Chapter 21

Audit of the Inventory and Warehousing

Warehousing Cycle

 Review Questions

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

1. Inve
Invent
ntor
ory
y is gene
general
rally
ly a majo
majorr item
item on the the balanc
balance e sheet
sheet andand often
often
the largest item making up the accounts included in working capital.
2. The need
need for
for organ
organiza
izati
tions
ons to
to have
have thethe invent
inventory
ory in
in divers
diversee locat
location
ionss
makes the physical control and counting of the inventory difficult.
. Invent
Inventory
ory takes
takes many
many differ
different
ent form
formss that
that are dif
diffic
ficult
ult for the
the audit
auditor 
or 
to fully understand.
!. The consi
consiststent
ent appli
applica
catio
tion
n of diffe
differen
rentt valuat
valuation
ion meth
methods
ods can
can be fairly
fairly
complicated.
". The
The valua
valuatition
on of inve
inventntor
oryy is diffi
difficu
cultlt due
due to such
such facto
factors
rs as the
the
large number of different
different items involved# the need to allocate the
manufacturing costs to inventory# and obsolescence.

21-2 The ac$uisition and payment cycle includes the system for purchasing all
goods and services# including raw materials and purchased parts for producing
finished goods. %urchase re$uisitions are used to notify the purchasing depart&
ment to place orders for inventory items. 'hen inventory reaches a predetermined
level or automatic reorder point# re$uisitions may be initiated by stockroom
personnel or by computer. In other systems# orders may be placed for the materials
re$uired to produce a customer order# or orders may be initiated upon periodic
evaluation of the situation in light of the prior e(perience of inventory activity.
 )fter receiving
rece iving the materials
mate rials ordered
orde red## as part of the ac$uisitio
ac$u isition
n and payment
payme nt
cycle# the materials are inspected with a copy of the receiving document used to
book perpetual inventory.
inventory. In a standard cost inventory system# the ac$uisition and
payment cycle computes any inventory purchase variances# which then enter the
inventory system.
The following audit procedures in the ac$uisition and payment cycle
illustrate
illustrate the relationship
relationship between that cycle and the inventory
inventory and warehousing
warehousing
cycle.

1. *ompar
*ompare e the inve
invento
ntory
ry cost
cost ente
entered
red int
into
o the inve
inventntory
ory syst
system
em to
to
the supporting invoice to determine that it was properly recorded
and the purchase variance +standard cost system,# if any# was properly
reflected.
2. Test the
the purch
purchase
ase cuto
cutoff
ff at the
the physi
physical
cal inv
inven
ento
tory
ry date
date and year&
year&
end to determine whether or not the physical inventory and year&
end inventory cutoffs are proper from a purchase standpoint.

21&1
21-3 *ost accounting records are those which are concerned with the processing
and storage of raw materials# work in process# and finished goods# insofar as
these activities constitute internal transfers within the inventory and warehousing
cycle. These records include computerized files# ledgers# worksheets and reports
which accumulate material# labor# and overhead costs by job or process as the
costs are incurred.
*ost accounting records are important in conducting an audit because
they indicate the relative profitability of the various products for management
planning and control# and determine the valuation of inventories for financial
statement purposes.

21-4 The most important tests of the perpetual records the auditor must make
before assessed control risk can be reduced# which may permit a reduction in
other audit tests are:

1. Tests
ests of the purchase
purchases s of raw materia
materials
ls and
and pric
pricing
ing thereo
thereof.
f.
2. Tests
ests of the cost
cost acco
account
untin
ing
g docum
documenents
ts and
and records
records by verif
verifyi
ying
ng
the reduction of the raw material inventory for use in production and
the increase in the $uantity of finished goods inventory when goods
have been manufactured.
. Tests
ests of the reduct
reductio
ion
n in the fini
finish
shed
ed goods
goods inven
inventotory
ry throu
through
gh the
the
sale of goods to customers.

 )ssuming the perpetuals are determined to be effective# physical inventory tests

may be reduced# as well as tests of inventory cutoff. In addition# an effective
perpetual
perpetual inventory will allow the company
company to test the physical inventory
inventory prior to
the balance sheet date.

21- The continuation of shipping operations during the physical inventory will
re$uire the auditor to perform additional procedures to insure that a proper cutoff 
is achieved. The auditor must conclude that merchandise shipped is either 
included in the physical count or recorded as a sale# but not both.
-ince no second count is taken# the auditor must increase the number of 
test counts to determine that the counts recorded are accurate.

21-! The auditor must not give the controller a copy of his or her test counts. The
auditors test counts are the only means of controlling the original counts recorded
by the company. If the controller knows which items were test counted# he or she
will be able to adjust other uncounted items without detection by the auditor.

21-" The most important audit procedures to test for the ownership of inventory
during the observation of the physical counts and as a part of subse$uent valuation
tests are:

1. /iscuss wi
with th
the cl
client.
2. 0bta
0btain
in an
an unde
underst
rstand
andin
ingg of the
the cli
clien
ent
ts
s oper
operat atio
ions.
ns.
. e ale
alert
rt for
for inve
invent
ntory
ory set
set asid
asidee or spec
speciaialllly
y mark
marked.
ed.

