Auditing the Inventory

Management Process
Overview of the Inventory
Management Process
Purchasing
process
Inventory
management
process
Revenue
process
Purchase of
raw materials
Payment of
manufacturing
overhead
Human resource
management
process
Assignment of
direct and indirect
labor costs
Sale of
goods
Types of Documents and
Records
1. Production Schedule
2. Receiving Report
3. Materials Requisition
4. Inventory Master File
5. Production Data Information
6. Cost Accumulation and Variance Report
7. Inventory Status Report
8. Shipping Order
Productio
n
Schedule
Inventory
Master
File
Shipping
Order
The Major Functions
Inventory management
Authorization of production activity and maintenance of
inventory at appropriate levels; issuance of purchase
requisitions to the purchasing department.
Raw materials stores
Custody of raw materials and issuance of raw materials to
manufacturing departments.
Manufacturing Production of goods.
Finished goods stores
Custody of finished goods and issuance of goods to the
shipping department.
Cost accounting
Maintenance of the costs of manufacturing and inventory in
cost records.
General ledger
Proper accumulation, classification, and summarization of
inventory and related costs in the general ledger.
Functions in the Inventory Management Process
Key Segregation of Duties
Segregation of Duties Possible Errors or Fraud
The inventory management function
should be segregated from the cost-
accounting function.
If the individual responsible for inventory management
also has access to the cost-accounting records,
production and inventory costs can be manipulated.
This may lead to an over- or understatement of
inventory and net income.
The inventory stores function should
be segregated from the cost-
accounting function.
If one individual is responsible for both controlling and
accounting for inventory, unauthorized shipments can
be made or theft of goods can be covered up.
The cost-accounting function should
be segregated from the general
ledger function.
If one individual is responsible for the inventory
records and also for the general ledger, it is possible for
that individual to conceal unauthorized shipments. This
can result in the theft of goods, leading to an
overstatement of inventory.
The responsibility for supervising
physical inventory should be
separated from the inventory
management and inventory stores
functions.
If the individual responsible for production
management or inventory stores functions is also
responsible for the physical inventory, it is possible that
inventory records to the physical inventory, resulting in
an overstatement of inventory.
Inherent Risk Assessment
The auditor should consider industry-related factors
and operating and engagement characteristics
when assessing the possibility of a material
misstatement.
If industry competition is intense,
there may be problems with the
proper valuation of inventory.
Technology changes in certain
industries may also promote
material misstatement due to
obsolescence.
Products that are small and of
high value are more susceptible
to theft. The auditor must be
alert to related-party transactions
for acquiring raw materials and
selling finished products. Prior-year
misstatements are good indicators
of potential misstatements in the
current year.
Control Risk Assessment
Major steps in setting the control risk in the
inventory management process.
Understand and document the inventory
management process based on a reliance strategy.
Set and document the control risk for the inventory
management process.
Plan and perform tests of controls on inventory
transactions.
Control Activities and Tests of Controls
Inventory Transactions
Assertion Test of Controls
Occurrence
Observe and evaluate proper segregation of duties. Review and test procedures for transfer
of inventory. Review and test procedures for issuing materials to manufacturing
departments. Review and test client procedures for account for numerical sequence of
materials requisitions.
Completeness
Observe the physical safeguards over inventory. Review and test client's procedures for
consignment goods.
Authorization
Review authorized production schedules. Review and test procedures for developing
inventory levels and procedures used to control them.
Accuracy
Review and test procedures for taking physical inventory. Review and test procedures used
to develop standard costs. Review and test cost accumulation and variance reports. Review
and test procedures for identifying obsolete, slow-moving, and excess quantities. Review
the reconciliation of perpetual inventory to general ledger control account.
Cutoff
Review and test procedures for processing inventory included on receiving reports into the
perpetual records. Review and test procedures for removing inventory from perpetual
records based on shipments of goods.
Classification Review the procedures and forms used to classify inventory.
Relating the Assessed Level of
Control Risk to Substantive
Procedures
Assertions about Classes of Transactions and Events
Assertions about Account Balances at the Period End
Assertions about Presentation and Disclosure
Auditing Inventory
Substantive Analytical Procedures
Substantive Analytical Procedure Possible Misstatement Detected
Compare raw material, finished goods, and total inventory
turnover to previous years' and industry averages.
Obsolete, slow-moving, or excess inventory
Compare days outstanding in inventory to previous years'
and industry average.
Obsolete, slow-moving, or excess inventory
Compare gross profit percentage by product line with
previous years' and industry data.
Unrecorded or fictitious inventory
Compare actual cost of goods sold to budgeted amounts. Over- or understated inventory
Compare current-year standard costs with prior years' after
considering current conditions.
Over- or understated inventory
Compare actual manufacturing overhead costs with
budgeted or standard overhead costs.
Inclusion or exclusion of overhead costs
Auditing Inventory
Auditing Standard Costs
Material
Test the quantity and
type of materials
included in the product
and the price of the
materials.
Labor
Gather evidence about
the type and amount of
labor needed for
production and the labor
rate.
Overhead
Review the clients method of
overhead allocation for
reasonableness, compliance
with GAAP, and consistency.
Auditing Inventory
Observing Physical Inventory
During the observation of the physical inventory
count, the auditor should do the following:
1. Ensure that no production is scheduled.
2. Ensure that there is no movement of goods during the count.
3. Make sure that the clients count teams are following instructions.
4. Ensure that inventory tags are issued sequentially to individual
departments.
5. Perform test counts.
6. Obtain tag control information.
7. Obtain cutoff information.
8. Observe the condition of the inventory excess, obsolete, slow moving.
9. Inquire about goods held on consignment.
Tests of Details of Transactions,
Account Balances, and Disclosures
Occurrence
Completeness
Authorization
Accuracy
Cutoff
Classification
Substantive Tests
of Transactions
Existence
Rights and obligations
Completeness
Valuation and allocation
Test of Details of
Account Balances
Accuracy and Valuation
Test of Details of
Disclosures
Occurrence, Rights and Obligations
Completeness
Classification and Understandability
Tests of Details of Transactions,
Account Balances, and Disclosures
Examples of Disclosure Items:
1. Cost method (FIFO, LIFO, retail method).
2. Components of inventory.
3. Long-term purchase contracts.
4. Consigned inventory.
5. Purchases from related parties.
6. LIFO liquidations.
7. Pledged or assigned inventory.
8. Disclosure of unusual losses from write-downs
or losses on long-term purchase commitments.
9. Warranty obligations.
Evaluating the Audit Findings -
Inventory
At the conclusion of testing, the auditor should
aggregate all identified misstatements. The likely
misstatement is compared to the tolerable
misstatement allocated to the inventory account.
Likely misstatement < Tolerable misstatement
The auditor may accept the inventory account as fairly
presented.
Likely misstatement > Tolerable misstatement
The auditor must conclude the inventory is not fairly
presented.