CHAPTER FOUR

AUDIT OF INVENTORIES AND COST OF GOOD SOLD

4.1 Inventory Management Process

 The inventory management process is affected by the internal control procedures for revenue,
purchasing and payroll processes. The acquisition of and payment for inventory are controlled via
purchasing process. The cost of both direct and indirect labor assigned to inventory is controlled
through the payroll process. Last, finished goods are sold and accounted for as part of the revenue
process. Thus, the “cradle-to-grave” cycle for inventory begins when goods are purchased and
stored and ends when the finished goods are shipped to customers.
 The following are the more important documents and records that are normally involved in the
inventory system. In advanced IT system, some of these documents and records may exist for only
a short time or only in machine readable form.
 Production and schedule
 Receiving report
 Material requisition
 Inventory master file
 Production data information
 Cost accumulation and variance report
 Inventory status report
 Shipping Order
4.2 Internal Control over Inventories

 The followings are internal control procedures that should exist in the client’s business to control
inventory properly
 Purchase or other commitment should be initiated only by authorized personnel, preferably on
the basis of competitive bid.
 Purchase orders for good and materials are placed as needed and for optimum quantity
 Follow up should be made on purchase orders if delivery has not been made by the scheduled
delivery date
 Incoming shipment should be accepted only if the receiving department has authorization in
the form of a copy of purchase order.
 Quantity and quality of goods received should be as specified before payment is authorized

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  Terms, prices, and clerical accuracy of vendors invoice should be correct before payment is
authorized
 Refund or credit should be received for all purchase returned and allowance
 The need to reorder signaled as soon as the amount of inventory on hand reaches a minimum
safety balance
 Inventory quantity should be adequately protected against losses from theft, spoilage,
unauthorized withdrawal by employee.
 There should be full accountability for both units and birr for inventory quantity received, on
hand and issued or sold.
 Difference between book and physical inventories are ascertained, differences adjusted and
the amount of overage or shortage should be properly accounted for.
 Proper authorization exists for inventory quantity removed from stock
 All transactions pertaining to the issue or sales of inventories quantity should be accounted for
and entered in the controlling record.
 Inventory issues should be valued according to an acceptable method and the costs should be
accounted for in a manner that provides adequate information for management including
variance from standard
4.3 Audit Objectives for Testing Inventory

General Audit
Objective Specific Audit Objective
Validity Determine whether recorded inventory actually exists
Completeness Determine whether all inventories are recorded
Cutoff Determine whether all transaction that affect inventory are record in the correct
period
Ownership Determine whether all recorded inventories are owned by the entity and whether it
is subject to any liens or restrictions.
Accuracy Determine whether inventory is properly accumulated from journals to ledgers

Valuation Determine whether inventory is properly valued in accordance with GAAP

Classification Determine whether inventory is properly classified in the general ledger and the
financial statements
Disclosure Determine whether all disclosure related to inventories are included in the financial
statement

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4.4 Test of Account Balances for Inventory

 Accuracy: Testing the accuracy of inventory requires obtaining a copy of the compilation of the
physical inventory quantities and prices. The inventory compilation is footed, and the
mathematical extensions of quantity multiplied by price are tested. Additionally, test counts made
by the auditor during the physical inventory and tag control information are traced into the
compilation. Many times the client has adjusted the general ledger inventory balance to agree to
the physical inventory amount (referred to as book–to–physical adjustment) before the auditor
begins the substantive tests of account balances. If the client has made the book- to physical
Adjustment, the totals from the compilation for inventory should agree with the general ledger.
 When the client maintains perpetual inventory system, the totals from the inventory compilation
should also be agreed to these records. The auditor can use computer-assisted audit techniques to
accomplish these audit steps. For example, the auditor can use a generalized or custom audit soft–
ware package to trace test control information into the client’s computer file of the inventory
compilation. The extensions and footing can also be tested at the same time.
 Validity or Existence: is one of the more important audit objectives for the inventory account.
Observation of the physical inventory is the primary audit step used to verify this objective. If the
auditor is satisfied with the client’s physical inventory count, the auditor has sufficient, competent
evidence on the validity or existence of recorded inventory.
 Completeness: The auditor must determine whether all inventories have been included in the
inventory compilation and the general ledger inventory account. The tests related to the
observation of the physical inventory count provide assurance that all goods on hand are included
in inventory. Tracing test counts and tag control information into the inventory compilation
provides assurance that the inventory counted during the physical inventory observation is
included in the compilation. In some cases, inventory is held on consignment by others or is stored
in public warehouses. The auditor normally confirms or physically observes such inventory.
 Cutoff: In testing the cutoff objective for inventory, the auditor attempts to determine whether all
sales of finished goods and purchases of raw materials are recorded in the proper period. For sales
cutoff, the auditor can examine a sample of shipping documents for a few days before and after
year-end for recording of inventory shipments in the proper period. For purchases cut off, the
auditor can examine a sample of receiving documents for a few days before and after year-end for
recording of inventory purchases in the proper period.
 Ownership: The auditor must determine whether the recorded inventory is actually owned by the
entity. Two issues related to ownership can arise. First, the auditor must be sure that the inventory

