Aeb SM CH21 1 PDF

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Chapter 21
Audit of the Inventory and Warehousing Cycle
Review Questions
21-1
Inventory is often the most difficult and time consuming part of many
audit engagements because:
1.
2.
3.
4.
5.
Inventory is generally a major item on the balance sheet and often

the largest item making up the accounts included in working capital.
The need for organizations to have the inventory in diverse locations
makes the physical control and counting of the inventory difficult.
Inventory takes many different forms that are difficult for the auditor
to fully understand.
The consistent application of different valuation methods can be fairly
complicated.
The valuation of inventory is difficult due to such factors as the
large number of different items involved, the need to allocate the
manufacturing costs to inventory, and obsolescence.
21-2
The acquisition and payment cycle includes the system for purchasing all
goods and services, including raw materials and purchased parts for producing
finished goods. Purchase requisitions are used to notify the purchasing department to place orders for inventory items. When inventory reaches a predetermined
level or automatic reorder point, requisitions may be initiated by stockroom
personnel or by computer. In other systems, orders may be placed for the materials
required to produce a customer order, or orders may be initiated upon periodic
evaluation of the situation in light of the prior experience of inventory activity.
After receiving the materials ordered, as part of the acquisition and payment
cycle, the materials are inspected with a copy of the receiving document used to
book perpetual inventory. In a standard cost inventory system, the acquisition and
payment cycle computes any inventory purchase variances, which then enter the
inventory system.
The following audit procedures in the acquisition and payment cycle
illustrate the relationship between that cycle and the inventory and warehousing
cycle.
1.
2.
Compare the inventory cost entered into the inventory system to

the supporting invoice to determine that it was properly recorded
and the purchase variance (standard cost system), if any, was properly
reflected.
Test the purchase cutoff at the physical inventory date and yearend to determine whether or not the physical inventory and yearend inventory cutoffs are proper from a purchase standpoint.
21-1
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21-3
Cost accounting records are those which are concerned with the processing
and storage of raw materials, work in process, and finished goods, insofar as
these activities constitute internal transfers within the inventory and warehousing
cycle. These records include computerized files, ledgers, worksheets and reports
which accumulate material, labor, and overhead costs by job or process as the
costs are incurred.
Cost accounting records are important in conducting an audit because
they indicate the relative profitability of the various products for management
planning and control, and determine the valuation of inventories for financial
statement purposes.
21-4
The most important tests of the perpetual records the auditor must make
before assessed control risk can be reduced, which may permit a reduction in
other audit tests are:
1.
2.
3.
Tests of the purchases of raw materials and pricing thereof.

Tests of the cost accounting documents and records by verifying
the reduction of the raw material inventory for use in production and
the increase in the quantity of finished goods inventory when goods
have been manufactured.
Tests of the reduction in the finished goods inventory through the
sale of goods to customers.
Assuming the perpetuals are determined to be effective, physical inventory tests

may be reduced, as well as tests of inventory cutoff. In addition, an effective
perpetual inventory will allow the company to test the physical inventory prior to
the balance sheet date.
21-5
The continuation of shipping operations during the physical inventory will
require the auditor to perform additional procedures to insure that a proper cutoff
is achieved. The auditor must conclude that merchandise shipped is either
included in the physical count or recorded as a sale, but not both.
Since no second count is taken, the auditor must increase the number of
test counts to determine that the counts recorded are accurate.
21-6
The auditor must not give the controller a copy of his or her test counts. The
auditor's test counts are the only means of controlling the original counts recorded
by the company. If the controller knows which items were test counted, he or she
will be able to adjust other uncounted items without detection by the auditor.
21-7
The most important audit procedures to test for the ownership of inventory
during the observation of the physical counts and as a part of subsequent valuation
tests are:
1.
2.
3.
Discuss with the client.