21&2
21-" #continued$

!. eview contracts with suppliers and customers to test for the

possibility of consigned inventory or inventory owned by others that
is in the clients shop for repair or some other purpose.
". 3(amine vendor invoices indicating that merchandise on hand was
sold to the company.
4. Test recorded sales just before and just after the physical inventory
to determine that the items were or were not on hand at the physical
inventory date and that a proper cutoff was achieved.

21-%  )uditing procedures to determine whether slow&moving or obsolete items

have been included in inventory are:

1. 0btain a sufficient understanding of the clients business to aid in

recognizing inventory that is no longer useful in the clients business.
2. eview the perpetual records for slow&moving items.
. /iscuss the $uality of the inventory with management.
!. )sk $uestions of production personnel during physical inventory
observation about the e(tent of the use or nonuse of inventory items.
". 5ake observations during the physical inventory for rust# damaged
inventory# inventory in unusual locations# and unusual amounts of 
dust on the inventory.
4. e aware of inventory that is tagged obsolete# spoiled# or damaged#
or is set aside because it is obsolete or damaged.
6. 3(amine obsolescence reports# scrap sales# and other records in
subse$uent periods that may indicate the e(istence of inventory that
should have been e(cluded from the physical inventory or included
at a reduced cost.
7. *alculate inventory ratios# by type of inventory if possible# and compare
them to previous years or industry standards.

21-& The auditor could have uncovered the misstatement if there were ade$uate
controls over the use of inventory tags. 5ore specifically# the auditor should have
assured himself or herself that the client had accounted for all used and unused
tag numbers by e(amining all tags# if necessary. In addition# the auditor should
have selected certain tags +especially larger items, and had the client show him
or her where the goods were stored. The tag numbers used and unused should
have been recorded in the auditors working papers for subse$uent follow&up. )s
part of substantive procedures# the auditor could have performed analytical tests
on the inventory and cost of sales. ) comparison of ratios such as gross margin
percentage and inventory turnover could have indicated that a problem was
present.

21&
21-1'  ) proper cutoff of purchases and sales is heavily dependent on the physical
inventory observation because a proper cutoff of sales re$uires that finished
goods inventory included in the physical count be e(cluded from sales and all
inventory received be included in purchases.
To make sure the cutoff for sales is accurate# the following information
should be obtained during the taking of the physical inventory:

1. The last shipping document number should be recorded in the

working papers for subse$uent follow&up to sales records.
2. ) review should be made of shipping to test for the possibility of 
shipments set aside for shipping and not counted or other potential
cutoff problems.
. 'hen prenumbered shipping documents are not used# a careful review
of the clients method of getting a proper sales cutoff is the first
step in testing the cutoff.
!. ) list of the most recent shipments should be included in the working
papers for subse$uent follow&up to sales records.

8or the purchase cutoff# the following information should be noted:

1. The last receiving report number should be noted in the working

papers for subse$uent follow&up to purchase records.
2. ) review should be made of the receiving department to make sure
all inventory has been properly included in the physical inventory.

21-11 *ompilation tests are the tests of the summarization of physical counts#
the e(tension of price times $uantity# footing the inventory summary# and tracing
the totals to the general ledger.
-everal e(amples of audit procedures to verify compilation are:

1. Trace the tag numbers used to the final inventory summary to make
sure they were properly included and the numbers not used to the
final inventory summary to make sure no tag numbers have been
added.
2. Trace the test counts recorded in the working papers to the final
inventory summary to make sure they are correctly included.
. Trace inventory items on the final inventory list to the tags as a test
of the e(istence of recorded inventory.
!. Test the e(tensions and footings of the physical inventory summary.

21&!
21-12

+*,. 
A(A)*+ICA) ,RC./0R. ,+.(+IA) I+A+..(+
1. *ompare gross margin percentage 0verstatement or understatement of
with previous years. inventory amounts +prices and9or
$uantities,.
2. *ompare inventory turnover with 0bsolete inventory.
previous years.
. *ompare unit costs with previous 0verstatement or understatement of unit
years. costs.
!. *ompare e(tended inventory value 3rrors in compilation# unit costs# or
with previous years. e(tensions.
". *ompare current year manufacturing 5isstatement of unit costs of inventory#
costs with previous years. especially direct labor and manufacturing
overhead.

21-13

,0RCA. + 5. I(C)0/./ I(
/A+. Q0A(+I+* ,RIC. 12-31-'& I(6.(+R* .7+.(I(

11&24&11 2#! <2.6 6 = <2.6 <1#!!;.

12&4&11 1#; <2.27 1#; = <2.27 !#2.
<"#671 .

