UNIT 4

AUDIT OF INVENTORIES
Estimated Time: 4.5 HOURS
*Use Louwers 4th edition

Discussion questions 4-1

1. Many auditors consider the substantiation of the figure for inventory to be a more
difficult and challenging task than the verification of most other items on the balance
sheet. List several specific factors that support this view.
2. What should be considered in classifying inventory items? What are those items that
should be accounted for as part of inventory? What role does passage of title play in
the recognition of inventories? How should an auditor account for items not classified
as inventory?

Discussion questions 4-2

Refer to Louwers 9-10, 9-12, 9-14 and 9-17.

Problem 4-1 Items to be reported as inventory

In an annual audit at December 31, 2012, you find the following transactions near the
closing date:
1) Merchandise costing P18,220 was received on January 3, 2013, and the related
acquisition invoice recorded January 5. The invoice showed the shipment was
made on December 29, 2012, FOB destination.
2) Merchandise costing P6,250 was received on December 28, 2012, and the
invoice was not recorded. You located it in the hands of the purchasing agent; it
was marked “ON CONSIGNMENT.”
3) A package case containing products costing P8,160 was standing in the shipping
room when the physical inventory was taken. It was not included in the inventory
because it was marked “HOLD FOR SHIPPING INSTRUCTIONS.” Your
investigation revealed that the customer’s order was dated December 18, 2012,
but that the case was shipped and the customer billed on January 10, 2013. The
product was a stock item of your client.
4) Merchandise received on January 6, 2013, costing P7,200 was entered in the
acquisitions journal on January 7, 2013. The invoice showed shipment was made
FOB supplier’s warehouse on December 31, 2012. Because it was not on hand
December 31, it was not included in inventory.
5) A special machine, fabricated to order for a customer, was finished and in the
shipping room on December 31, 2012. The customer was billed on that date and
the machine excluded from inventory, although it was shipped on January 4,
2013.

Assuming that each of the amounts is material, state whether the merchandise should be
included in the client’s inventory or not and give your reason for your decision on each
item.

Problem 4-2 Sales/inventory cutoff

Refer to Louwers 9.46.

Problem 4-3 Purchasing cutoff

Refer to Louwers 9.47.

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Problem 4-4 Sales and purchases cut-off
WWW Enterprises engaged you to examine its books and records for the fiscal year
ended June 30, 2012. The company’s accountant has furnished you not only the copy of
trial balance as of June 30, 2012 but also the copy of company’s balance sheet and
income statement as of the said date. The following data appears in the cost of goods
sold section of the income statement:

Inventory, July 1, 2011 P500,000

Add: Purchases 3,600,000
Goods available for sale 4,100,000
Less: Inventory, June 30, 2012 700,000
Cost of goods sold P3,400,000

The beginning and ending inventories of the year were ascertained through physical
count except that no reconciling items were considered. Even though the books have
been closed, your working paper trial balance shows all accounts with activity during the
year. All purchases are FOB shipping point. The company is employing a periodic
inventory system.

In your examination of inventory cutoffs at the beginning and end of the year, you took
note of the following:

July 1, 2011:
a) June invoices totaling to P130,000 were entered in the voucher register in June.
The corresponding goods not received until July.
b) Invoices totaling P54,000 were entered in the voucher register in July but the
goods received during June.
June 30, 2012:
c) Invoices with an aggregate value of P186,000 were entered in the voucher
register in July, and the goods were received in July. The invoices, however,
were dated June.
d) June invoices totaling P74,000 were entered in the voucher register in June but
the goods were not received until July.
e) Invoices totaling P108,000 (the corresponding goods for which were received in
June) were entered in the voucher register in July.
f) Sales on account in the total amount of P176,000 were made on June 30 and the
goods delivered at that time. Book entries relating to the sales were made in June.

