The document describes the inventory and warehousing cycle and audit procedures related to inventory. It explains the key steps in the inventory cycle as goods are purchased, received, stored in the warehouse, transferred to production, finished and stored or sold. It outlines the primary audit objectives of existence, rights, accuracy and realizable value for inventory. The primary audit procedure is observing the client's physical inventory count. It provides details on procedures for testing inventory held at public warehouses or counted by third parties.

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Copyright 2003 Pearson Education Canada Inc.
CHAPTER 18
Audit of the
Inventory and
Warehousing
Cycle

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What is the sequence of functions in the
inventory and warehousing cycle?

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1. An employee recognizes a
need for a purchase; com-
pletes a requisition and sends
it to purchasing.
PURCHASING
DEPARTMENT
Ace Company
PURCHASE
REQUISITION
The production
dept. needs 200
kgs. of dry #4
solvent.
authorized
employee

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2. Purchasing shops for the ap-
propriate quality at the best
price, then prepares a pur-
chase order.
PURCHASING
DEPARTMENT
Ace Company
PURCHASE
ORDER
To: Big Chemical Co.
Please ship 200
kgs. of dry #4 sol-
vent by 6/2/04
Price $38.40/kg.
purchasing agent
BIG
Chemical Co.

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3. When goods arrive from the
vendor, the receiving dept.
inspects, counts, and pre-
pares a receiving report.
RECEIVING
DEPARTMENT
Ace Company
RECEIVING
REPORT
Received 200
kgs. of dry #4
solvent on 6/1/04.
Condition: OK
receiving employee
BIG
Chemical Co.
BIG
Chemical Co.

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WAREHOUSE
4. Goods are moved from re-
ceiving to a warehouse; per-
petual inventory is updated.
RECEIVING
DEPARTMENT
perpetual inventory
description $$
6/1/04-dry #4
solvent-200 kgs.7680

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PRODUCTION
DEPARTMENT
WAREHOUSE
5. When needed, goods are moved from
the warehouse to production; perpetu-
al inventory and cost accounting re-
cords are updated.
cost acctg. system
description _ $$ _
June 8, 2004
Raw mat’l added
- dry #4 solvent
(200 kgs.) 7680
perpetual inventory
description $$
6/1/01-dry #4
solvent-200 kgs.7680
6/8/04-trans.200
kgs.to prod. -7680

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WAREHOUSE
6. When finished, goods are moved from
production to the warehouse; perpetu-
al inventory and cost accounting re-
cords are updated.
perpetual inventory
description $$
6/9/04-fin.goods
50 litres x7g 9680
PRODUCTION
DEPARTMENT
cost acctg. system
description _ $$ _
6/9/04-trans.
50 litres of
finished x7g
to warehouse 9680

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7. When sold, goods are shipped
and perpetual inventory re-
cords are updated.
A
C
E
perpetual inventory
description $$
6/9/04-fin.goods
50 litres-x7g 9680
8/5/03- sold 30
litres-x7g -5808
Ace Co.

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What are the primary audit
objectives with regard to inventory?

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What are the primary audit
objectives with regard to inventory?
- existence

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What are the primary audit
objectives with regard to inventory?
- existence
- rights
ABC Electronics Co.
Sales Invoice

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What are the primary audit
objectives with regard to inventory?
- existence
- rights
- accuracy

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What are the primary audit
objectives with regard to inventory?
- existence
- rights
- accuracy
- realizable value

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What is the primary audit procedure
with regard to inventory?

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What is the primary audit procedure
with regard to inventory?
Observe the client’s
inventory-taking
procedures.

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What is the primary audit procedure
with regard to inventory?
Observe the client’s
inventory-taking
procedures.

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When do client inventory-
taking procedures occur?

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When do client inventory-
taking procedures occur?
If the client has a
periodic inventory
system, the
physical inventory
count determines
the balance in
inventory accounts and will probably
occur on the balance sheet date.
December

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When do client inventory-
taking procedures occur?
If the client has a
perpetual inventory
system, the
physical inventory
count may occur
any time during
the accounting period.
Whenever the count occurs, the auditor
is required to observe.
June

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Some clients use
statistical sampling in their
inventory methods.
why?

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Some clients use
statistical sampling in their
inventory methods.
reduces
the need to count
every inventory item
(sample results can be
statistically extended
to the population)

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Some clients use
statistical sampling in their
inventory methods.
What are the
auditor’s
concerns?

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Some clients use
statistical sampling in their
inventory methods.
The auditor is concerned that
the statistical inventory plan:
- has statistical validity
- is properly applied
- achieves reasonable results

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Should the auditor test
beginning inventory balances?
January

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Should the auditor test
beginning inventory balances?
When the auditing firm has not audited
beginning balances, the auditors must
satisfy themselves as to the appropri-
ateness of beginning balances, if they
are satisfied as to the current balances.