Obtain an understanding of the client's operations.
Be alert for inventory set aside or specially marked.
21-2
21-7 (continued)
4.
5.
6.
Review contracts with suppliers and customers to test for the

possibility of consigned inventory or inventory owned by others that
is in the client's shop for repair or some other purpose.
Examine vendor invoices indicating that merchandise on hand was
sold to the company.
Test recorded sales just before and just after the physical inventory
to determine that the items were or were not on hand at the physical
inventory date and that a proper cutoff was achieved.
21-8
Auditing procedures to determine whether slow-moving or obsolete items
have been included in inventory are:
1.
2.
3.
4.
5.
6.
7.
8.
Obtain a sufficient understanding of the client's business to aid in

recognizing inventory that is no longer useful in the client's business.
Review the perpetual records for slow-moving items.
Discuss the quality of the inventory with management.
Ask questions of production personnel during physical inventory
observation about the extent of the use or nonuse of inventory items.
Make observations during the physical inventory for rust, damaged
inventory, inventory in unusual locations, and unusual amounts of
dust on the inventory.
Be aware of inventory that is tagged obsolete, spoiled, or damaged,
or is set aside because it is obsolete or damaged.
Examine obsolescence reports, scrap sales, and other records in
subsequent periods that may indicate the existence of inventory that
should have been excluded from the physical inventory or included
at a reduced cost.
Calculate inventory ratios, by type of inventory if possible, and
compare them to previous years or industry standards.
21-9
The auditor could have uncovered the misstatement if there were adequate
controls over the use of inventory tags. More specifically, the auditor should have
assured himself or herself that the client had accounted for all used and unused
tag numbers by examining all tags, if necessary. In addition, the auditor should
have selected certain tags (especially larger items) and had the client show him
or her where the goods were stored. The tag numbers used and unused should
have been recorded in the auditor's working papers for subsequent follow-up. As
part of substantive procedures, the auditor could have performed analytical tests
on the inventory and cost of sales. A comparison of ratios such as gross margin
percentage and inventory turnover could have indicated that a problem was
present.
21-3
21-10 A proper cutoff of purchases and sales is heavily dependent on the physical
inventory observation because a proper cutoff of sales requires that finished
goods inventory included in the physical count be excluded from sales and all
inventory received be included in purchases.
To make sure the cutoff for sales is accurate, the following information
should be obtained during the taking of the physical inventory:
1.
2.
3.
4.
The last shipping document number should be recorded in the

working papers for subsequent follow-up to sales records.
A review should be made of shipping to test for the possibility of
shipments set aside for shipping and not counted or other potential
cutoff problems.
When prenumbered shipping documents are not used, a careful
review of the client's method of getting a proper sales cutoff is the
first step in testing the cutoff.
A list of the most recent shipments should be included in the working
papers for subsequent follow-up to sales records.
For the purchase cutoff, the following information should be noted:

1.
2.
The last receiving report number should be noted in the working

papers for subsequent follow-up to purchase records.
A review should be made of the receiving department to make sure
all inventory has been properly included in the physical inventory.
21-11 Compilation tests are the tests of the summarization of physical counts,
the extension of price times quantity, footing the inventory summary, and tracing
the totals to the general ledger.
Several examples of audit procedures to verify compilation are:
1.
2.
3.
4.
Trace the tag numbers used to the final inventory summary to make
sure they were properly included and the numbers not used to the
final inventory summary to make sure no tag numbers have been
added.
Trace the test counts recorded in the working papers to the final
inventory summary to make sure they are correctly included.
Trace inventory items on the final inventory list to the tags as a test
of the existence of recorded inventory.
Test the extensions and footings of the physical inventory summary.
21-4
21-12
TYPE OF
POTENTIAL MISSTATEMENT
ANALYTICAL PROCEDURE
1. Compare gross margin percentage
with previous years.
Overstatement or understatement of
inventory amounts (prices and/or
quantities).
2. Compare inventory turnover with

previous years.
Obsolete inventory.
3. Compare unit costs with previous

years.
Overstatement or understatement of unit

costs.
4. Compare extended inventory value

with previous years.
Errors in compilation, unit costs, or

extensions.
5. Compare current year manufacturing

costs with previous years.
Misstatement of unit costs of inventory,

especially direct labor and
manufacturing overhead.
21-13
DATE
11-26-09
12-06-09
PURCHASE
QUANTITY
2,400
1,900
PRICE
TO BE INCLUDED IN
12-31-09 INVENTORY
$2.07
$2.28
700 @ $2.07
1,900 @ $2.28
EXTENSION
$1,449.00
4,332.00
$5,781.00
Assuming FIFO inventory valuation, the 12-31-09 inventory should be