 )ssuming 8I80 inventory valuation# the 12&1&11 inventory should be

valued at <"#671# and is thus currently overstated by <121.
If the 1&24&12 purchase was for 2# binders at <2.12 each# the 12&1&
11 inventory should be valued at <"#!66. +1#; = <2.12 > 6 = <2.6, and
is thus currently overstated by <!2". 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 verified by
e(amining engineering specifications or similar information to determine whether the
number of hours to complete a unit of finished goods was correctly computed.
0rdinarily it is difficult to test the number of hours to an independent source.
The manufacturing overhead rate is calculated by dividing the total annual
number of labor hours into total manufacturing overhead. These two totals are
verified as a part of the payroll and personnel and ac$uisition and payment cycles.
0nce these two numbers are verified +overhead rate per direct labor hour 
and the number of direct labor hours per unit of each type of inventory,# it is not
difficult to verify the overhead cost in inventory.

21&"
21-1 'ith a job cost system# labor charged to a specific job is accumulated on
a job cost sheet. The direct labor dollars included on the job cost sheet can be
traced to the employee ?job time sheet? to make sure the hours are correctly
included on the job cost sheet. The labor rate can be verified by comparing it to
the amount on the employees earnings record.
21-1!  )ssuming the auditor properly documents receiving report numbers as a
part of the physical inventory observation procedures# the auditor should verify
the proper cutoff of purchases as a part of subse$uent tests by e(amining each
invoice to see if a receiving report is attached. If the receiving report is dated on
or before the inventory date and the last recorded number# the received inventory
must have been included in the physical inventory@ therefore the invoice should
be included in accounts payable. Those invoices that are received after the balance
sheet date but shipped 8.0.. shipping point on or before the close of the year 
would indicate merchandise in transit.

 ultiple Choice Questions ro8 C,A .9a8inations

21-1" a. +, b. +2, c. +1,

21-1% a. +1, b. +2, c. +2,
21-1& a. +!, b. +, c. +2,

 /iscussion Questions and ,ro:le8s

21-2'

,+.(+IA) 05+A(+I6.
,0R,.  +.+  I(A(CIA) A0/I+
I(+.R(A) C(+R) C(+R) I+A+..(+ ,RC./0R.

1. 8or a proper valuation 3(amine receiving 5isstatement of *ompare

of inventory. and re$uisition inventory. physical count
+)ccuracy, documents# trace to perpetual
to perpetual inventory
records. record.
2. To make sure physical 0bserve counting 5isstatement of *ompare
inventory counts are personnel and inventory. physical count
accurate. discuss with to perpetual
+)ccuracy# e(istence client. inventory
and completeness, record.
. To make sure inventory 0bserve who 5isstatement of eperform
compilation is accurate. compiles the inventory. clerical tests
+)ccuracy, inventory and of inventory
discuss with compilation.
client.

21&4
21-2' #continued$

,+.(+IA) 05+A(+I6.
,0R,.  +.+  I(A(CIA) A0/I+
I(+.R(A) C(+R) C(+R) I+A+..(+ ,RC./0R.

!. To ensure inventory  )ccount for a Anderstatement Trace $uantity

is recorded when numerical of inventory or and description
received# payments se$uence of payment for on vendors
made are for goods receiving reports goods not invoice to
received# and $uantities and observe received. receiving
and descriptions are matching invoices report.
accurate. received from
+*ompleteness# vendors.
e(istence and
accuracy,

". To minimize theft or /iscuss with 0verstatement *ompare

unrecorded shipments client and of inventory. physical count
of inventory. observe whether to perpetual
+3(istence, personnel records.
prepare shipping
documents.

4. To ensure inventory  )ccount for Anderstatement Trace $uantity

shipments are a numerical of sales. and descrip&
recorded as sales. se$uence of tion on bills of
+*ompleteness, shipping orders. lading to
recorded sales.

6. To assure reasonable eview 5isstatement of Trace costs

costs are used for procedures inventory. from supporting
inventory and cost for determining documents to
of goods sold. standard costs. development
+)ccuracy, of standards.

7. To make sure obsolete ead policy 5isstatement of  )nalytical

goods are classified and discuss inventory. procedures for
as such. procedures with inventory.
+)ccuracy, client.

21&6
21-21

a;
+RA(AC+I(- :; c;
R.)A+./ A0/I+
5<.C+I6. R.)A+./ RI= +.+  C(+R)

1. ecorded transactions If purchasing agents can 3nter non&valid vendor

represent valid# make purchases from any numbers into the
approved purchases vendor# there is a risk that purchasing system to
+0ccurrence,. purchasing agents may see if the related
make unauthorized transaction is rejected.
purchases of items not
approved +for personal
use,.

2. ecorded inventory 'ithout information about -elect a sample of

may not be recorded at the amount of time inventory items from
appropriate amounts# inventory is in the ware& the perpetual inventory
due to obsolescence house# management is system and recalculate
+)ccuracy,. less likely to identify slow the number of days each
moving items that should item has been present in
be recorded at the lower the warehouse.
of cost or market.

. )ctual shipments of -hipments of inventory -elect a sample of items

inventory are recorded may occur but not be in the warehouse and
in the perpetual recorded. physically move them to
inventory records the shipping areas to see
+*ompleteness,. if the microchip correctly
removes those items from
the perpetual inventory
records.

!. Inventory recorded in Bon&inventory warehouse 0bserve client personnel

the perpetual records individuals may remove in the inventory ware&
physically e(ists inventory without house and determine if
+0ccurrence,. authorization. each person is authorized
to be in the warehouse.