Prepare an audit working paper to answer the following questions:

1) How much is the adjusted Inventory as of July 1, 2011?
2) How much is the adjusted Purchases for the fiscal year ended June 30, 2012?
3) How much is the adjusted Inventory as of June 30, 2012?
4) How much is the adjusted Cost of Goods Sold for the fiscal year ended June 30,
2012?
5) What are the necessary adjusting entries to be made as of June 30, 2012?

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Problem 4-5 Valuation and accuracy of reported inventory
An audit is being made of the accounts of XXX Company for the year ended December
31, 2012. You were asked to verify the following merchandise inventory items as to
correctness of quantity, pricing, and extension.

Item Quantity Price per unit Amount

A 31,700 P 5.00 P 158,500.00
B 9,500 45.20 423,400.00
C 3,500 112.00 392,000.00
D 11,500 pcs 8.50 (per doz) 97,750.00
E 81,000 1.80 1,458,000.00
F 3,700 gross 17.20 per gross 63,640.00
G 21,500 20.00 430,000.00
H 2,100 63.90 134,190.00
I 25,500 5.50 140,250.00
J 4,100 doz 19.00 per piece 77,900.00
K 7,000 36.00 252,000.00
L 8,800 95.10 836,880.00
P 4,464,510.00

A comparison of the quantities in the inventory with those on the original tags used in
making the count disclosed that item “C” should be 5,300 units instead of 3,500 and item
“F” should be 7,300 gross instead of 3,700 gross. Quantities of the other items in the
inventory were in agreement with quantities on the inventory tags.

Net realizable values as of the closing date were as follows:

Item Item Item
A P 5.10 E P 1.50 I P 4.50
B 45.50 F 17.20 per J 19.00 per piece
gross
C 112.00 G 19.00 K 30.00
D 8.30 per doz H 64.00 L 94.70

1. Prepare a schedule or schedules showing the corrected inventory values.

2. Using direct write-off, what adjustments should be made to correct the accounts,
assuming inventory per books agrees with the inventory total shown above (use one
compound entry only)?

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Problem 4-6 Inventory estimation - gross profit
On March 31, 2012, DDD Company had a fire which completely destroyed the factory
building and inventory of goods in process; some pieces of equipment were saved.

After the fire, a physical inventory was taken. The material was valued at P750,000 and
the finished goods at P620,000.

The inventories on January 1, 2012 consisted of:

Materials P 335,000
Goods in process 1,215,000
Finished goods 1,700,000
Total P 3,250,000

A review of the accounting records disclosed that the sales and gross profit on sales for
the last three years were:

Sales Gross profit

2009 P 8,000,000 P 2,400,000
2010 7,600,000 2,250,000
2011 5,000,000 1,775,000

The sales for the first three months of 2012 were P3,000,000. Material purchases were
P1,250,000, transportation on purchases was P90,000 and direct labor cost for the three
months was P1,000,000. For the past two years, factory overhead cost has been 70% of
direct labor cost.

1. Determine the most likely gross profit rate to be used in estimating the inventory of
goods in process destroyed by fire.
2. Compute for the total cost of goods placed in process.
3. Compute for the total cost of goods manufactured.
4. Determine the goods in process that were destroyed by fire.

Problem 4-7 –Physical observation audit tests for inventory – periodic

You have been engaged for the audit of ZZZ Chemicals, Inc. for the year ended
December 31, 2012. ZZZ is engaged in the wholesale chemical business and makes all
sales at 25% over cost.

Following are portions of the client’s sales and purchases accounts for the calendar year
2012.

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 EXHIBIT
Sales
Balance Forward
Date Reference Amount Date Reference Amount
Closing
12/31 P699,860 P658,320
entry
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
P360,300 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

You observed the physical inventory of goods in the warehouse on December 31, 2012,
and were satisfied that it was properly taken.
When performing a sales and purchases cutoff test, you found that at December 31,
2012, 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, 2012, were
chemicals that had been acquired and received on receiving report no. 1060 but
for which an invoice was not received until 2013. Cost was P2,183.
2. In the warehouse at December 31, 2012, were goods that had been sold and
paid for by the customer but which were not shipped out until the year 2013.
They were all sold on sales invoice no. 965 and were not inventoried.
3. On the evening of December 31, 2012, two cars were on ZZZ Chemicals siding:
a. Car AR38162 was unloaded on January 2, 2013, and received on
receiving report no. 1063. The freight was paid by the vendor.
b. Car BAE74123 was loaded and sealed on December 31, 2012, and was
switched off the company’s siding on January 2, 2013. The sales price
was P12,700 and the freight was paid by the customer. This order was
sold on sale invoice no. 968.

