understated as inventory may be left off the financial statements.This is generally considered a lower risk than existence, which isthe same for all other assets.

c. See chart below:

d. Auditor notes that no items with tag AU07 are found in records.Auditor notes that all items appear to exist and list appearscomplete. Auditor would follow up on possible obsolescence of oldinventory. No material changes noted, no changes to the audit plandeemed necessary.

Item number Item Description Tag No. Item appears

on lot?

1001-08 Earth mover, 1988, yellow AU05 Yes1002-08 Front loader, 2002, green AU06 Yes1003-08 Backhoe, 2000, yellow AU03 Yes1004-08 Earth mover, 2004, green AU02 Yes1005-08 Dump Truck, 2000, yellow AU04 Yes1006-08 Steam Roller, 1997, yellow AU01 Yes

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Case

21-33

a. Assertion is accuracy. Audit purpose is to check that inventory isproperly valued. Risk is overstatement of asset.

b. All items appear to be valued properly except for the bumpers. Itappears that the last price ($210) was applied to the entire 1,000bumpers instead of applying 500 @ $200 and 500 @ $210 as perthe FIFO method.

qty perinvoice

$ perinvoice need

qtyFIFO $ FIFO ext

Struts3,000 $ 35.00 4,000 3,000 $ 35.00

$105,000

2,000 $ 40.00 1,000 $ 40.00$40,000

Tires 4,000 $ 25.00 4,000 4,000 $ 25.00$

100,000

fastners 4,000 $ 2.00 10,000 4,000 $ 2.00$8,000

4,000 $ 2.10 4,000 $ 2.10$8,400

4,000 $ 2.50 2,000 $ 2.50$5,000

4,000 $ 2.60 - $ 2.60 $ -

bumpers 500 $ 200.00 1,000 500 $ 200.00$

100,000

500 $ 210.00 500 $ 210.00$

105,000

c. The variance for the error found is $5,000, since this amount isbelow tolerable misstatement, no changes to the audit plan are

deemed necessary. Had the variance been material, the auditorwould have to re-evaluate the audit plan, possibly performalternative procedures, expand the scope of testing, or request thatthe client to reconcile and adjust the inventory pricing.

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Internet Problem Solution: Using Inventory Count Specialists

21-1 Since 1938 when auditors failed to uncover fictitious inventory recordedby the McKesson & Robbins Company, auditors have been ordinarily required tophysically observe the counting of inventory. It is important to recognize thatauditors are not required to actually count the inventory for inclusion on the

balance sheet, but they are required to observe the inventory being counted.Occasionally, companies employ inventory specialists to perform their inventorycounts. One very large inventory counting specialist is Retail Grocery InventoryService, now known as RGIS. Visit RGISs [www.rgisinv.com] Web site andanswer the following questions.

1. Does an auditors responsibility for observing the physical inventorydiffer if a company hires an inventory specialist such as RGIS toperform counts as opposed to having its own employees performinventory counts? (Hint: Read AU Section 331.)

Answer:No, the auditors responsibility is unchanged by who does thecounting of the clients inventory. The auditor must be present duringthe physical counting of the inventory.

2. Would your expectations of the physical observation of a clientsinventory change if a client hired a company such as RGIS?

Answer:Student responses will likely vary based upon their experience withcompanies such as RGIS and whether they have participated in a

physical inventory. This question is meant to encourage students toconsider whether the hiring of an outside company such as RGISaffects how the auditor executes his/her responsibilities during aphysical inventory. Most students have very likely never consideredwhoactually counts a companys inventory let alone the significanceof hiring another company to do the work. For example, theinstructor might ask the students to explain the difference betweenhiring temporary employees to help with the counting of inventoryand hiring a company such as RGIS to count the inventory.

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Internet Problem 21-1 (continued)

3. What are the advantages and disadvantages of hiring an inventoryspecialist such as RGIS?

Answer:

Student responses will vary. However, advantages and disadvantagesinclude the following:

Advantages: Experienced inventory specialists; No orvery limited management time required to train employeeson inventory procedures; Ability to continue business while thecounting proceeds; Company employees are free to continuewith their daily tasks, etc.

Disadvantages: Company may lose control over the countingprocess; Management may experience a disconnect from

the inventory counting process which might lead to a loss ofinformation; Inventory specialists may not be familiar withinventory if the company is in a unique industry; etc.

(Note: Internet problems address current issues using Internet sources. BecauseInternet sites are subject to change, Internet problems and solutions may change. Currentinformation on Internet problems is available at www.pearsonglobaleditions.com/arens.)

Documents

AEB_SM_CH21_1.pdf