Audit of the Inventory and Distribution Cycle. The Complexity of Inventory Why? A major item Inventory items could Very diverse items are included Valuation

Audit of the Inventory and Distribution Cycle

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

Inventory Cycle-2

Functions in the Inventory and Warehousing Cycle

• Process purchase orders• Receive new materials• Store materials• Process goods• Store finished goods• Ship finished goods

Inventory Cycle-3

An Overview of Functions, Documents, and Accounting Systems

Starting point• E.g. Stockroom

Accounts Payable

Purchasing

Prepare prenumbered Purchase Requisition Purchase Requisition

Purchase details

Inventory Cycle-4

Purchasing Department

Accounts Payable

Vendor

Determine Vendor, prepare prenumbered Purchase Order

Purchase RequisitionStockroom

Receiving

Originating Department

Inventory Cycle-5

Receive new materials

Accounts Payable

Purchasing

Count goods, match with Purchase Order, and prepare Receiving Report

Blind copy of Purchase Order

Purchasing

Storage with goods

Filed until goods received along with invoice copy

Blind copy of Purchase Order

Goods

Inventory Cycle-6

Vendor’s Invoice

Voucher Register to General Accounting

Compare. Then prepare Voucher and enter in Voucher Register

Purchase Requisition

Purchasing

To Cash Disbursements when due

Purchase Order

Receiving Report

Vendor’s Invoice

Originating Department

Receiving

Vendor

Inventory Cycle-7

Raw Materials Requisition

Storage


Goods are placed in storage. Raw materials

perpetual inventory updated

Goods from Receiving

Inventory Master file

N

Goods are placed in production


Cost Accounting

Production

Production

Inventory Cycle-8

Manufacturing

Goods are placed in storage in production

Goods

Cost Accounting

Records

N

Raw Materials RequisitionStorage

Finished Goods to storage

Inventory Cycle-9

Finished Goods Storage

Update Perpetual Inventory Master File.

Update Cost Accounting Records

Finished Goods from Production

Finished Goods

Master File

Finished Goods to shipment

Cost Accounting

Records

Inventory Cycle-10

Finished Goods Shipment

Approved Sales Order

Prepare Multi-Part Bill of Lading. UpdatePerpetual Inventory

Master File on shipment

Order Entry

Common Carrier

Customer

Billing and A/R

Finished Goods

Master File

Inventory Cycle-11

The Audit of Inventory

Price and compile inventory

Acquisition and Payments, Payroll and Personnel

Inventory and warehousing

Sales and Collections



Audit area Cycle

Acquire and record raw materials, labour, and

overhead

Internally transfer assets and costs

Ship goods and record revenue and costs

Physically observe inventory

Inventory Cycle-12

Cost Accounting

Typical Controls• Good controls are essential

1. Physical controls• Inventory must be protected from theft and misuse

• What does the auditor look for?

• If auditor assesses the physical controls and inadequate?

Inventory Cycle-13

2. Documents and Records

• If testing internal controls• Auditor examines

• Testing a series of documents

• Does the auditor always test the controls around inventory production?

.

Inventory Cycle-14

3. Inventory files

• When does the auditor examine the Perpetual Inventory system?

• If level of control risk is low

Inventory Cycle-15

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

Inventory Cycle-16

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

Design and perform substantive tests of

inventory.

The type of audit procedures?What is the sample size?

Items to be selected? Timing – when to do the

procedures?

Inventory Tests of Details of Balances

Inventory Cycle-17

Physical Inventory Observation: Existence

• Remember McKesson & Robbins 1937

• Select a random sample of tag numbers

• If inventory is not tagged

• Movement of inventory

Inventory Cycle-18

Physical Inventory Observation: Completeness

• Tagging inventory

• If tags are not used

• Enquire as to inventory in other locations.

Inventory Cycle-19

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.

Inventory Cycle-20

Physical Inventory Observation: Classification

• Examine inventory tags:• What to look for?

• How about percentage of completion for work-in-process?

Inventory Cycle-21

Physical Inventory Observation: Cutoff

• Record for subsequent follow-up

• Inventory for that shipment

• Review shipping area for inventory

• The receiving process

Inventory Cycle-22

Physical Inventory Observation: Valuation

• What is the auditor looking for?

• What else should the auditor do?

Inventory Cycle-23

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?