". Inventory transactions 3$uipment or supplies 0bserve whether

are properly classified may be inaccurately e$uipment or supplies
+*lassification,. classified as inventory if are stored in the same
they are not physically physical space as
separated from the inventory.
inventory.

21&7
21-21 #continued$

a;
+RA(AC+I(- :; c;
R.)A+./ A0/I+
5<.C+I6. R.)A+./ RI= +.+  C(+R)

4. ecorded inventory If periodic reconciliations Inspect the clientCs test

items are physically of inventory records to samples for accuracy and
present +0ccurrence, physical counts are not reasonableness. In$uire
and recorded at performed# there is a risk about the nature of
correct amounts that items may be discrepancies identified.
+)ccuracy,. removed from the
warehouse without
knowledge# which would
result in overstated
inventory amounts.

6. )ctual inventory on There is a risk that Inspect the clientCs test

hand may not be inventory on hand is not samples for accuracy and
recorded in the included in the inventory reasonableness. In$uire
perpetual inventory records. about the nature of
listing +*ompleteness,. discrepancies identified.

7. The perpetual There could be errors in ecalculate the inventory

inventory records are the mathematical amounts and determine
accurately summarized formulas of the inventory that the totals agree to the
and posted to the records. general ledger balances.
general ledger
accounts +%osting and
-ummarization,

;. ecording inventory Inventory could be added 3nter an addition to the

transactions represent to the inventory account perpetual inventory
actual receipts of balance before actual system without a valid
inventory items goods are received. receiving report number to
+0ccurrence,. determine if the system
rejects the transaction.

1. ecording of inventory Inventory held on 0bserve whether

in the clientCs records consignment may be inventory held on
is valid +0ccurrence, recorded as the clientCs consignment is stored in
inventory. the same physical space
as inventory.

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

1. The cost accounting records determine unit costs that are

applied to derive inventory values. -ince inventory is usually
material# unit costs must be verified.
2. In many companies# there are many types of inventory items
with comple( cost structures. The potential for misstatement
is great in determining costs. The auditor would need to go
to an e(treme effort to verify such costs without being able to
rely on the cost accounting records which provides the costs#
+i.e.# it is far more efficient to test the cost accounting records
than the costs themselves,.
. The cost accounting records also deal with transferring
inventories through the production cycle and then from finished
goods for sales. These transfers must be handled accurately
for inventory to be properly stated.

b. 1. 3(amine engineering specifications for e(pected +standard,

labor hours. 3(amine time records for hours worked on part
during measured period. /ivide by units produced to test
reasonableness of standard.
2. eview specifications for types of labor re$uired to produce
parts# or observe production. eview union contracts or 
earnings records to develop reasonable rate for this labor mi(.
. Identify appropriate overhead accounts# paying careful
attention to consistent application. /etermine amounts for 
these accounts for a measured period. /etermine direct labor 
hours from payroll records from the same period. *ompute
the overhead rate per direct labor hour.
!. eview engineering specifications. eview material usage
variance.
". Trace to vendors invoices. eview material price variance.
4. -um individual components.

21&1
21-23

A0/I+
,RC./0R. +*,.  +.+ ,0R,.

1 Test of *ontrol To make sure that proper

controls e(ist and are being
followed in the taking of the
physical inventory.
+3(istence# completeness#
accuracy and classification,

2 -ubstantive Test To ensure that all inventory

represented by an inventory tag
actually e(ists.
+3(istence,

 -ubstantive Test To test the accuracy of the

clients perpetual inventory
records.
+3(istence# completeness#
and accuracy,

! -ubstantive Test To test clients final inventory

compilation.
+3(istence# completeness#
accuracy and classification,

" -ubstantive Test To test that the final inventory

was valued at its proper cost.
+)ccuracy,

4 Test of *ontrol To ensure that no raw material

was issued without proper
approval.
+3(istence,

6 Test of *ontrol or   To ensure that additions

-ubstantive Test recorded on the finished goods
perpetual records were
recorded on the books as
completed production.
+)ccuracy and classification,

21&11
21-24

a; :;
C(+R) +A+ 05+A(+I6.
0)/ A6. A0/I+ ,RC./0R.
,R.6.(+./ +A+ C0)/ 5.
+. I+A+..(+ 0./ + 0(C6.R
I+A+..(+ R CC0RRI(> +. I+A+..(+

1 Internal verification by 3(amine vendors invoices in

another person. support of prices used.

2 Deep a record of the last 3(amine bills of lading for first

shipping report number shipments recorded after the
shipped before the inventory physical inventory to determine
count. that they were shipped after
year&end.

 %erform independent ecord test counts and trace to

second counts on all compiled inventory.
merchandise. )ll persons
responsible for inventory
tags and compilation of
physical inventory should be
independent of custody of
perpetual inventory records.

! Ase of prenumbered tags  )ccount for all prenumbered

and accounting for tags during the physical
numerical se$uence. e(amination and during
compilation tests.

" Internal verification of *ompare vendor invoice prices

perpetual inventory prices. to perpetual inventory prices.