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Should the auditor test
beginning inventory balances?
how?
When the auditing firm has not audited
beginning balances, the auditors must
satisfy themselves as to the appropri-
ateness of beginning balances, if they
are satisfied as to the current balances.

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how?
analytical
procedures
review of prior
inventory
count records
tests of inventory
transactions and
documents
When the auditing firm has not audited
beginning balances, the auditors must
satisfy themselves as to the appropri-
ateness of beginning balances, if they
are satisfied as to the current balances.

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How should the auditor test
inventory held at a public
warehouse?
client head-
quarters &
auditor’s
office
public
warehouse

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How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse
Are additional
procedures
necessary?

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How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse
Confirmation, alone, will not be
sufficient if inventory quantities held
at the warehouse
are significant.

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How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse
- if inventory held at the public ware-
house is significant:
~ review client’s procedures for
investigating and evaluating the
warehouse

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How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse
- if inventory held at the public ware-
house is significant:
~ review client’s procedures for
investigating and evaluating the
warehouse
~ obtain report from warehouse’s
auditor regarding internal controls

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How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse
- if inventory held at the public ware-
house is significant:
~ review client’s procedures for
investigating and evaluating the
warehouse
~ obtain report from warehouse’s
auditor regarding internal controls
~ observe warehouse’s physical
counts (if practical)

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Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.

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Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.
What are the
auditing
implications?

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Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.
- since the inventory-taking company
is a third party, their work has greater
reliability than the client’s

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Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.
- since the inventory-taking company
is a third party, their work has greater
reliability than the client’s
- the auditor still should observe the
physical inventory count

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Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.
- since the inventory-taking company
is a third party, their work has greater
reliability than the client’s
- the auditor still should observe the
physical inventory count
- the auditor must test the effectiveness
of the inventory-taking company’s
procedures

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Inventory Audit Procedures
perform
analytical
procedures
to test inventory
reasonableness

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Inventory Audit Procedures
regarding the client physical inventory count:
Review the client’s plan for counting
the physical inventory. Attend
client count planning
meetings.

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Inventory Audit Procedures
Observe the physical inventory count.
Determine whether client’s counting methods
are effective.
regarding the client physical inventory count:

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Inventory Audit Procedures
Observe the quality and condition of the
inventory. Consider obsolescence.
regarding the client physical inventory count:

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Inventory Audit Procedures
On a random basis:
- select a sample of inventory items from the
warehouse floor, count them, trace the
quantity to client count records
regarding the client physical inventory count:

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Inventory Audit Procedures
On a random basis:
- select a sample of inventory items from the
client count records, find them in the
warehouse, count them
regarding the client physical inventory count:

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Copyright 2003 Pearson Education Canada Inc.
Inventory Audit Procedures
On a random basis:
- select a sample of inventory items from the
client count records, trace them to the
perpetual inventory records
4/30/x7 Physical
Inventory
18# widgets
- purple
4/30/04 Physical
Inventory
18# widgets
- purple
4/30/04 Physical
Inventory
18# widgets
- purple
perpetual inventory
description qty
widgets - red 87
widgets - green 4
widgets - purple 18
regarding the client physical inventory count:

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Inventory Audit Procedures
4/30/x7 Physical
Inventory
18# widgets
- purple
4/30/04 Physical
Inventory
18# widgets
- purple
4/30/04 Physical
Inventory
18# widgets
- purple
perpetual inventory
description qty
widgets - red 87
widgets - green 4
widgets - purple 18
regarding the client physical inventory count:
On a random basis:
- select a sample of inventory items from the
perpetual inventory records trace them to
the client count records

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Inventory Audit Procedures
determine whether any
inventory has been
pledged as collateral
(disclosure)

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Inventory Audit Procedures
Enquire of client
management regarding the
existence of consigned
inventories.
consignments “R” us
ACE

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Inventory Audit Procedures
Enquire of client
management regarding the
existence of consigned
inventories:
- if a consignee holds a portion of the
client’s inventory, confirm that amount
with the consignee

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Inventory Audit Procedures
Enquire of client
management regarding the
existence of consigned
inventories:
- if a consignee holds a portion of the
client’s inventory, confirm that amount
with the consignee
- if a client consignee holds a portion of
a consignor’s inventory, confirm that
amount with the consignor

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Inventory Audit Procedures
Consider the effects of
sales and purchases
cutoff tests on
inventories.

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Inventory Audit Procedures
Test the client’s
application of their
inventory valuation
method (FIFO, LIFO) and
the lower-of-cost-or-
market rule.

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Inventory Audit Procedures
For manufactured
inventories:
test the cost accumulation
process as it affects
valuation of ending
inventories and COGS