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 on hand belongs to the client. If the client holds inventory on consignment, such inventory should
not be included in the physical inventor. Second, in some industries, goods are sold on a” bill-and
hold” basis. In such a case, the goods are treated as a sales but the client holds the goods until the
customer needs them. Again, the auditor must be certain that such goods are segregated and not
counted at the time of the physical inventory.
 Valuation: A number of important valuation issues are related to inventory. The first issue relates
to the costs used to value the inventory items included in the compilation. When the client
purchases inventory, Valuation of the inventory can normally be accomplished by vouching the
costs to vendors’ invoices. When the client uses standard costs, the auditor audits the standard cost
as discussed previously. The second valuation issue relates to the lower-of –cost-or market tests for
inventory. The auditor normally performs such tests on large-dollar items or on the client’s various
product lines. A third valuation issue relates to obsolete, slow- moving, or excess inventory. The
auditor should ask management about such issues. When these issues exist, the inventory should
be written down to its current market value. Finally, the auditor should investigate any large
adjustments between the amount of inventory shown in the general ledger account and the amount
determined from the physical inventory account for possible misstatement.
 Classification: In a manufacturing company, the auditor must determine that inventory is properly
classified as raw materials, work in process or finished good. In most manufacturing companies,
proper classification can be achieved by determining which manufacturing processing department
has control of the inventory on the date of the physical count. For example, if inventory tags are
used to count inventory and they are assigned numerically to department, classification can be
verified at the physical inventory. The auditor can ensure that each department is using the
assigned tags. The tag control information by department can be compared to the information on
the inventory compilation to assure that it is properly classified among raw materials, work in
process, and finished goods.
 Disclosure: Several important disclosure issues are related to inventory For example, management
must disclose the cost method, such as LIFO or FIFO, used to value inventory. Management must
also disclose the components (raw materials, work in process, and finished goods) of inventory
either on the face of the balance sheet or in the footnotes. Finally, if the entity uses LIFO to value
inventory and there is a material LIFO liquidation, footnote disclosure is normally required. Other
information’s which requires disclosure are:
 Long term purchase contract
 Purchase from related parties
 Pledged or assigned inventory
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  Warranty obligation
 Unusual loss
 Consigned inventory
 Observing Physical Inventory: the auditor’s observation of inventory is generally accepted
auditing procedure. However, the auditor is not required to observe all inventories, but only
inventory that is material. Internal auditors may also observe physical inventory. The primary
reason for observing the clients physical inventory is to establish the validity or existence of the
inventory. The observation of the physical inventory also provides evidence on the ownership and
valuation audit objectives. Based on the physical inventory count, the client compiles the physical
inventory. While the form of compilation may differ among entities, it normally contains a list of
the item by type and quantity, the assigned cost for each item, the inventory value for each item,
and a total for the inventory.
 Prior to the physical count of the inventory, the auditor should be familiar with the inventory
location, the major items in inventory and the client’s instructions for counting inventory. During
observation of physical inventory, the auditor should do the following.
 Ensure that no production is scheduled or if production is scheduled, ensure that proper
control are established for movement between departments in order to prevent double
counting.
 Ensure that there is no movement of goods during the inventory count. If movement is
necessary, the auditor and client personnel must ensure that the goods are not double
counted and that all goods are counted.
 Make sure that the clients count teams are following the inventory count instruction, the
auditor notify the client’s representation in charge of the area.
 Ensure that inventory tags are issued sequentially to individual departments for many
inventory counts; the goods are marked with multi copy inventory tags. The count teams
record the type and quantity of inventory on each tag, and one copy of each tag is then used
to compile the inventory, such as detailed inventory listing on handheld computers, the
auditor should obtain copies of the listing or files prior to the start of the inventory count.
 Perform test counts and record a sample of counts in the working papers. This information
will be used to test the accuracy and completeness of the client’s inventory compilation.
 Obtain tag control information for testing the client’s inventory compilation. Tag control
information includes documentation of the numerical sequence of all inventory tags and
accounting for all used and unused inventory tags. If inventory listings are used by the

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 clients, copies of listing will accomplish the objectives of documenting the entire inventory
count.
 Obtain cutoff information, including the numbers of the last shipping and receiving
document issued on the date of the physical inventory count.
 Observe the condition of the inventory for items that may be obsolete, slow moving or
carried in excess quantity.
 Inquiry about goods held on consignment for others or held on a bill and hold basis, such
items should not be included in the clients inventory. The auditor must also inquire about
goods held on consignment for the client. These goods should be included in the inventory
count. If these audit procedures are followed, the auditor has reasonable assurance that a
proper inventory count has been taken.