UNIT 4

AUDIT OF INVENTORIES
Estimated Time: 5.0 HOURS

Discussion questions 4-1

1. For what purposes do the auditors make and record test counts of inventory
quantities during their observation of the taking of the physical inventory? Discuss.
2. “If the auditors can determine that all goods in the physical inventory have been
accurately counted and properly priced, they will have discharged fully their
responsibility with respect to inventory.” Evaluate this statement.

Discussion questions 4-2

Identify the assertion that each audit procedure related to inventory would test:
1. Observe the client counting inventory.
2. Confirm inventory stored in public warehouses.
3. Foot the inventory listing.
4. Trace test counts to inventory listing.
5. Account for inventory tags.
6. Determine whether inventory has been valued at the lower of cost or net realizable
value.
7. Tour the inventory area to determine that all inventory items have been tagged.
8. Obtain the receiving report for the last goods received.
9. Test perpetual records for inventory, using records-to-floor and floor-to-records tests.
10. Review the client’s written inventory procedures.

Discussion questions 4-3

During your observation of the November 30, 2019, physical inventory of EJM Company,
you note the following unusual items:
a. Electric motors in finished goods storeroom not tagged. Upon inquiry, you are
informed that the motors are on consignment to EJM Company.
b. A cutting machine (one of EJM’s principal products) in the receiving department, with
a large REWORK tag attached.
c. A crated cutting machine in the shipping department, addressed to a nearby
Philippine naval base, with a Department of National Defense “Material Inspection
and Receiving Report” attached, dated November 30, 2019, and signed by the Naval
Source Inspector.
d. A small, isolated storeroom with five types of dusty raw materials stored therein.
Inventory tags are attached to all of the materials, and your test counts agree with
tags.

Required: What additional procedures, if any, would you carry out for each of the above?
Explain.

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Problem 4-1 Inventory Count, Items to be Reported as Inventory
Zaldy Inc. uses a perpetual inventory system and reports inventory using the First-In-
First-Out (FIFO) basis. Zaldy’s inventory per records on December 31, 2019 was
P450,000. A physical count conducted on that day found inventory on hand of P440,000.
An investigation of the discrepancy revealed the following information:
a. Goods worth P15,000 held on consignment from Dy Co. had been included in the
physical count.
b. Goods costing P4,000 were purchased on credit from Sitingco Co. on December 27.
Freight term of the purchase was FOB Shipping Point. The goods were shipped on
December 28 but remained in transit as of December 31 and thus, was not included
in the physical count. The purchase invoice was received and processed on
December 31, 2019.
c. Goods costing P5,000 were sold on credit to Patricia Co. for P7,000 on December
28, 2019 under a FOB Destination freight term. The goods were still in transit on
December 31. The sales invoice was processed and recorded on December 29,
2019.
d. Goods costing P6,000 were purchased on credit (FOB Destination) from Erica Co.
on December 28, 2019. The goods were received on December 29, 2019 and were
included in the physical count. The purchase invoice was received on January 2,
2020.
e. On December 31, 2019, Zaldy sold goods costing P15,000 on credit (FOB Shipping
Point) to Meann Corporation for P20,000. The goods were dispatched from the
warehouse on December 31, 2019 but the sales invoice had not been processed at
that date.
f. Damaged inventory items valued at P6,000 were discovered during the physical
count. These items were omitted from the physical count but write-off of these items
was still pending.

Required:
1. How much is the adjusted inventory balance on December 31, 2019?
2. What adjustment should be made to the reported sales amount of Zaldy for the year
ended December 31, 2019?
3. What is the adjustment to the accounts payable as of December 31, 2019?
4. How much is the “unlocated difference” between the perpetual balance and the
physical count?

Problem 4-2 Sales/Inventory/Purchase Cut-off

The following information was obtained from Mikko’s accounting records for the year
ended December 31, 2019:

Inventory based on December 31 physical count P1,900,000

Accounts Payable, December 31 1,500,000
Sales, net of returns 9,700,000

Additional Information:
a. The physical count included merchandise billed to a customer FOB Shipping Point
on December 31, 2019. These merchandise cost P100,000 and were billed at
P120,000. They were in the client’s shipping area waiting to be picked up by the
customer.

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b. Goods shipped FOB Shipping Point by a vendor were still in transit on December 31,
2019 Invoice cost of the goods amounted to P140,000.
c. Work in process inventory costing P45,000 was sent to a contractor for processing.
d. The physical count excluded goods that were returned by customers on December
31, 2019. These goods had a cost of P75,000 were inspected and returned to
inventory on January 5, 2020. Credit memos for P105,000 were issued for the
returns on January 5.
e. In transit to a customer on December 31, 2019, were merchandise costing P26,000
shipped FOB Shipping Point on December 26, 2019. A sales invoice for P45,000
was issued on January 3, 2020 upon being notified of the customer’s receipt of the
goods.
f. Goods costing P47,000 were received from a vendor on December 31, 2019. In
preparation of New Year, however, these inventories were recorded on a receiving
report dated January 2, 2020. The related invoice was recorded on December 31,
2019. These goods were not included in the physical count.
g. Included in the physical count were goods received from a vendor on December 27,
2019. The related invoice for P54,000 was not recorded by the accounting
department.
h. A monthly freight bill for P48,000 was received on January 3, 2020. It is specifically
related to merchandise bought in December 2019, one-half of which was still in the
inventory at December 31, 2019. The freight was not included in either the inventory
or in accounts payable on December 31, 2019.

