INTRODUCTION 3.

The receiving department receives and inspects

Inventories, as defined by IAS 2 the goods, verifying quality and quantity, and
- are assets that are held for sale in the normal prepares a receiving report.
course of business or are in the process of 4. The receiving department transfers the goods to
production for such sale or are in the form of the warehouse.
materials or supplies to be used in the 5. The goods are transferred from the warehouse
production process or in rendering of services. to the production. department, upon requisition
- In case of a service provider, inventories include by latter.
the cost of the service for which the enterprise
has not yet recognized the related revenue. Separate departments shall undertake the foregoing
- Inventories become expenses when the related activities separately for effective internal control.
revenue is recognized, that is at the point of - Merchandising companies deliver the goods
sale. from the warehouse directly to the customers or
Enterprises presenting expenses following the function to the company’s authorized sales agents or
of expense method in the statement of comprehensive distributors.
income shows the related expense as cost of goods - Shipment of goods to customers, sales agents
sold. or the company’s own store (or retail outlet) shall
- Those following the nature of expense method only be made upon proper authorization by the
present purchases adjusted by the increase or management.
decrease in inventory amounts as part of - The purchasing department shall prepare at
operating expenses. least three copies of the purchase order: one
- The decline in net realizable value of inventory is copy is sent to the vendor, another is sent to the
another expense relating to inventories that may receiving department, and another copy must be
warrant separate presentation. sent to the accounting department for proper
- The recovery in net realizable value of inventory, recording of purchases and corresponding
or the gain arising from the adjustment in the liability.
valuation allowance of inventory, is shown as - Likewise, the receiving department also sends
other operating income or a deduction from the one copy each of the receiving report to the
amount of inventory that is shown as expense in accounting department, the storeroom, and the
profit or loss. purchasing department.
A misstatement of inventories results in misstatement of
expenses and profit in the statement of comprehensive Manufacturing entities are engaged in another set of
income and in misstatement of assets presented in the activities after the warehousing cycle. This set of
statement of financial position. activities is called the conversion cycle.
- This starts when the warehouse, upon the
WAREHOUSING AND CONVERSION CYCLES requisition of the production department, issues
The acquisition of goods or services and issuance of the materials to production.
inventories is the inventory and warehousing cycle. - The production department converts these
materials into finished goods by additionally
This group of activities includes the following sequential incurring costs of direct labor and overhead.
steps:
The conversion process may involve one or two or more
1. An employee or a department recognizes a production departments, depending on the nature of the
need for the purchase of goods, prepares a manufacturing process.
requisition form and sends it to the purchasing - The transfers of materials from the warehouse to
department; the production department, and transfers of
2. The purchasing department locates an goods from one production department to
appropriate supplier, after considering quality another or to the finished goods warehouse and
and price, and prepares and issues a purchase the shipment of goods to the customers must be
order to the supplier; accounted for using an appropriate cost
accounting system.
To monitor the costs incurred in the production AUDIT OBJECTIVES
department, a manufacturing company applies either a
job order cost system or a process system, depending The auditor examines inventories principally to achieve
on the nature of its products and its production the following objectives:
process.The information developed by an appropriate - Determine the existence of inventories, and that
cost accounting system provides reliable basis for the client has rights to these assets;
formulation of management policies for purchasing, - Establish the completeness of inventories;
production and sales. - Establish the clerical accuracy of records and
supporting schedules for inventories and related
expenses;
INTERNAL CONTROLS - Determine that the measurement of inventories
and related expenses is appropriate; and,
Inventories are assets that become the major source of - Determine that the presentation and disclosure
the company’s revenue, thus internal control of inventories and related expenses are
procedures must be adopted by an entity to safeguard adequate.
inventories and to ensure that there is reliable
information on inventories. To determine the extent of
audit procedures necessary to achieve the foregoing AUDIT PROCEDURES
objectives, the auditor considers the internal control To establish existence of inventories and to satisfy
adopted by the client to safeguard inventories. themselves about the condition of inventories at the
reporting date, the auditors observe the physical count
Internal control procedures on inventories focus on the of inventories conducted by the client’s personnel. It is
following: not the auditors’ function to take inventory. The auditors
1. Physical inspection and counting of all items of merely observe the taking of the inventory.
inventories received by the company from
suppliers to immediately remedy any If the client has a physical inventory system, the
discrepancy between delivery and purchase physical inventory count determines the balance in
order; inventory accounts at year-end; as such, the count is
2. Keeping inventories in a warehouse that restricts conducted at the reporting date.
access to unauthorized persons;
3. Monitoring movements of inventories, from If the client has a perpetual inventory system, the
receiving department, to the stockroom, to the physical inventory count may be conducted at any
production department, to finished goods convenient time during the reporting period.
warehouse, to shipping department, etc.; - If the count is conducted at the end of the
4. Appropriate storage of inventories by reporting period, the auditor has to reconcile the
classification, using inventory tags, so that inventory amount determined through physical
inventory requirements are served without count and the ledger balance in the stock cards,
undue delay; and appropriate adjustments must be made to
5. Monitoring inventory quantities to minimize update the inventory records.
losses due to stockouts and losses from - If the count is conducted earlier than the end of
obsolescence; the reporting period, roll forward procedures
6. Conducting a periodic obsolete inventory review; must be undertaken to ensure that the inventory
7. Periodic reconciliation of stock cards inventory balance at year-end equals the physical goods.
and physical inventory;
8. Auditing of bill of materials, which is a record of The auditors normally participate in the client’s
parts used to construct a product; advanced planning of the physical inventory and review
9. Creating a procedure to track scrap the written instructions prepared by management for the
transactions. employees who will make the counts.
- During the physical inventory, the auditors will
note that all goods are being counted and that
controls exist to prevent double counting of
items and omission of items from the count.
 - Also, the auditors will make test counts of whether the inventory costing procedure used by
numerous items and compare these counts with the client has been properly applied.
the quantities reported by the client’s counting
teams.
To establish completeness and correctness of inventory
If the auditors do not observe the taking of the inventory balances, the auditor conducts a purchase cutoff test by
because it is impossible to do so, some audit reviewing purchase invoices and receiving report
procedures must be undertaken to validate the several days before and several days after the end of
existence of and the amount reported as inventory. the reporting period, noting the date that the enterprise
- For the auditors to be satisfied in such obtains economic control (or the date ownership
situations, the client generally must have passed) and the date the transaction was recorded in
effective internal control over inventories, and at the accounting records.
some point the auditors must observe or make
physical counts of the inventory. For audits of a manufacturing entity, the auditor has to
review the bill of materials for a sample of finished
The auditors should take exceptions for indications of goods to test whether the cost of materials has been
goods that are damaged or otherwise obsolete or non- properly included in the cost of work in process or
salable. finished goods inventories.
- The auditor should test the net realizable value - The auditors shall also trace the labor charged
of goods by reference to sale transactions to production based on time cards and labor
during the subsequent reporting period. routings to ensure that the client charges labor
- If evidence exists that the price less cost to sell that is supported by payroll records.
of goods will be less than cost, the prospective - Likewise, overhead costs charged to production
loss should be recognized in the current period, shall be validated to determine whether the
as inventories in the statement of financial company uses appropriate and consistent
position are measured at the lower of cost and method of allocating overhead to product
net realizable value. manufactured.