4 -egregation of obsolete %erform net realizable value

inventory. and lower of cost or market
tests of inventory# including
tests of the perpetual inventory.

6 %eriodic review of Test reasonableness of

reasonableness of manufacturing overhead rate.
manufacturing overhead
rate.

21&12
21-2 a.

Internal Controls +ests of Controls

1. Inventory purchases are Trace inventory $uantities for a sample
used to update the of purchase transactions to the perpetual
perpetual )tlanta inventory inventory records as a part of tests of
records. controls and substantive tests of
ac$uisition transactions.
2. Transfers of inventory are Trace inventory $uantities for a sample
used to update the )tlanta of shipments from )tlanta to local
and local distribution center distribution centers to the perpetual
perpetual inventory records. inventory records.
. Inventory sales are used to Trace inventory $uantities for a sample
update the local distribution of sales transactions to the perpetual
center perpetual inventory inventory records as a part of tests of
records. controls and substantive tests of sales
transactions.
!. Eocal distribution centers Test the effectiveness of the perpetual
access to perpetual records records access restrictions using the *%)
is restricted to processing firmCs computer audit specialists.
sales transactions.
". Fuarterly physical inventory 3(amine local distribution center physical
is taken for comparison to inventory count records and adjustments
and adjustment of perpetual to the perpetual records.
records.
4. Internal auditors test the 3(amine internal auditor audit programs
perpetual records and working papers for their tests of the
continuously. perpetual records and the findings.
6. Internal auditors sample 3(amine internal auditor audit programs
inventory counts and test and working papers for their tests of the
inventory adjustments. physical observation of inventory and the
findings.

b. There are four ways to reduce physical observation of inventory.

 )uditors will use their judgment to decide which combination of these
to use.

1. educe the number of local warehouses to observe inventory

counting and do test counts of inventory.
2. educe the number of auditors who observe the inventory
counting at each location.
. educe the sample sizes for test counts inventory.
!. %erform the physical observation of inventory at an interim date.

21&1
21-2! a.

+otal ?uare
(u8:er of  ,er 0nit ootage
0nits 0nits Re?uired Re?uired to
Inventory on Re?uiring ?; tore Inventory
/escription and /ollars loor pace ootage #0nits 9 ? ft$
 )* Anit G 5odel 4" 12! <74# !1.a 14 441.
 )* Anit G 5odel 66 16 <1#;!#;4 "66.444446 a 14 ;2!2.44446
8urnace G 5odel 22 1;;2 <2#"7;#4 ;;4b 14 1";4
8urnace G 5odel 22" 27 <2#641# 1!b 14 144!
 )ir Handling /ucts 1177 <1#!7"#! 2;6.6"c 2" 6!#247.6"
<;#"72#;4 122#12!.6"
a
2 pallets of )* units sit on top of 1 pallet that rests on the floor +12!9  !1.@
169  "66.44446.
b
1 furnace can sit on top of the unit that rests on the floor +1;;292  ;;4@ 2792
 1!,
c
 bo(es can be stored on top of the bo( that rests on the floor +11779!  2;61,
.
b. .The above analytical procedure suggests that inventory may be
significantly overstated. The amount of s$uare footage that would
be needed +122#12!.6" s$uare feet, to store the stated amount of 
inventory is 22.1J greater than the amount of s$uare footage
+1# s$uare feet, available in the warehouse facility. The
auditor would need to design further substantive tests to e(amine
the e(istence of inventory at year end.

21-2" a. The auditor in this situation should observe the recording of the
shipments on the day of occurrence and record these details in the
working papers so a determination can be made as to whether the
shipments affected the physical inventory count.

b. 1. There is no clear&cut answer to sample size for inventory

counts. The answer to the $uestion depends on additional
factors# such as the randomness of your test counts and
whether the values of the merchandise are relatively stratified.
It also depends on inherent risk for inventory physical counts
and the materiality of inventory compared to total assets.

2. e$uest a recount by the client or greatly e(pand your tests

to determine whether a material misstatement e(ists.

21&1!
21-2" #continued$

c. The auditor should determine how this inventory is valued and after 
discussion with the client it may be well to classify it as obsolete. In
all cases# the auditor must specifically identify the merchandise in
the working papers for subse$uent evaluation. The auditor should
also be aware that this could be an indication of widespread
obsolescence problems in other parts of the inventory.
d. 0ne of the important tasks the auditor undertakes during the
observation is to determine that inventory tags are physically
controlled. This assures that the inventory is not understated because
tags are lost# or overstated because falsified tags are added. In this
situation# the auditor should recover the discarded tags and re$uest
that the practice be stopped# and that control of tags be established
under the auditorCs direct observation.
21-2% The following procedures should be established to insure that the
inventory count includes all items that should be included and that nothing is
counted twice:
1. )ll materials should be cleared from the receiving area and stored
in the appropriate space before the count.
2. Incoming shipments of unassembled parts and supplies should be
held in the receiving area until the end of the day and then inventoried.
. If possible# the days shipments of finished appliances should be
taken to the shipping area before the count. +Anshipped items
remaining in the shipping area should be inventoried at the end of 
the day.,
!. Kreat care must be e(ercised over goods removed from the
warehouse itself. These may be unassembled parts and supplies
re$uisitioned on an emergency basis or unscheduled shipments of 
finished appliances. )lternative methods for recording these removals
are:
a, Deep a list of all items removed and indicate on the list whether 
the item had been counted.
b, ecord the removal on the inventory tag if the item has been
inventoried.
c, Indicate on the material re$uisition or the shipping order that
the item had been inventoried. 8or any of these alternatives#
a warehouse employee or the perpetual inventory clerk must
adjust the recorded counts.
". The finished appliances remaining in the warehouse should be
inventoried at the end of the day.