Inventory Cycle-24

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?

Inventory Cycle-25

Tests for Existence

• What items should be used for this test?

• What type of test is performed?

Inventory Cycle-26

Tests for Completeness

• What about unused tags?

• How about the tags sequence?

• Hand-held computers

Inventory Cycle-27

Tests for Accuracy

• Want to ensure that the counts are accurate. What type of test?

• Perform pricing tests. Type of tests?• Manufacturing

• Non-Manufacturing

Inventory Cycle-28

Tests for Classification

• Want to inventory is classified correctly as to the type of inventory

Inventory Cycle-29

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

Inventory Cycle-30

Tests for Rights and Obligations

• The auditor is concerned about what type of inventory?

• What type of test?

Inventory Cycle-31

Tests for Presentation and Disclosure

• What document should be examined here?

Inventory Cycle-32

Interrelationship of Various Audit Tests

Beginning inventory

+Acquisitions of raw materials

-Ending inventory

=Raw material

used

Tests of acquisition and payments cycle

Tests of cost accounting:

Perpetual inventory records

Unit cost records

Raw materialsWork in process

Beginning inventory

+Direct labour

+Raw material used

+Indirect labour and

other manufacturing

overhead-

Ending inventory=

Cost of goods manufactured

Tests of physical inventory

observation

Compilation and pricing

Beginning inventory+

Cost of goods manufactured

-Ending inventory

=Cost of goods sold

Finished goods

Tests of payroll and personnel cycle

Tests of sales and collection cycle

Inventory Cycle-33

Problem 17-18, p. 552

The table below shows sales, cost of sales, and inventory data for Aladdin Products Supply Inc., a wholesale distributor of cleaning supplies. All amounts are in the thousands.

2012 2011 2010 2009

Sales $23.2 $21.7 $19.6 $17.4

Cost of Sales 17.1 16.8 15.2 13.5

Beginning inventory 2.3 2.1 1.9 1.5

Ending inventory 2.9 2.3 2.1 1.9

REQUIRED:

a.Calculate the following ratios:

1) Gross margin as a percentage of sales

2) Inventory turnover

b.List several logical causes of the changes in the two ratios.

c.Assume that $500,000 is considered material for audit planning purposes for 2010. Could any of the fluctuations in the computed ratios indicate a possible material misstatement? Demonstrate this by performing a sensitivity analysis.

d.What should the auditor do to determine the actual cause of the changes?

Inventory Cycle-34

Problem 17-16, p. 551Items 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.

1.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?

2.Is all inventory stored under the control of a custodian in areas where access is limited?

3.Are all shipments to customers authorized by prenumbered shipping documents?

4.Is a detailed perpetual inventory master file maintained for raw materials inventory?

5.Are physical inventory counts made by someone other than storekeepers and those responsible for maintaining the perpetual inventory master file?

6.Are standard cost records used for raw materials, direct labour, and manufacturing overhead?

7.Is there a stated policy with specific criteria for writing off obsolete or slow moving inventory?

8.Is the clerical accuracy of the final inventory compilation checked by a person independent of those responsible for preparing it?

REQUIRED:

a.For each of the preceding questions, state the purpose of the internal control.

b.For each internal control, list a test of controls to test its effectiveness.

c.For each of the preceding questions, identify the nature of the potential financial misstatement(s) if the control is not in effect.

d.For each of the potential misstatements in part (c), list a substantive audit procedure to determine whether a material misstatement exists.

Inventory Cycle-35

Problem 19-22, p. 664 Canadian 11th. Edition

You are testing the summarization and cost of raw materials and purchased part inventories as part of the audit of Rubber Products and Supply Corp. There are 2,000 inventory items with a total recorded value of $648,500.

Your audit will compare recorded descriptions and counts with the final inventory listing, compare unit costs with vendors’ invoices, and extend unit costs times quantity. A misstatement in any of those is defined as a difference. You plan to use monetary unit sampling.

You make the following decisions about the audit of inventory:

Tolerable misstatement (same as for upper as for lower) $24,000

Average percent of error assumption - overstatements 50%

Average percent of error assumption - understatements 100%

Acceptable risk of incorrect acceptance 5%

Estimated error rate in the population 0.5%

Inventory Cycle-36

REQUIRED:

a. What are the advantages of using monetary unit sampling in this situation?

b. What is the sample size necessary to achieve your audit objectives using monetary unit sampling?

c. Disregarding your answer to part (b), assume that a sample of 125 items is selected and that the following differences between book and audited values are identified (understatements are in parentheses). The book or recorded amounts are also shown.