valued at $5,781, and is thus currently overstated by $121.
If the 1-26-10 purchase was for 2,300 binders at $2.12 each, the 12-3109 inventory should be valued at $5,477.00 (1,900 @ $2.12 + 700 @ $2.07) and
is thus currently overstated by $425. The reason is the lower of cost or market rule,
with the $2.12 being the replacement cost.
21-14 The direct labor hours for an individual inventory item would be verified
by examining engineering specifications or similar information to determine whether
the number of hours to complete a unit of finished goods was correctly computed.
Ordinarily it is difficult to test the number of hours to an independent source.
The manufacturing overhead rate is calculated by dividing the total
annual number of labor hours into total manufacturing overhead. These two totals
are verified as a part of the payroll and personnel and acquisition and payment
cycles.
Once these two numbers are verified (overhead rate per direct labor
hour and the number of direct labor hours per unit of each type of inventory), it is
not difficult to verify the overhead cost in inventory.
21-5
21-15 With a job cost system, labor charged to a specific job is accumulated on
a job cost sheet. The direct labor dollars included on the job cost sheet can be
traced to the employee "job time sheet" to make sure the hours are correctly
included on the job cost sheet. The labor rate can be verified by comparing it to
the amount on the employee's earnings record.
21-16 Assuming the auditor properly documents receiving report numbers as a
part of the physical inventory observation procedures, the auditor should verify
the proper cutoff of purchases as a part of subsequent tests by examining each
invoice to see if a receiving report is attached. If the receiving report is dated on
or before the inventory date and the last recorded number, the received inventory
must have been included in the physical inventory; therefore the invoice should
be included in accounts payable. Those invoices that are received after the
balance sheet date but shipped F.O.B. shipping point on or before the close of
the year would indicate merchandise in transit.
Multiple Choice Questions From CPA Examinations
21-17
a.
(4)
b.
(2)
c.
(1)
21-18
a.
(1)
b.
(2)
c.
(2)
21-19
a.
(4)
b.
(3)
c.
(2)
Discussion Questions and Problems
21-20
POTENTIAL
FINANCIAL
MISSTATEMENT
SUBSTANTIVE
AUDIT
PROCEDURE
Examine receiving
and requisition
documents, trace
to perpetual
records.
Misstatement of
inventory.
Compare
physical count
to perpetual
inventory
record.
Account for a
numerical
sequence of
receiving reports
and observe
matching invoices
received from
vendors.
Understatement
of inventory or
payment for
goods not
received.
Trace quantity
and description
on vendor's
invoice to
receiving
report.
PURPOSE OF
INTERNAL CONTROL
TEST OF
CONTROL
1. For a proper valuation

of inventory.
(Accuracy)
2. To ensure inventory
is recorded when
received, payments
made are for goods
received, and quantities
and descriptions are
accurate.
(Completeness,
existence and
accuracy)
21-6
21-20 (continued)
POTENTIAL
FINANCIAL
MISSTATEMENT
SUBSTANTIVE
AUDIT
PROCEDURE
Discuss with
client and
observe whether
personnel
prepare shipping
documents.
Overstatement
of inventory.
Compare
physical count
to perpetual
records.
4. To ensure inventory
shipments are
recorded as sales.
(Completeness)
Account for
a numerical
sequence of
shipping orders.
Understatement
of sales.
Trace quantity
and description on bills of
lading to
recorded sales.
5. To make sure physical

inventory counts are
accurate.
(Accuracy, existence
and completeness)
Observe counting
personnel and
discuss with
client.
Misstatement of
inventory.
Compare
physical count
to perpetual
inventory
record.
6. To assure reasonable
costs are used for
inventory and cost
of goods sold.
(Accuracy)
Review
procedures
for determining
standard costs.
Misstatement of
inventory.
Trace costs
from supporting
documents to
development
of standards.
7. To make sure obsolete

goods are classified
as such.
(Accuracy)
Read policy
and discuss
procedures with
client.
Misstatement of
inventory.
Analytical
procedures for
inventory.
8. To make sure inventory