21&1"
21-2% #continued$

4. The warehouse should be instructed to date all documents as of 

the day the materials are received# issued# or shipped.

6. The inventory clerk should post the 5ay 1 production and shipment
of finished goods to the inventory record based upon the dates
shown on the plant production report and the shipping report. This
will provide a proper cutoff because provisions have been made to
adjust all counts for goods manufactured and shipped on 5ay 1.

7. The listing of inventory differences should be reviewed by the controller 

and warehouse supervisor prior to booking the adjustment. )bnormal
differences should be investigated# and recounts +with appropriate
reconciliation, should be made where appropriate.

21-2&

*omputer Solution. *omputer solutions in 3(cel are contained on the companion

'ebsite +8ilename is %212;.(ls,.

a.

2'11 2'1' 2''& 2''%

Kross margin J 24.J 22.4J 22.!J 22.!J

Inventory turnover 4.4 6.4 6.4 6.;

b. Eogical causes of the changes in the gross margin as a percent of 

sales include:

1. -elling prices were raised without a corresponding increase

in cost of sales.
2. The method of accounting for inventory was changed# causing
a higher ending inventory +more e(penses absorbed into
inventory, and lower cost of sales.
. Inventory cutoff was improper# causing sales to be recorded
without the corresponding entry to cost of sales.
!. The product mi( of the company changed. 5ore high markup
items were sold than in previous years.
". )n improper journal entry was recorded which adjusted the
gross margin upward.

21&14
21-2& #continued$

Eogical causes of the changes in the inventory turnover include:

1. The increased selling prices# which caused the gross margin
percent to increase# reduced demand for the product# and
decreased the inventory turnover.
2. The company is building its inventory supply in anticipation of 
increased sales in the future.
. The companys inventory contains obsolete or unsalable
merchandise# which is affecting the turnover rate.

c. 24.J & 22.4J  .6J increase in gross margin J

.6J ( sales of <;2.7 million 

<#!#4 potential misstatement

<47.! million +2; *0K-, 9 6.4 inventory turnover 

<;. million

<11.4 million & ;. million 

<2#4# potential misstatement
oth calculations indicate a potential misstatement e(ceeding
<2##.
d. The auditor should discuss the two changes with the client and obtain
a reasonable e(planation for them. He or she should then perform
appropriate procedures to verify the validity of the e(planation.
Altimately# the auditor must be confident the change does not result
from a misstatement in the financial statements.

21-3' a.
1. 3(clude
2. 3(clude
. Include
!. Include
". 3(clude
b. 1. This merchandise would be e(cluded because title does not
pass to buyer on an 8.0.. destination shipment until delivery
to the buyer. -ince it was not received until Lanuary 212#
there is no basis for including it in inventory.
2. Koods held ?on consignment? do not belong to the consignee#
and should not be included in inventory.
. Bormally title to a stock item does not pass to the customer 
until shipment# even though it has been set aside. Therefore
it should be included in inventory.

21&16
21-3' #continued$

!. Title to goods shipped 8.0.. shipping point normally passes

to the buyer on delivery to the transportation agency# and in
this instance the goods belong to your client at /ecember 
1# 211. There is an error in recording the ac$uisition.
". -ince this machine is fabricated to the customers order# title
to customer made&merchandise passes to the buyer as
materials and labor are appropriated to the job. 'hen the job
is completed and ready for shipment as in this case# it may
be considered as a completed sale.

21-31 a. 1. 3(tension errors are as follows:

.7+.(I( 6.R
A AC+0A) #0(/.R$
/.CRI,+I( R.CR/./ .7+.(I( +A+..(+

'ood < 11.! < 11.! <+ ;;.4,

5etal cutting tool 1#6!. 1#!6. 26.
*utting fluid 2!. 1#!. +7.,
-andpaper  "6;. ".6 "6.
< + "4 .4,

2. The differences in the previous years and this years cost

indicate a problem. The auditor should attempt to obtain support
for the current years cost if the effect of the differences noted
seems significant +considering that the test only covered 2J
of the dollar items,. ) review for reasonableness indicates the
following:

a, %recision cutting torches are e(pensive. 5aybe <7

each is a reasonable price. 3(amine a vendors invoice
or a price list.
b, )luminum scrap values may fluctuate significantly. The
two prices may be reasonable. Eook at sales invoices
for the two years.
c, Eubricating oil cost appears unreasonable for this year 
and for the previous year. The auditor should e(amine
invoices for both years. If the previous years costs
were incorrect# determination of the effect of the
misstatements on the prior years and this years
financial statements must be completed to determine
the need for disclosure of the misstatements.