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 4. Temporarily stranded at December 31, 2012 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.
5. En route to ZZZ Chemicals on December 31, 2012, 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 ZZZ Chemicals. However, the freight
was deducted from the purchase price of P975.
6. Included in the physical inventory were chemicals exposed to rain in transit and
deemed unsalable. Their invoice cost was P1,250, and freight charges of P350
had been paid on the chemicals. ZZZ Chemicals filed a claim against the shipper
in January 2013.

1) Prepare a schedule or schedules showing the corrected inventory values and draft
proposed adjusting entries as of December 31, 2012.
2) Calculate the corrected physical inventory at December 31, 2012.

Problem 4-8 –Physical observation audit tests for inventory – perpetual

You have been engaged for the audit of AAA Tires, Inc. for the year ended December 31,
2012. AAA Tires is engaged in the wholesale auto parts business. All sales are made at
cost plus 30 percent of cost. AAA Tires maintains perpetual inventory records and
adjusts the records annually after taking a physical inventory.

Shown in Exhibit are portions of AAA Tires’ sales and inventory accounts for tires, the
single most important (40 percent of total sales) product handled by the firm.

EXHIBIT
Tire Sales
Date Reference Amount Date Reference Amount
Closing Balance
12/31 P11,460,200 P11,250,000
entry Forward
12/27 SO# 1278 16,400
12/28 SO# 1279 48,600
12/28 SO# 1280 20,100
12/31 SO# 1281 56,800
12/31 SO# 1282 17,600
12/31 SO# 1283 42,700
12/31 SO# 1284 8,000
P11,460,200 P11,460,200

Tire Inventory
Date Reference Amount Date Reference Amount
Balance Adjustment
P780,680 12/31 P120,480
Forward to physical
12/28 RR# 2060 6,400
12/30 RR# 2062 22,600
12/31 RR# 2063 10,800

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You observed the physical inventory and are satisfied that it was taken properly. The tire
inventory is located in two adjacent bays in the company’s central warehouse.
When performing a sales and purchases cutoff test, you found that at December 31,
2012, the last receiving report used was #2063. Moreover, you determined that no
shipments had been made on any shipping orders with numbers larger than 1281.
You also obtained the following information:
1. Included in the physical inventory at December 31, 2012, were tires that had
been purchased and received on receiving report #2061 but for which an invoice
was not received until 2013. The cost was P14,200.
2. In the warehouse at December 31, 2012, were tires that had been sold and paid
for by the customer but that were not shipped until 2013. They were all sold on
sales invoice/shipping order #1278. The tires were included in the physical
inventory.
3. On the evening of December 31, 2012, two cars were on the AAA Tires railroad
track. Both cars contained tires that were included in the 12/31/12 physical
inventory. Car #SA877560 was unloaded on January 2, 2013, and received on
receiving report #2064 (cost of tires, P16,800). The freight was paid by the
vendor. Car #EE455621 was loaded and sealed on December 31, 2012, and
because the freight was paid by the customer, title passed when the car was
switched off the Hedley track on January 2, 2013. The sales price was P56,800.
This order was sold on sales invoice/shipping order #1281.
4. Temporarily stranded on a railroad track at December 31, 2012, were two cars of
tires in transit to St. Luke Tires of San Felipe. They were sold on sales
invoice/shipping order #1279 and the terms were FOB shipping point.
5. En route to AAA Tires on December 31, 2012, was a truckload of tires that was
received on receiving report #2065. The tires were shipped FOB shipping point
and freight of P1,600 was paid by AAA Tires. However, the freight was deducted
from the purchase price of P32,100.
6. Included in the physical inventory were tires damaged by excessive heat in transit
and deemed unsalable. Their invoice cost was P16,300; freight charges of P960
had been paid on the tires. AAA Tires filed a claim against the shipper in January
2013.