compilation is accurate.
(Accuracy)
Observe who
compiles the
inventory and
discuss with
client.
Misstatement of
inventory.
Reperform
clerical tests
of inventory
compilation.
PURPOSE OF
INTERNAL CONTROL
TEST OF
CONTROL
3. To minimize theft or
unrecorded shipments
of inventory.
(Existence)
21-7
21-21
a.
TRANSACTIONRELATED AUDIT
OBJECTIVE
b.
c.
RELATED RISK
TEST OF CONTROL
1. Recorded transactions
represent valid,
approved purchases
(Occurrence).
If purchasing agents can

make purchases from any
vendor, there is a risk that
purchasing agents may
make unauthorized
purchases of items not
approved (for personal
use).
Enter non-valid vendor

numbers into the
purchasing system to
see if the related
transaction is rejected.
2. Recorded inventory
may not be recorded at
appropriate amounts,
due to obsolescence
(Accuracy).
Without information about

the amount of time
inventory is in the warehouse, management is
less likely to identify slow
moving items that should
be recorded at the lower
of cost or market.
Select a sample of
inventory items from
the perpetual inventory
system and recalculate
the number of days each
item has been present in
the warehouse.
3. Actual shipments of
inventory are recorded
in the perpetual
inventory records
(Completeness).
Shipments of inventory
may occur but not be
recorded.
Select a sample of items

in the warehouse and
physically move them to
the shipping areas to see
if the microchip correctly
removes those items from
the perpetual inventory
records.
4. Inventory recorded in
the perpetual records
physically exists
(Occurrence).
Non-inventory warehouse
individuals may remove
inventory without
authorization.
Observe client personnel

in the inventory warehouse and determine if
each person is authorized
to be in the warehouse.
5. Inventory transactions
are properly classified
(Classification).
Equipment or supplies
may be inaccurately
classified as inventory if
they are not physically
separated from the
inventory.
Observe whether
equipment or supplies
are stored in the same
physical space as
inventory.
21-8
21-21 (continued)
a.
TRANSACTIONRELATED AUDIT
OBJECTIVE
b.
c.
RELATED RISK
TEST OF CONTROL
6. Recorded inventory
items are physically
present (Occurrence)
and recorded at
correct amounts
(Accuracy).
If periodic reconciliations
of inventory records to
physical counts are not
performed, there is a risk
that items may be
removed from the
warehouse without
knowledge, which would
result in overstated
inventory amounts.
Inspect the clients test

samples for accuracy and
reasonableness. Inquire
about the nature of
discrepancies identified.
7. Actual inventory on
hand may not be
recorded in the
perpetual inventory
listing (Completeness).
There is a risk that

inventory on hand is not
included in the inventory
records.
Inspect the clients test

samples for accuracy and
reasonableness. Inquire
about the nature of
discrepancies identified.
8. The perpetual
inventory records are
accurately summarized
and posted to the
general ledger
accounts (Posting and
Summarization)
There could be errors in

the mathematical
formulas of the inventory
records.
Recalculate the inventory

amounts and determine
that the totals agree to the
general ledger balances.
9. Recording inventory
transactions represent
actual receipts of
inventory items
(Occurrence).
Inventory could be added

to the inventory account
balance before actual
goods are received.
Enter an addition to the

perpetual inventory
system without a valid
receiving report number to
determine if the system
rejects the transaction.
Inventory held on
consignment may be
recorded as the clients
inventory.
Observe whether
inventory held on
consignment is stored in
the same physical space
as inventory.
10. Recording of inventory

in the clients records
is valid (Occurrence)
21-9
21-22
a.
It is important to review the cost accounting records and test their

accuracy for the following reasons:
1.
2.
3.
b.
1.
2.
3.
4.
5.
6.
The cost accounting records determine unit costs that are

applied to derive inventory values. Since inventory is usually
material, unit costs must be verified.
In many companies, there are many types of inventory items
with complex cost structures. The potential for misstatement
is great in determining costs. The auditor would need to go
to an extreme effort to verify such costs without being able to
rely on the cost accounting records which provides the costs,
(i.e., it is far more efficient to test the cost accounting records
than the costs themselves).
The cost accounting records also deal with transferring
inventories through the production cycle and then from finished
goods for sales. These transfers must be handled accurately
for inventory to be properly stated.
Examine engineering specifications for expected (standard)
labor hours. Examine time records for hours worked on part
during measured period. Divide by units produced to test
reasonableness of standard.
Review specifications for types of labor required to produce
parts, or observe production. Review union contracts or
earnings records to develop reasonable rate for this labor mix.
Identify appropriate overhead accounts, paying careful
attention to consistent application. Determine amounts for
these accounts for a measured period. Determine direct labor
hours from payroll records from the same period. Compute
the overhead rate per direct labor hour.
Review engineering specifications. Review material usage
variance.
Trace to vendor's invoices. Review material price variance.
Sum individual components.
21-10
21-23
AUDIT
PROCEDURE
TYPE OF TEST
Test of Control
To make sure that proper