21&17
21-31 #continued$

. Investigate the reasons for the omission of these tags from

final inventory compilation. If it is determined that the omission
of two tags is significant based on the number of tags used
and tested# the auditor should account for all tags to determine
the total e(tent of omissions.

!. %age total footing errors are as follows:

C)I.(+ CRR.C+ 6.R- #0(/.R-$

,A>. (; ++A) ++A) +A+..(+

1! <2#6".4 <2#6". < .4

72 4#621.17   4#!21.17   .
<.4

b. 8irst# the auditor should keep in mind that only 2J of the inventory
was tested. If sampling were random# a direct e(trapolation would
magnify projected misstatements by five. In addition# the auditor must
consider sampling error.
The net effect of the misstatements for which we were able to
compute the actual misstatement was an overstatement of inventory
by <2!!. a small amount +see items 1 and !,. However# the
e(ceptions resulted from various causes including incorrect decimal
placement# mathematical errors# and unit of measure errors. The
auditor should determine that the net effect of the misstatements is
not significant@ in addition# to insure against other individual
misstatements that might be significant# the auditor should review
the e(tensions and other computations for reasonableness and
obvious misstatements.
8or the items for which the amount of the misstatement
could not be determined# the auditor should follow up as described
in 2 and  above. 8rom the results of the follow&up# the effect of the
misstatements noted should be assessed and determination made
as to the need for e(pansion of scope for the tests considered.

c. %rior to compiling the inventory ne(t year# 5artin 5anufacturing

should implement the following internal controls:
1. eview formulas in schedule for inventory compilation. )ccuracy
of spreadsheet should be independently reviewed.
2. -omeone familiar with the inventory should review the
compilation schedules for reasonableness of $uantities# prices#
and e(tensions.
. )ll inventory tags should be accounted for prior to posting to
the compilation schedules and a control total compared to the
total on the compilation sheets after the compilation is complete.

21&1;
21-32 a. Becessary adjustments to clients physical inventory:

5aterial in *ar M)7142 N received

in warehouse on Lanuary 2# 212 < 7#12
5aterials stranded en route
+-ales price <1;#26 9 12"J, 1"#!14
Total 2#"4
Eess unsalable inventory 1#2"O
Total adjustment <22#274

O If freight charges have been included in the clients inventory#

the amount would be <1#4 and the amount of the total
adjustment would be <21#;4. Lournal entry 4 probably
would have a credit to purchases of <1#4 in this case.

b. )uditors worksheet adjusting entries:

1. %urchases < 2#17

 )ccounts %ayable < 2#17
To record goods in warehouse but
not invoicedGreceived on  14.

2. Bo entry re$uired. Title to goods had passed.

. )ccounts receivable 12#6

-ales 12#6
To record goods as sold which
were loaded on /ecember 1
and not inventories&-I ;47.

!. -ales 1;#26
 )ccounts receivable 1;#26
To reverse out of sales material
included in both sales +-I ;44, and in
physical inventory +after adjustment,.

". Bo adjustment re$uired.

4. *laims receivable 1#4

%urchases 1#2"
8reight In "
To record claim against carrier for 
merchandise damaged in transit.

21&2
21-32 #continued$

6. Inventory 22#274
*ost of goods sold 22#274
To adjust accounts for changes
in physical inventory $uantities.
7. -ales 1"#66
 )ccounts receivable 1"#66
To reverse out of sales invoices
M;4;# ;6# ;6l. The sales book
was held open too long. This
merchandise was in warehouse
at time of physical count and so
included therein.

@ Case

21-33

Computer Solution. *omputer solutions in 3(cel are contained on the *ompanion

'ebsite +8ilename %21.PE-,.
 ). ) price of <7 is proper for pricing E6 spars at 12&1&11 since the
ne(t shipment of spars was not received until 1&4&12. However#
the ne(t invoice shows a lower cost# which indicates a decline in the
value of this product. If the net realizable value +selling price less
cost to sell, is less than the <7 per meter cost# the spars should be
revalued to net realizable value at 12&1&11.

. The total is 1#912 feet times <1.2 per foot  <1#. In addition#
the freight of <2 should have been as follows:
  <2 QQQQQQQQQQQQ 
 <.176" per ft.
+12#7 inches 9 12 inches per foot,

Total inventory cost should be +<1.2 > .176" per foot, times 7
feet +1#912,  <1#1"".6; or an overstatement of inventory by
<1#7!!.21.
*. 8I80 value would be:
Roucher 12&41 1# yards at <1. per yard  <1#
Roucher 11&71 " yards at < ;." per yard  !#6"
Inventory is overstated by <2" <1!#6"

Roucher number 12&71 is not used because the receiving date

is after year&end.

21&21
21-33 #continued$

/. 8I80 value would be:

Roucher 12&41 7 feet at <7. per foot  <4#!

Roucher 11&71 2 feet at <7.2 per foot  1#4!
<7#!

Inventory is understated by <!. However# if the reduction in

cost on voucher M12&41 indicates that the net realizable value
of the struts is below the cost on voucher M11&71# then the
net realizable value of the struts should be used as the cost.