Item No. Difference Book Amount

1 $19 $700

2 11 136

3 (19) 820

4 40 250

5 90 300

6 38 210

7 (90) 2,150

8 70 300

9 (85) 950

Total $74

For each of the other 116 items in the sample, there was no difference between book and audited values.

Based on this sample, calculate the adjusted overstatement and understatement error bounds.

d.Are the book values misstated?Inventory Cycle-37

Item Recorded Accounts Receivable Amount

Audited Amount

Misstatement Misstatement Divided by Recorded Amount

1. $700 681 $192. 136 125 113. 820 839 (19)4. 250 210 405. 300 210 906. 210 2150 387. 2,150 2240 (90)8. 300 230 709. 950 1035 (85)

c. Misstatements

Number of Misstatements

Upper Precision Limit from Table 13-8

Increase in Precision Limit Resulting from Each Layer (Layers)

0123456

Percentage Misstatement BoundsRead along the row of 125 sample size on the first table (5% ARACR)

Inventory Cycle-38

OverstatementsNumber of Misstatements Upper

Precision Limit Portion

Recorded Value

Unit Misstatement Assumption

Misstatement Bound Portion (Columns 2 X 3 X 4)

0123456Upper precision limitInitial misstatement bound

Determination of Initial Upper and Lower Misstatement Bounds

UnderstatementsNumber of Misstatements Upper

Precision Limit Portion

Recorded Value


Misstatement Bound Portion (Columns 2 X 3 X 4)

0123Lower precision limitInitial misstatement bound

Inventory Cycle-39



Sample Size

Recorded Population

Point Estimate

Bounds

Initial overstatement boundUnderstatement misstatements123SumAdjusted overstatement bound



Sample Size

Recorded Population

Point Estimate

Bounds

Initial understatement boundOverstatement misstatements123456SumAdjusted understatement bound

Determination of Adjusted Misstatement Bounds

Inventory Cycle-40

Estimated Population Exception Rate (EPER)

(in percentage)

Tolerable Exception Rate (TER) (in percentage)