Goods stored in public warehouses and goods held by Analytical review procedures may be conducted to
consignees should be confirmed by direct disclose the presence of obsolete inventory items,
communication with the custodian of the warehouse or material errors in counting and pricing. Such analytical
the consignee. review procedures include, but are not limited to:
- When the amounts of inventory involved are ● Comparisons of inventories classified by major
significant, the auditors should consider types to prior years’ amounts;
performing supplementary procedures, including ● Comparisons of gross profit percentages by
review of the client’s procedures for investigating product line to prior years’ and industry
prospective warehouses and evaluating their statistics; and,
performance, obtaining reports on internal ● Comparison of this year’s inventory turnover to
control from the auditors of the warehouses, or prior years.
observing the inventories at the warehouses. Such reviews may disclose material errors in counting,
pricing and obsolete inventory items.
The auditors’ tests of the cost accounting system are
designed to determine that appropriate costs have been In the audit of a new client, the auditors must obtain
assigned to work-in-process, finished goods, and cost evidence that the client’s beginning inventories are fairly
of goods sold. stated, as errors in beginning inventory balances will
- The auditors must determine that the methods of misstate current year profit.
measuring the cost of inventory are in conformity - This evidence may be obtained by review of the
with the cost formula applicable to the audit working papers of the predecessor auditor
enterprise, in accordance with IAS 2 Inventories. (if the client’s financial statements were audited
- The auditors also perform tests of prices (NRV in the prior year), tests of the perpetual inventory
Testing) applied to inventories to determine records, tests of the documents used in the
physical inventory, tests of the overall
 reasonableness of the inventory figures, tests of
transactions affecting inventory balances, and
other analytical review procedures.

The auditor determines whether inventories are properly

presented and measured in the financial statements.
- The financial statement should disclose the
inventory costing formula in use, any amount of
inventories pledged for liabilities, and significant
sales or purchase commitments.