Auditing Principles - CH 12 - Inventories and Cost of Goods Sold
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The Special Significance of Audit of Inventories
ØThe valuation of goods on hand and in process often presents complex and difficult issues
ØDetermining the quantities of inventories may require specialized techniques
ØInventories often represent the largest current asset of a company
ØMisstatements of inventories directly affect cost of goods sold and, therefore, net income
ØManagement fraud has often involved the fraudulent overstatement of inventories
Source of Inventories
- lGoods on hand ready for sale
- lGoods in the process of production
- lGoods to be consumed directly or indirectly in production such as raw materials, purchased parts and supplies
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.
McKesson & Robbins Fraud Case
ØSignificant impact on responsibility of auditors with respect to validity of inventories
ØCase: 1939 – the audited financial statements contained $19 million of fictitious assets including $10 million of nonexistent inventories
lAuditors followed customary auditing practice which limited audit work on inventories to examining records only
lStatements 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
- ØPeriodic inventory system
- lDetermine inventory quantities solely by an annual physical count
- ØPerpetual inventory records
- lInventory updated constantly
- lStrong internal control over inventories
- lMay use test counts throughout the year
lCommitment to competence and human resource policies and practices
- •Appropriately qualified and trained personnel assigned to inventory
- lIntegrity and ethical values
- •Company purchasing agents do not accept “kickbacks”
- lOrganizational structure and assignment of authority and responsibility
•Purchasing, receiving and production understand roles
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
lObservations by production supervisors of performance of various activities and functions
lQuality and performance reviews
lFormal program to consider improvements in purchasing and production noted by internal auditors
Functions related to inventories
lSegregation of purchasing, receiving and recording
- lPurchase requisition form completed by department
- lPurchasing 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
Issuing and Production
- ØStores department issues goods to requesting department
- lPrenumbered requisition
- lControlled with master production schedule
- lProduction orders
- lMaterials requisitions and move tickets
- lJob time tickets
ØShipment upon authorized sales order approved by credit department
- lGenerates 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
ØAccounts for usage of raw materials
ØDetermines content and value of goods in progress
ØCompute finished inventory
ØPerpetual inventory system
- lProvide information essential to purchasing, sales and production-planning policies
- lAllows companies to control high costs of holding excessive inventory
- ØIT systems
- lEasier to control inventories
- lEDI to coordinate production and purchasing
Controls Over the Conversion Cycle
ØSegregation of duties over purchases and custody of inventory
ØUse of pre-numbered requisitions, purchase orders, and receiving reports
ØProcedures for authorizing purchase transactions and verifying them for payment
ØGeneral ledger control of inventories and reconciliation to production records
ØCost accounting controls
ØAnalysis of variances from standard costs
ØUse of perpetual records for inventories
ØUse of appropriate procedures for taking inventory
ØAppropriate physical controls over inventories
Examples of tests of controls
a. Examine significant aspects of a sample of purchase transactions.
b. Perform tests of the cost accounting system.
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.
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
Risks of Material Misstatements
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.
Considerations in Planning a Physical Inventory
ØSelecting of the appropriate date
ØSegregating obsolete and defective goods
ØEstablishing control over the counting process
ØAchieving proper cutoff of sales and purchases
ØArranging for the services of specialists
Documentation of Physical Inventory
ØPlan should be documented and communicated in form of written instructions to personnel taking physical inventory
- lLetter from client reviewed by auditors
- lAuditors consider nature and materiality of inventories
- lDate is typically at or near balance sheet date unless internal control is effective
ØClient counts and supervises inventory
- ØAuditors observe
- lDetermine all items included
- lEmployees comply with instructions
- lBe alert for inclusion of obsolete or damaged merchandise
- lRecord numbers of final receiving and shipping documents issued before inventory taking
- lMake test counts
- lTag control
ØInquire as to existence of Inventory on consignment
ØDetermine involvement of outside count firms
When the Auditors are Engaged after Year-End
ØInventory verification when auditor unable to observe taking of inventory at close of year.
lMay conclude that sufficient appropriate evidence cannot be obtained to express an opinion
lOr 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
Proper Cut-off of Inventory
ØExamine on a test basis the purchase invoices and receiving reports for several days before and after the inventory date.
lDetermine that liability has been recorded for all goods in inventory
lMake sure shipments and purchases recorded in proper period
- lWhat method of pricing does the client use?
- lIs the method of pricing the same as that used in prior years?
- lHas the method selected by the client been applied consistently and accurately in practice?
- •Test the pricing of inventories
Presentation and Disclosure
ØDisclosure of inventory pricing methods or methods in use
- ØOther important disclosures:
- lChanges in methods
- lClassifications of inventory
- lDetails of pledged inventory
- lDeduction of valuation allowance for inventory losses
- lExistence and terms of inventory purchase commitments.
Problems with First Year Clients
ØProcedures to obtain evidence that beginning inventory is fairly stated
- lReview predecessor’s working papers
- lDiscuss with person who supervised physical inventory at beginning
- lStudy written instructions in planning
- lTrace numerous items from inventory tags to final summary sheets
- lTest perpetual inventory records for previous year
- lTest overall reasonableness of beginning inventory
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