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TOPIC 5
AUDIT OF
INVENTORY CYCLE

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INVENTORY

 Raw material inventory

 Work-in-process inventory
 Finished goods inventory.
 Cost of goods sold.

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DOCUMENTS AND RECORDS

 Production schedule.
 Receiving report.
 Material requisition.
 Inventory master file.
 Production data information.
 Cost accumulation and variance report.
 Inventory status report.
 Shipping order.

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THE MAJOR FUNCTIONS

 Inventory Management- maintain inventory at appropriate
levels
 Raw materials Stores- receipt, custody, and issue raw
materials
 Manufacturing- producing the product
 Finished goods stores- storage and control
 Cost accounting- record costs
 General ledger- all inventory and costs of production
are properly accumulated, classified
and summarised in GL

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SEGREGATION OF DUTIES

 The inventory management function should be

segregated from the cost accounting function.
 The inventory stores function should be segregated
from the cost-accounting function.
 The cost-accounting function should be segregated
from the general ledger function.
 The responsibility of supervising physical
inventory taking should be separated from the
inventory management and inventory stores
functions.

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INHERENT RISK ASSESSMENT

 Industry-related factors
 Competition
 Inventory valuation issues
 Rapid technology changes
 Engagement and Operating Characteristics
 Types of product-defalcation(jewelry)
 Valuation can lead to disagreements with client
 Possible related-parties transactions

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CONTROL RISK ASSESSMENT

Understanding and documenting

the inventory internal control system based
on the planned level of control risk

Planning and performing tests of controls

on inventory cycle transactions

Assessing and documenting the

control risk for the inventory cycle

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AUDITING INVENTORY

 Substantive tests of transactions-

 Analytical procedures-
 Tests of account balances

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SUBSTANTIVE TESTS OF
TRANSACTIONS
 Because the inventory cycle interacts with the
revenue, purchasing, and payroll cycles, control
procedures over the receipt of raw materials,
shipment of goods, and assignment of labor costs are
normally tested as part of those cycles.
 If the auditor intends to obtain substantive evidence
on the perpetual inventory records, the tests of
receipt and shipment of goods can be extended by
tracing the transactions into the perpetual inventory
records.

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ANALYTICAL PROCEDURES

 Compare raw material, finished goods, and total

inventory turnover to previous years’ and industry
averages.
 Compare days outstanding in inventory to previous
years’ and industry averages.
 Compare gross profit percentage by product line with
previous years and industry data.
 Compare actual cost of goods sold to budgeted
amounts.

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ANALYTICAL PROCEDURE
(continued)
 Compare current year standard costs with prior
years’ after considering current conditions.
 Compare actual manufacturing overhead costs with
budgeted or standard manufacturing overhead costs.

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AUDITING STANDARD COSTS

 Materials costs-the quantity and type review

 Labor costs-type and amount for production
 Overhead costs-overhead allocation for
reasonableness, compliance with accounting
standards and consistency

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OBSERVATION OF PHYSICAL
INVENTORY
 The auditor's observation of inventory is a generally
accepted auditing procedure.
 The observation of the physical inventory provides
evidence primarily on the validity audit objective
(also ownership and valuation).

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OBSERVATION PROCEDURES
 Insure that no production is scheduled.
 Ensure that there is no movement of goods during
the inventory count.
 Make sure that the client's count teams are following
the inventory count instructions.
 Ensure that inventory tags are issued sequentially to
individual departments.
 Perform test counts and record a sample of counts in
the working papers.

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OBSERVATION PROCEDURES
(continued)
 Obtain tag control information for testing the
client's inventory compilation.
 Obtain cutoff information.
 Observe the condition of the inventory for items
that may be obsolete, slow moving, or in excess
quantities.
 Inquiry about goods held on consignment for
others or held on a "bill and hold" basis.

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PRICING TEST AND SUMMARY

 Examine the valuation (FIFO, LIFO, other

pricing)
 Recalculation.
 Physical quantities and valuations.

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TESTS OF ACCOUNT BALANCES

•Accuracy
•Validity
•Completeness
•Cutoff
•Ownership
•Valuation
•Classification
•Disclosure

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POSSIBLE CAUSES OF BOOK-TO-

PHYSICAL DIFFERENCES

 Inventory cutoff errors.

 Unreported scrap or spoilage.
 Pilferage or theft.

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SAMPLE DISCLOSURE ITEMS FOR

INVENTORY AND RELATED
ACCOUNTS
 Cost method (FIFO, LIFO, retail method).
 Components of inventory.
 Long-term purchase contracts.
 Consigned inventory.
 Purchases from related parties.
 LIFO liquidations.
 Pledged or assigned inventory.
 Disclosure of unusual losses from writedowns of
inventory or losses on long-term purchase commitments.
 Warranty obligations.
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