3. %ricing is correct if the item is for inventory. It is possible that this item
should be capitalized.

8. %roper 8I80 cost is ! pair ( 2  7 springs ( <4;. each  <"#"2.

Inventory is understated by <"#2!!.

K. %ricing is correct. However# the fasteners were purchased in 2! five

years ago# and only eleven or 1!J have been used. *onsideration
should be given as to whether net realizable value is less than cost.

21&22
 21-33 #continued$

-3) KAEE )I8)53-# IB*.

-A55)S 08 IBR3BT0S 5I--T)T353BT-
Quantity Price
Item No. and  Per  Per  Differenc  Recorded  Correct   Amount of 
Description Inventory Correct Difference Inventory Correct   e  Amount   Amount  Misstatement 

 ). E6 -pars # #  7. 7. . 2!#. 2!#. .
. 47 5etal 8ormers 1# 7 ;#146 1.2 1.76"  G 12#. 1#1"".6;  G 1#7!!.21
.176"
*. 1 5etal ibs 1#" 1#"  1. 19;." 1"#. 1!#6".  G 2".
/. -t24 -truts 1# 1#  7.  ." 7#. 7#!. !.
3. Industrial hand !" !"  2. 797.2  G .2 ;. ;. .
drills 2. .
2        
1        
8. E7 -teel Eeaf ! 7  G ! 4;. 264. "#"2. "#2!!.
&    -prings 4;. .
2        
         
K. R14 8asteners "." "."  1. "". "".   .
1. .

Total misstatement G "#71.21

Items over <"#  G 11#"!.21

Items under <"#   "#2!!.

G "#71.21

*0B*EA-I0B: +see ne(t page for calculations, 35)D-

There is a material potential misstatement  ). BR assumedU e(ceeds cost.
due to the number and size of misstatements found . Fuantity based on inches# not feet@ freight not included.
relative to the sample chosen. In order to *. " yards overpriced.
determine a more accurate estimate of the
/. 2 feet underpriced. BR assumedU 0.D.
actual misstatement# additional tests are
necessary. 3. )ssumedU not capitalizable.
8. Includes e(tension error in inventory.
K. *onsider separately for obsolescence.
21-33 #continued$

PROJC!D MISS!A!MN!S

/ollars tested

a8ple ite8s 0ver "# Ander <"#

Bo e(ceptions 4# 2#4

 ) 2!#
 12#
* 1"#
/ 7#
3 ;
8 264
K QQQQQQQQQ ""
/ollars tested !1;# #71

PROJC!D MISS!A!MN! I"NORIN" SAMP#IN" RROR$ 

!#1"#
5ore than <"# P G11#"!.21  G <1;#!74
!1;#
!#12"#
Eess than <"# P "#2!!  <"#4!4#!4
#71
O Ased ratio estimation for projected misstatement. /ifference estimation
results are e$ually unacceptable.

 Internet ,ro:le8 olution 0sing Inventory Count pecialists

Internet ,ro:le8 21-1

a. KI- has assisted Hines Horticulture in the physical inventory counts

of HinesC products held on consignment at Home /epot stores. Hines
maintains ownership of the inventory until it is scanned and sold at a
Home /epot store. KI- helps Hines maintain its perpetual inventory
records by providing coverage on a wide geographic basis.

b. The business arrangement between Hines and Home /epot

involves HinesC products being on consignment at numerous Home
/epot stores. ecause Hines maintains ownership# it must maintain
accurate counts of inventory located at numerous Home /epot
stores that span a wide geographic area. Hines doesnCt have the
workforce needed to verify accurate counts of items on consignment
at Home /epot. KI-# as an outsourced inventory count specialist#
is able to assist Hines in the inventory count procedures.

21&2!
Internet ,ro:le8 21-1 #continued$

c. The auditor has a responsibility to obtain sufficient appropriate

evidence about inventory related assertions. That responsibility would
not differ for inventory counted by count specialists or client personnel.
The auditor would need to obtain evidence about inventory balances
counted by KI- and Hines employees.

d. The fact that some of HinesC inventory is counted by KI-# a reputable

inventory count specialists company# may be viewed by the auditor 
as an effective internal control to support a lower control risk
assessment than when the inventory is counted by Hines personnel.
The auditor may also be able to send re$uests to KI- to confirm
directly to the auditor inventory counts at a sample of Home /epot
stores.

e. Advantages: 3(perienced inventory specialists@ Bo or very limited

management time re$uired to train employees on inventory
procedures@ )bility to continue business while the counting
proceeds@ *ompany employees are free to continue with their daily
tasks# etc.

/isadvantages: *ompany may lose control over the counting process@

5anagement may e(perience a disconnect from the inventory counting
process which might lead to a loss of information@ Inventory specialists
may not be familiar with inventory if the company is in a uni$ue
industry@ etc.

+ (ote: Internet problems address current issues using Internet sources. ecause
Internet sites are subject to change# Internet problems and solutions may change. *urrent
information on Internet problems is available at www.pearsonhighered.com9arens.,

21&2"