2 3 4 5 6 7 8 9 10 15 20

5-Percent ARACR

0.00 149 99 74 59 49 42 36 32 29 19 14

0.25 236 157 117 93 78 66 58 51 46 30 22

0.50 . 157 117 93 78 66 58 51 46 30 22

0.75 . 208 117 93 78 66 58 51 46 30 22

1.00 . . 156 93 78 66 58 51 46 30 22

1.25 . . 156 124 78 66 58 51 46 30 22

1.50 . . 192 124 103 66 58 51 46 30 22

1.75 . . 227 153 103 88 77 51 46 30 22

2.00 . . . 181 127 88 77 68 46 30 22

2.25 . . . 208 127 88 77 68 61 30 22

2.50 . . . . 150 109 77 68 61 30 22

2.75 . . . . 173 109 95 68 61 30 22

3.00 . . . . 195 129 95 84 61 30 22

3.25 . . . . . 148 112 84 61 30 22

3.50 . . . . . 167 112 84 76 40 22

3.75 . . . . . 185 129 100 76 40 22

4.00 . . . . . . 146 100 89 40 22

5.00 . . . . . . . 158 116 40 30

6.00 . . . . . . . . 179 50 30

7.00 . . . . . . . . . 68 37

Table 14-9

Inventory Cycle-41

EPER2 3 4 5 6 7 8 9 10 15 20

10–Percent ARACR

0.00 114 76 57 45 38 32 28 25 22 15 11

0.25 194 129 96 77 64 55 48 42 38 25 18

0.50 194 129 96 77 64 55 48 42 38 25 18

0.75 265 129 96 77 64 55 48 42 38 25 18

1.00 . 176 96 77 64 55 48 42 38 25 18

1.25 . 221 132 77 64 55 48 42 38 25 18

1.50 . . 132 105 64 55 48 42 38 25 18

1.75 . . 166 105 88 55 48 42 38 25 18

2.00 . . 198 132 88 75 48 42 38 25 18

2.25 . . . 132 88 75 65 42 38 25 18

2.50 . . . 158 110 75 65 58 38 25 18

2.75 . . . 209 132 94 65 58 52 25 18

3.00 . . . . 132 94 65 58 52 25 18

3.25 . . . . 153 113 82 58 52 25 18

3.50 . . . . 194 113 82 73 52 25 18

3.75 . . . . . 131 98 73 52 25 18

4.00 . . . . . 149 98 73 65 25 18

4.50 . . . . . 218 130 87 65 34 18

5.00 . . . . . . 160 115 78 34 18

5.50 . . . . . . . 142 103 34 18

6.00 . . . . . . . 182 116 45 25

7.00 . . . . . . . . 199 52 25

7.50 . . . . . . . . . 52 25

8.00 . . . . . . . . . 60 25

8.50 . . . . . . . . . 68 32

TER

Inventory Cycle-42

SAMPLE SIZEACTUAL NUMBER OF DEVIATIONS FOUND

0 1 2 3 4 5 6 7 8 9 10

5 PERCENT RISK OF OVER RELIANCE

25 11.3 17.6 . . . . . . . . .

30 9.5 14.9 19.5 . . . . . . . .

35 8.2 12.9 16.9 . . . . . . . .

40 7.2 11.3 14.9 18.3 . . . . . . .

45 6.4 10.1 13.3 16.3 19.2 . . . . . .

50 5.8 9.1 12.1 14.8 17.4 19.9 . . . . .

55 5.3 8.3 11.0 13.5 15.9 18.1 . . . . .

60 4.9 7.7 10.1 12.4 14.6 16.7 18.8 . . . .

65 4.5 7.1 9.4 11.5 13.5 15.5 17.4 19.3 . . .

70 4.2 6.6 8.7 10.7 12.6 14.4 16.2 18.0 19.7 . .

75 3.9 6.2 8.2 10.0 11.8 13.5 15.2 16.9 18.4 20.0 .

80 3.7 5.8 7.7 9.4 11.1 12.7 14.3 15.8 17.3 18.8 .

90 3.3 5.2 6.8 8.4 9.9 11.3 12.7 14.1 15.5 16.8 18.1

100 3.0 4.7 6.2 7.6 8.9 10.2 11.5 12.7 14.0 15.2 16.4

125 2.4 3.7 4.9 6.1 7.2 8.2 9.3 10.3 11.3 12.2 13.2

150 2.0 3.1 4.1 5.1 6.0 6.9 7.7 8.6 9.4 10.2 11.0

200 1.5 2.3 3.1 3.8 4.5 5.2 5.8 6.5 7.1 7.7 8.3

Table 14-10

Inventory Cycle-43

Sample size ACTUAL NUMBER OF DEVIATIONS FOUND

0 1 2 3 4 5 6 7 8 9 10

10 PERCENT RISK OF OVER RELIANCE

20 10.9 18.1 . . . . . . . . .

25 8.8 14.7 19.9 . . . . . . . .

30 7.4 12.4 16.8 . . . . . . . .

35 6.4 10.7 14.5 18.1 . . . . . . .

40 5.6 9.4 12.8 15.9 19.0 . . . . . .

45 5.0 8.4 11.4 14.2 17.0 19.6 . . . . .

50 4.5 7.6 10.3 12.9 15.4 17.8 . . . . .

55 4.1 6.9 9.4 11.7 14.0 16.2 18.4 . . . .

60 3.8 6.3 8.6 10.8 12.9 14.9 16.9 18.8 . . .

70 3.2 5.4 7.4 9.3 11.1 12.8 14.6 16.2 17.9 19.5 .

80 2.8 4.8 6.5 8.3 9.7 11.3 12.8 14.3 15.7 17.2 18.6

90 2.5 4.3 5.8 7.3 8.7 10.1 11.4 12.7 14.0 15.3 16.6

100 2.3 3.8 5.2 6.6 7.8 9.1 10.3 11.5 12.7 13.8 15.0

120 1.9 3.2 4.4 5.5 6.6 7.6 8.6 9.6 10.6 11.6 12.5

160 1.4 2.4 3.3 4.1 4.9 5.7 6.5 7.2 8.0 8.7 9.5

200 1.1 1.9 2.6 3.3 4.0 4.6 5.2 5.8 6.4 7.0 7.6

Inventory Cycle-44