Inventories and Cost of Goods Sold

Chapter 12

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Special Significance of The Special Significance of Audit of InventoriesAudit of Inventories

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

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Source of InventoriesSource of Inventories

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

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ObjectivesObjectives1. 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.

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McKesson & Robbins McKesson & Robbins Fraud CaseFraud Case

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

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Inventory MethodsInventory Methods

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

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Internal Control (1 of 3)Internal Control (1 of 3)

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

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Internal Control (2 of 3)Internal Control (2 of 3)

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

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Internal Control (3 of 3)Internal Control (3 of 3)

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

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Functions related to inventoriesFunctions related to inventories

Purchasing Receiving Storing Issuing Processing Shipping

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Purchasing FunctionPurchasing Function

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

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Receiving and StoringReceiving and Storing

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

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Issuing and ProductionIssuing and Production

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

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ShippingShipping

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

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Cost AccountingCost Accounting

Accounts for usage of raw materialsDetermines content and value of

goods in progressCompute finished inventory

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Other functionsOther functions

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

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Controls Over the Controls Over the Conversion CycleConversion Cycle

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

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Relating Controls to Assertions Relating Controls to Assertions

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Audit Steps (1 of 3)Audit Steps (1 of 3)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.

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Audit Steps (2 of 3)Audit Steps (2 of 3)

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.

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Audit Steps (3 of 3)Audit Steps (3 of 3)

E. Perform further audit procedures5. 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.

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Figure 12.1 Objectives of Major Substantive Figure 12.1 Objectives of Major Substantive Procedures for Inventories and Cost of Goods SoldProcedures for Inventories and Cost of Goods Sold

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Risks of Material MisstatementsRisks of Material Misstatements1. 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.

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Relating Relating Controls Controls

to to AssertionsAssertions

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Considerations in Planning Considerations in Planning a Physical Inventory a Physical Inventory

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

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Documentation of Documentation of Physical InventoryPhysical Inventory

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

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Inventory ObservationInventory Observation 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

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When the Auditors are Engaged When the Auditors are Engaged after Year-Endafter Year-End

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

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Proper cut-off of inventoryProper cut-off of inventory

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

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Inventory PricingInventory Pricing

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

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Presentation and DisclosurePresentation and Disclosure

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.

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Problems with First Year ClientsProblems with First Year Clients

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