1. Prepare a schedule or schedules showing the corrected inventory values and

draft proposed adjusting entries as of December 31, 2012.
2. Calculate the corrected physical inventory at December 31, 2012.

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Problem 4-9 Comprehensive problem
You are observing inventory as a part of the August 31 year-end audit of BBB
Warehouse Supply Company, a wholesale and retail engine parts company. Inventory
included a large number of diverse parts varying from small bolts to large engines for
earth-moving equipment.

The company has ceased operation during the physical count except for receiving goods
from suppliers and making shipments to essential wholesale customers. On the morning
of the physical count, which is Saturday, September 2, you record in your working
papers the last shipping document and receiving report number issued the previous day.
They are 109313 and 41682, respectively.

You observe the client’s counting procedures and test count selected inventory yourself.
You conclude the counts and descriptions are accurate. Before you leave the warehouse
at the end of the day, after all counting is completed, you do several things:
1) Examine the receiving report book. The last number used was 41685. The
receiving clerk informs you that all goods received on September 2 were kept in
the receiving department with other goods received during the past two or three
days.
2) Examine the shipping document book. The last number used was 109317. The
shipping department informs you that two shipments were made in the morning,
one was made after noon, and one was still in the shipping department.
3) Ask the receiving department to identify all goods received September 1. He
identifies receiving reports 41680 through 41682 as having been received
September 1.
4) Ask the shipping department to identify all goods shipped or sold over the counter
September 1. He informs you goods on shipping document 109311 to 109313
were shipped September 1. He shows you approximately 300 duplicate sales
slips for September 1 over-the-counter sales. September 1 retail sales totaled
P12,690, but they were not included in August sales.
5) Examine the client’s inventory counts in the receiving department. Inventory had
been counted only for receiving reports 41674 to 41684.
6) Examine the client’s inventory counts in the shipping department. Inventory had
been counted only for shipping documents 109316 and 109317. Further
examination shows that the inventory for all shipments made September 2 were
included in the counts in the department from which the inventory was taken.

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 During the year-end audit work you obtain selling prices, costs, terms, and recording
data for each receipt and shipment. They are as shown as follow:

ACQUISITON OF INVENTORY
Receiving Date Date Amount of Included In FOB Origin
Report Shipped Received Acquisition Or Excluded or
From August Destination
Acquisitions
Journal

41679 8-29 8-31 P 860 I Destination

41680 8-27 9-01 1,211 I Origin
41681 8-20 9-01 193 I Origin
41682 8-27 9-01 4,674 I Destination
41683 8-30 9-02 450 E Destination
41684 8-30 9-02 106 E Origin
41685 9-02 9-02 2,800 E Origin
41686 8-30 9-02 686 E Destination

SHIPMENTS OF INVENTORY
Shipping Date Shipped Amount of Sale Included in or
Document Excluded from
No. August
Sales Journal
109310 8-31 P 780 I
109311 9-01 56 I
109312 9-01 3,194 I
109313 9-01 635 I
109314 9-02 193 I
109315 9-02 1,621 E
109316 9-02 945 E
109317 9-02 78 E
109318 9-02 3,611 E

Assume the information you have obtained from the receiving and shipping departments
about the September 1 receipts and shipments is accurate.

1. Prepare all adjustments for cutoff errors in accounts payable, assuming no

acquisitions are made for cash.
2. Prepare all adjustments for errors in sales.
3. What is the amount of the client’s error in inventory assuming a periodic inventory
method, and no adjustments in part (a) or (b) affected inventory? For retail sales,
assume the gross margin percentage is approximately 30 percent.

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