CHAPTER FOUR

AUDITING OF INVENTORY AND COST OF GOODS 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.

1. Requisitioning goods and services. It includes;

 Identify the need of the firm in relation to inventory.
 Prepare a completed pre-numbered requisition form and sent to purchasing
department.
2. purchase orders (goods and services)
 Purchase order shows quantity and price of goods ordered, quality specifications,
shipping terms
 Purchase orders must be properly authorized
 Purchase orders should be pre-numbered
 Separating purchasing department personnel from custody and recording.
3. Receiving the goods.
 The receiving department should ensure
 Only authorized goods are received
 The goods meet order specifications
 An accurate count of goods received is taken
 All receipts of goods are recorded
4. Storing goods received for inventory.

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  The received goods must be placed in a proper place (prepared warehouse) to store
them.
5. Recording the liability.
 Accounting matches vendor invoice, purchase order, and receiving reports - If
quantity and quality matched, account payable is recorded
6. Prepare the payment voucher and make cash disbursement
 Supporting documentation is reviewed and approved for payment
 Documents are marked "paid" to avoid duplicate payment

In short, the summary of inventory and purchase cycle is;

4.2. Internal Controls over Inventories and purchases

The followings are internal control procedures that should exist in the client’s business to control
inventory properly

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  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
 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

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

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Disclosure Determine whether all disclosure related to inventories are included in the
financial statement

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
compidlation 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.

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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 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

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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
 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.

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 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
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.