Required:
1. How much is the inventory that would be reported in the 2019 statement of financial
position?
2. How much is the adjusted accounts payable that would be reported in the 2019
statement of financial position?
3. How much is the amount of net sales to be reported on the 2019 income statement?
4. How much is the adjustment to inventory on December 31, 2019?
5. How much is the adjustment to accounts payable on December 31, 2019?

Problem 4-3 Physical Observation Audit Tests for Inventory – Periodic

You have been engaged for the audit of Z Company for the year ended December 31,
2019. Z Company is engaged in the wholesale chemical business and makes all sales
at 25% over cost. Unadjusted balances for accounts receivable, inventory and accounts
payable were: P250,000, P300,000 and P200,000 respectively.
Following are portions of the client’s sales and purchases accounts for the calendar year
2019.

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 EXHIBIT
Sales
Balance Forward
Date Reference Amount Date Reference Amount
12/31 Closing entry P699,860 P658,320
12/27 SI# 965 5,195
12/28 SI# 966 19,270
12/28 SI# 967 1,302
12/31 SI# 969 5,841
12/31 SI# 970 7,922
12/31 SI# 971 2,010
P699,860 P699,860

Purchases
Balance Forward
Date Reference Amount Date Reference Amount
P360,000 12/31 Closing entry P385,346
12/28 RR# 1059 3,100
12/30 RR# 1061 8,965
12/31 RR# 1062 4,861
12/31 RR# 1063 8,120
P385,346 P385,346

*SI = Sales Invoice; **RR = Receiving Report

You observed the physical inventory of goods in the warehouse on December 31, 2019,
and were satisfied that it was properly taken.
When performing a sales and purchases cutoff test, you found that at December 31,
2019, the last receiving report used was no. 1063 and that no shipments have been
made on any sales invoices with numbers larger than no. 968. You also obtained the
following additional information:
1. Included in the warehouse physical inventory at December 31, 2019, were chemicals
that had been acquired and received on receiving report no. 1060 but for which an
invoice was not received until 2020. Cost was P2,183.
2. In the warehouse at December 31, 2019, were goods that had been sold and paid for
by the customer but which were not shipped out until the year 2020. They were all
sold on sales invoice no. 965 and were not inventoried. It was appropriately recorded
as a sale.
3. On the evening of December 31, 2019, two cars were on Z Company siding:
a. Car AR38162 was unloaded on January 2, 2020, and received on receiving
report no. 1063. The freight was paid by the vendor.
b. Car BAE74123 was loaded and sealed on December 31, 2019, and was
switched off the company’s siding on January 2, 2020. The sales price was
P12,700 and the freight was paid by the customer. This order was sold on
sale invoice no. 968.
4. Temporarily stranded at December 31, 2019 on a railroad siding were two cars of
chemical en route to the Papyrus Paper Company. They were sold on sales invoice
no. 966, and the terms were FOB destination.

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5. En route to Z Company on December 31, 2019, was a truckload of material that was
received on receiving report no. 1064. The material was shipped FOB destination,
and freight of P75 was paid by Z Company. However, the freight was deducted from
the purchase price of P975.
6. Included in the physical inventory were chemicals exposed to rain while in transit and
deemed unsalable. Their invoice cost was P1,250, and freight charges of P350 had
been paid on the chemicals. Z Company filed a claim against the shipper in January
2020.

Required:
1. Prepare a working paper and the necessary adjusting entries that are required as of
December 31, 2019.
2. How much is the adjusted accounts receivable account as of December 31, 2019?
3. How much is the adjusted sales account for 2019?
4. How much is the adjusted inventory account as of December 31, 2019?
5. How much is the adjusted purchases account for 2019?
6. How much is the accounts payable to be reported in the 2019 statement of financial
position?

Problem 4-4 Inventory Cost Formula & LCNRV

Lawson Company uses the first-in, first-out method in calculating cost of goods sold for
the three products that the company handles. Product A is being sold at P8 per unit,
Product B is being sold at P11 per unit while Product C is being sold at P2 per unit.
Inventories and purchases information concerning the three products are shown below:

Product A Product B Product C

Beginning Inventory 50,000 units @ 30,000 units @ 65,000 units @
P6.00 P10.00 P1.00
January – June Purchases 70,000 units @ 45,000 units @ 30,000 units at
P6.50 P10.50 P1.50
July – December Purchases 30,000 @
P8.00
January – Sales 105,000 units 50,000 units 45,000 units
December

Costs to sell each product is at 10% of the selling price. Normal profit margins of A, B
and C are 30%, 30% and 15% of selling price after selling costs respectively.

On December 31, 2019, the suppliers reduced their prices from the most recent
purchase prices by 20%, 10% and 5% for Products A, B and C respectively. Accordingly,
Lawson decided to reduce their selling price by 10% effective January 1, 2020.

Required:
1. How much is the total cost of the ending inventory on December 31, 2019?
2. How much is the inventory to be presented in the 2019 balance sheet?
3. How much is the allowance for inventory write-down on December 31?
4. How much is the cost of sales, adjusted for the year ended December 31, 2019?

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