Copyright © 2016 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.

12-1
  The valuation of goods on hand and in process
often presents complex and difficult issues
 Determining the quantities of inventories may
require specialized techniques
 Inventories often represent the largest current asset
of a company
 Misstatements of inventories directly affect cost of
goods sold and, therefore, net income
 Management fraud has often involved the
fraudulent overstatement of inventories

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-2
 Includes
 Goods on hand ready for sale
 Goods in the process of production
 Goods to be consumed directly or indirectly in
production such as raw materials, purchased parts
and supplies

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-3
1. Use the understanding of the client and its environment to consider inherent
risks, including fraud risks, related to inventories and cost of goods sold.
2. Obtain an understanding of internal control over inventories and cost of goods
sold.
3. Assess the risks of material misstatement and design tests of controls and
substantive procedures that:
a. Substantiate the existence of inventories and the occurrence
of transactions affecting cost of goods sold.
b. Establish the completeness of recorded inventories.
c. Verify the cutoff of transactions affecting cost of goods sold.
d. Determine that the client has rights to the recorded inventories.
e. Establish the proper valuation of inventories and the accuracy of
transactions affecting cost of goods sold.
f. Determine that the presentation and disclosure of information about
inventories and cost of goods sold are appropriate, including disclosure of
the classification of inventories, accounting methods used, and inventories
pledged as collateral for debt.

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-4
 Significant impact on responsibility of auditors
with respect to validity of inventories
 Case: 1939 – the audited financial statements
contained $19 million of fictitious assets
including $10 million of nonexistent
inventories
 Auditors followed customary auditing practice which limited
audit work on inventories to examining records only
 Statements on Auditing Procedures 1 and 2 – first formal
auditing standards issued by AICPA affirmed the importance
of auditors’ observation of physical inventories although other
auditing procedures could be substituted

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-5
  Periodic inventory system
 Determine inventory quantities solely by an annual
physical count
 Perpetual inventory records
 Inventory updated constantly
 Strong internal control over inventories
 May use test counts throughout the year

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-6
 Control environment
 Commitment to competence and human resource
policies and practices
 Appropriately qualified and trained personnel assigned to
inventory
 Integrity and ethical values
 Company purchasing agents do not accept “kickbacks”
 Organizational structure and assignment of
authority and responsibility
 Purchasing, receiving and production understand roles

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-7
  Risk assessment; risks related to
 Availability of a supply of goods, services, and skilled
labor
 Stability of prices and labor rates
 Generation of sufficient cash flow to pay for purchases
 Changes in technology that affect manufacturing
processes
 Obsolescence of inventory

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-8
  Monitoring
 Observations by production supervisors of
performance of various activities and functions
 Quality and performance reviews
 Formal program to consider improvements in
purchasing and production noted by internal
auditors

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-9
 Purchasing
 Receiving
 Storing
 Issuing
 Processing
 Shipping

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-10
  Internal control
 Segregation of purchasing, receiving and recording
 Cycle
 Purchase requisition form completed by department
 Purchasing prepares purchase order
 May obtain bids but need approval
 Item description and quantity
 Copy forwarded to accounting
 Copy forwarded to receiving should not include
quantity

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-11
  Receiving
 Determines quantity of goods received
 Detects damaged or defective merchandise
 Prepares receiving report
 Prompt transmittal of goods received to stores
department
 Storing
 Counts, inspects and receives goods
 Notifies accounting of receipt
 Physically secures inventory

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-12
 Stores department issues goods to requesting
department
 Prenumbered requisition
 Production
 Controlled with master production schedule
 Production orders
 Materials requisitions and move tickets
 Job time tickets

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-13
  Shipment upon authorized sales order
approved by credit department
 Generates a prenumbered shipping document
 One copy in shipping
 One copy to billing
 Third copy used as packing slip
 For goods shipped common carrier – fourth copy
services as bill of lading

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-14
  Accounts for usage of raw materials
 Determines content and value of
goods in progress
 Compute finished inventory

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-15
 Perpetual inventory system
 Provide information essential to purchasing, sales
and production-planning policies
 Allows companies to control high costs of holding
excessive inventory
 IT systems
 Easier to control inventories
 EDI to coordinate production and purchasing