controls exist and are being
followed in the taking of the
physical inventory.
(Existence, completeness,
accuracy and classification)
Substantive Test
To ensure that all inventory

represented by an inventory
tag actually exists.
(Existence)
Substantive Test
To test the accuracy of the

client's perpetual inventory
records.
and accuracy)
Substantive Test
To test client's final inventory

compilation.
accuracy and classification)
Substantive Test
To test that the final inventory

was valued at its proper cost.
(Accuracy)
Test of Control
To ensure that no raw material

was issued without proper
approval.
(Existence)
Test of Control or
Substantive Test
To ensure that additions

recorded on the finished goods
perpetual records were
recorded on the books as
completed production.
(Accuracy and classification)
21-11
PURPOSE
21-24
MISSTATEMENT
a.
CONTROL THAT
SHOULD HAVE
PREVENTED
THE MISSTATEMENT
FROM OCCURRING
b.
SUBSTANTIVE
AUDIT PROCEDURE
THAT COULD BE
USED TO UNCOVER
THE MISSTATEMENT
Internal verification by
another person.
Examine vendors' invoices in

support of prices used.
Keep a record of the last

shipping report number
shipped before the inventory
count.
Examine bills of lading for first

shipments recorded after the
physical inventory to determine
that they were shipped after
year-end.
Perform independent
second counts on all
merchandise. All persons
responsible for inventory
tags and compilation of
physical inventory should be
independent of custody of
perpetual inventory records.
Record test counts and trace to

compiled inventory.
Use of prenumbered tags

and accounting for
numerical sequence.
Account for all prenumbered

tags during the physical
examination and during
compilation tests.
Internal verification of
perpetual inventory prices.
Compare vendor invoice prices

to perpetual inventory prices.
Segregation of obsolete
inventory.
Perform net realizable value

and lower of cost or market
tests of inventory, including
tests of the perpetual inventory.
Periodic review of
reasonableness of
manufacturing overhead
rate.
Test reasonableness of
manufacturing overhead rate.
21-12
21-25
a.
Internal Controls
Tests of Controls
1.
Inventory purchases are

used to update the
perpetual Atlanta inventory
records.
Trace inventory quantities for a sample

of purchase transactions to the perpetual
inventory records as a part of tests of
controls and substantive tests of
acquisition transactions.
2.
Transfers of inventory are

used to update the Atlanta
and local distribution center
perpetual inventory records.

of shipments from Atlanta to local
distribution centers to the perpetual
inventory records.
3.
Inventory sales are used to

update the local distribution
center perpetual inventory
records.

of sales transactions to the perpetual
inventory records as a part of tests of
controls and substantive tests of sales
transactions.
4.
Local distribution centers

access to perpetual records
is restricted to processing
sales transactions.
Test the effectiveness of the perpetual

records access restrictions using the
CPA firms computer audit specialists.
5.
Quarterly physical inventory

is taken for comparison to
and adjustment of perpetual
records.
Examine local distribution center physical

inventory count records and adjustments
to the perpetual records.
6.
Internal auditors test the

perpetual records
continuously.
Examine internal auditor audit programs

and working papers for their tests of the
perpetual records and the findings.
7.
Internal auditors sample

inventory counts and test
inventory adjustments.
Examine internal auditor audit programs

and working papers for their tests of the
physical observation of inventory and the
findings.
b.
There are four ways to reduce physical observation of inventory.

