Inventories and Cost of Goods Sold

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Inventories andCost of Goods Sold
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Periodic vs Perpetual Inventory

• Periodic
• Value only known by counting at periods end.
• Value of theft, shrinkage can only be estimated
• Perpetual
• Continual book value known
• Count may not determine B.S. amount if books are
  not materially different.
• Cycle counts frequently used to test for
  accuracy during the period.

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The Special AuditSignificance 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.
• Financial reporting fraud has often involved the
  fraudulent overstatement of inventories.

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Common Internal Controls Over the Conversion Cycle

• Segregation of duties - purchases inventory
  custody
• Use of pre-numbered requisitions, purchase
  orders, and receiving reports
• Procedures for authorizing purchase transactions
  and verifying them for payment
• General ledger control A/C 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 security controls over
  inventories

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Most Likely Misstatements

• Inaccurate recording of purchases
• Theft of inventory
• Duplicate payment for purchases
• Fraudulent inflation of purchases cost
• Misstatement of inventory unit costs
• Misstatement of inventory quantities
• Failure to accrue receipts of material
• (before vendor invoices arrive)

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Objectives for the Audit of Inventories and Cost
of Goods Sold

• Determine the Existence of inventories and
  occurrence of the elements of cost of goods sold.
• Establish the Completeness of inventories
• Establish that the client has Rights to the
  recorded inventories
• Establish the clerical accuracy of records and
  supporting schedules
• Determine that the Valuation of inventories and
  cost of goods sold is in accordance with GAAP
  proper cutoff
• Determine that the Presentation and disclosure of
  inventories and cost of goods sold are appropriate

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers
• Evaluate clients planning of physical count and
  plan auditors observation

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Planning a Physical Inventory Count
Observations Thereof

• Advising Client
• Selecting an appropriate date
• Suspending production or controlling movement
  cutoff
• Segregating obsolete and defective goods
• Adequate counting procedures, incl. recoding
  medium
• Auditor Observation Planning
• Locations to observe/staff requirements
• Extent of test counts
• How to confirm proper cutoff of sales and
  purchases
• Arranging for the services of specialists
• Not telling client where we will observe
• GOAL An Accurate Count Audit Evidence

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers
• Evaluate clients planning of physical count and
  plan observation
• Observe(not supervise) taking of physical count

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Observation Audit Procedures

• Observe Practices Used
• Control Tags/Count Sheets
• (Whatever Recording Medium Used)
• Make Test Counts Record in W/Ps
• Take Note of
• Damaged, dusty items
• End product in receiving area
• Items moving during count
• Last tag/count sheet used (copy electronic file?)

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers
• Evaluate clients planning of physical count and
  plan observation
• Observe the taking of physical count
• Confirm inventories in public warehouses and on
  consignment

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers
• Evaluate clients planning of physical count and
  plan observation
• Observe the taking of physical inventory
• Confirm inventories in public warehouses and on
  consignment
• Review the year-end cutoff of purchases and sales
  transactions

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers
• Evaluate clients planning of physical count and
  plan observation
• Observe the taking of physical inventory
• Confirm inventories in public warehouses and on
  consignment
• Review the year-end cutoff of purchases and sales
  and transactions
• Obtain a copy of completed physical inventory
  test its accuracy
• Test inventory pricing

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Auditing CompletedInventory Listing

• Test math accuracy
• Quantity
• Compare to W/P recorded test counts
• Last tag/count sheet or copy of file
• Unit cost
• Method (LIFO,FIFO) OK per GAAP?
• Consistent with prior year?
• Computed accurately?
• Lower of cost or market?
• Evaluate adjustments

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers
• Evaluate clients planning of physical count and
  plan observation
• Observe the taking of physical inventory
• Confirm inventories in public warehouses and on
  consignment
• Review the year-end cutoff of purchases and sales
  and transactions
• Obtain a copy of completed physical inventory
  test its accuracy
• Test inventory pricing
• Perform analytical procedures

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers
• Evaluate clients planning of physical count and
  plan observation
• Observe the taking of physical inventory
• Confirm inventories in public warehouses and on
  consignment
• Review the year-end cutoff of purchases and sales
  and transactions
• Obtain a copy of completed physical inventory
  test its accuracy
• Test inventory pricing
• Perform analytical procedures
• Identify pledged inventories Review commitments

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Substantive Tests for the Inventories and Cost of
Goods Sold

• Obtain listings of inventory and reconcile to
  ledgers
• Evaluate clients planning of physical count and
  plan observation
• Observe the taking of physical inventory
• Confirm inventories in public warehouses and on
  consignment
• Review the year-end cutoff of purchases and sales
  and transactions
• Obtain a copy of completed physical inventory
  test its accuracy
• Test inventory pricing
• Perform analytical procedures
• Identify pledged inventories Review commitments
• Evaluate financial statement presentation and
  disclosure

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Recap-Inventory Observation

• Unless Inventory is Immaterial - We Must Observe
  a Physical Count.
• We Observe to Gain Evidence About the Count - We
  Do Not Supervise.
• Can We Observe Weeks/Months Before Or After B.S.
  Date?
• If so, What Must Exist?
• Good Perpetual Inventory Records Which We Must
  Test During the Intervening Period

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Recap-Inventory Observation (Cont)

• Can We Accept a Stat Sample or is Wall-to-Wall
  Necessary?
• If We Can Live with the Added DR in the Form of
  Sampling Risk.
• Can We Observe Periodic Cycle Counts Rather Than
  Count Near Yearend?
• If They Regularly Confirm Reliability of the
  Perpetual Inventory Records.

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Added Tests - First Year Clients

• Assess if beg. balance is material to F.S.
  (income statement)
• Verify beg. balance to prior client CPA W/Ps
  and perform some tests.
• or
• Review procedures, supporting data for physical
  count and completed inventory listing to assess
  potential reliability or
• Use analytical procedures to assess
  reasonableness of beginning balance.
• Qualify audit opinion, if necessary.