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-16
 Segregation of duties over purchases and custody of
inventory
 Use of pre-numbered requisitions, purchase orders, and
receiving reports
 Procedures for authorizing purchase transactions and
verifying them for payment
 General ledger control of inventories and reconciliation to
production records
 Cost accounting controls
 Analysis of variances from standard costs
 Use of perpetual records for inventories
 Use of appropriate procedures for taking inventory
 Appropriate physical controls over inventories

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-17
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-18
 A. Use the understanding of the client and its environment to
consider inherent risks, including fraud risks, related to
inventories and cost of goods sold.
B. Obtain an understanding of internal control over inventories and
cost of goods sold.
C. Assess the risks of material misstatement and design further
audit procedures.
D. Perform further audit procedures—tests of controls.
1. Examples of tests of controls:
a. Examine significant aspects of a sample of purchase
transactions.
b. Perform tests of the cost accounting system.
2. If necessary, revise the risks of material misstatement based
on the results of tests of controls.

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-19
 E. Perform further audit procedures—substantive
procedures for inventories and cost of goods sold.

1. Obtain listings of inventory and reconcile to ledgers.

2. Evaluate the client’s planning of physical inventory.
3. Observe the taking of physical inventory and make test
counts.
4. Review the year-end cutoff of purchases and sales
transactions.

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-20
 E. Perform further audit procedures
5. Obtain a copy of the completed physical inventory, test its
clerical accuracy, and trace test counts.
6. Evaluate the bases and methods of inventory pricing.
7. Test the pricing of inventories.
8. Perform analytical procedures.
9. Determine whether any inventories have been pledged and
review purchase and sales commitments.
10. Evaluate financial statement presentation of inventories and
cost of goods sold, including the adequacy of disclosure.

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-21
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-22
 1. Inventories constitute a large asset and very
susceptible to major errors and fraud.
2. The accounting profession allows numerous
alternative methods for valuation of inventories, and
different methods may be used for various classes of
inventories.
3. The determination of inventory value directly affects
the cost of goods sold and has a major impact on net
income for the year.
4. The determination of inventory quality, condition, and
value is inherently a more complex and difficult task
than is the case with most other elements of financial
position.

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-23
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-24
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-25
  Selecting of the appropriate date
 Suspending production
 Segregating obsolete and defective
goods
 Establishing control over the counting
process
 Achieving proper cutoff of sales and
purchases
 Arranging for the services of specialists
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-26
 Plan should be documented and
communicated in form of written instructions
to personnel taking physical inventory
 Letter from client reviewed by auditors
 Auditors consider nature and materiality of
inventories
 Date is typically at or near balance sheet date unless
internal control is effective

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-27
 Client counts and supervises inventory
 Auditors observe
 Determine all items included
 Employees comply with instructions
 Be alert for inclusion of obsolete or damaged
merchandise
 Record numbers of final receiving and shipping
documents issued before inventory taking
 Make test counts
 Tag control

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-28
  Inventory verification when auditor unable to observe
taking of inventory at close of year.
 May conclude that sufficient appropriate evidence
cannot be obtained to express an opinion
 Or could obtain satisfaction with alternative auditing
procedures
 Existence of strong internal control
 Perpetual inventory records
 Documentation of well-planned and executed physical
inventory
 Making of test counts

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-29
  Examine on a test basis the purchase invoices
and receiving reports for several days before
and after the inventory date.
 Determine that liability has been recorded for all
goods in inventory
 Make sure shipments and purchases recorded in
proper period

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-30
  Emphasize:
 What method of pricing does the client use?
 Is the method of pricing the same as that used in
prior years?
 Has the method selected by the client been applied
consistently and accurately in practice?
 Test the pricing of inventories

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-31
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-32
  Disclosure of inventory pricing methods or
methods in use
 Other important disclosures:
 Changes in methods
 Classifications of inventory
 Details of pledged inventory
 Deduction of valuation allowance for inventory
losses
 Existence and terms of inventory purchase
commitments.

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-33
 Procedures to obtain evidence that beginning
inventory is fairly stated
 Review predecessor’s working papers
 Discuss with person who supervised physical
inventory at beginning
 Study written instructions in planning
 Trace numerous items from inventory tags to final
summary sheets
 Test perpetual inventory records for previous year
 Test overall reasonableness of beginning inventory

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-34