Auditors will use their judgment to decide which combination of these
to use.
1.
2.
3.
4.
Reduce the number of local warehouses to observe inventory

counting and do test counts of inventory.
Reduce the number of auditors who observe the inventory
counting at each location.
Reduce the sample sizes for test counts inventory.
Perform the physical observation of inventory at an interim date.
21-13
21-26
a.
When the inventory is a material item in the financial statements

that the CPA is auditing, his or her observation of the taking of the
physical inventory is in compliance with the auditing standard
pertaining to field work that requires obtaining sufficient appropriate
evidence to afford a reasonable basis for an opinion regarding the
financial statements. Observation is a generally accepted auditing
procedure applied in the audit of the physical inventory.
By observing the taking of the physical inventory, the CPA is
seeking to satisfy himself or herself as to the effectiveness and
application of the methods of inventory taking and as to the measure
of reliance which may be placed upon the client's inventory records
and its representations as to inventory quantities. He or she must
ascertain that the physical inventory actually exists, that the
inventory quantities are being determined by reasonably accurate
methods, that the inventory is in a salable or usable condition, and
that consigned goods are not commingled with owned goods.
b.
The CPA makes test counts of inventory quantities during

observation of the taking of the physical inventory to satisfy himself
or herself that an accurate count is being made by the individuals
taking the inventory. The extent of test counting will be determined
by the inventory taking procedures; for example, the number of test
counts would be reduced if there were two teams, one checking the
other, taking the inventory. On the other hand, the test counts would
be expanded if misstatements were found in the inventory counts.
Some test counts are recorded by the CPA for the purpose of
subsequent comparison with the client's compilation of the inventory.
The comparison procedure goes beyond the mere determination that
quantities have been accurately transcribed. The CPA also seeks
assurance that the description and condition of the inventory items
is accurate for pricing purposes and that the quantity information,
such as dozen, gross, cartons, etc., is proper.
Another reason for recording test counts in the working papers
is to provide evidence of the extent of tests in the event that audit
procedures are questioned at some future date.
c.
1.
The CPA does not regard the inventory certificate as a

satisfactory substitute for his or her own audit of the inventory.
The service company has merely assumed the client's function
of taking the physical inventory, pricing it, and making the
necessary extensions. To the extent that the service company
is competent, the system of internal control with regard to
the inventory has been strengthened. Nevertheless, as the
CPA would under other strong systems of internal control, he
or she would investigate the system to determine that it is
operating in a satisfactory manner. The CPA's investigation
would necessarily entail an observation of the taking of the
inventory and testing the pricing and calculation of the inventory.
21-14
21-26 (continued)
21-27
2.
The inventory certificate of the outside specialists would have

no effect upon the CPA's report. The auditor must be satisfied
that the inventory was fairly stated by observing the taking of
the inventory and testing the pricing and compilation of the
inventory.
On the other hand, if the taking of the inventory was not
observed and no audit tests were applied to the computation
of the inventory, the CPA would be compelled to disclaim an
opinion on the financial statements as a whole if the amount
of the inventory is material.
If it is impractical or impossible for the CPA to observe
the taking of the physical inventory, but he or she is able to
determine that inventory is fairly stated by the application of
other auditing procedures, the CPA would be able to issue an
unqualified opinion.
3.
The CPA would make no reference to the certificate of the

outside specialists in his report. The outside specialists are
serving as adjuncts of the company's staff of permanent
employees. The outside specialists are not independent.
a.
The auditor in this situation should observe the recording of the

shipments on the day of occurrence and record these details in the
working papers so a determination can be made as to whether the
shipments affected the physical inventory count.
b.
1.
2.
c.
There is no clear-cut answer to sample size for inventory

counts. The answer to the question depends on additional
factors, such as the randomness of your test counts and
whether the values of the merchandise are relatively stratified.
It also depends on inherent risk for inventory physical counts
and the materiality of inventory compared to total assets.
Request a recount by the client or greatly expand your tests
to determine whether a material misstatement exists.
The auditor should determine how this inventory is valued and after
discussion with the client it may be well to classify it as obsolete. In
all cases, the auditor must specifically identify the merchandise in
the working papers for subsequent evaluation. The auditor should
also be aware that this could be an indication of widespread
obsolescence problems in other parts of the inventory.
21-15
21-27 (continued)
d.
One of the important tasks the auditor undertakes during the

observation is to determine that inventory tags are physically
controlled. This assures that the inventory is not understated because
tags are lost, or overstated because falsified tags are added. In this
situation, the auditor should recover the discarded tags and request
that the practice be stopped, and that control of tags be established
under the auditors direct observation.
21-28 The following procedures should be established to insure that the

inventory count includes all items that should be included and that nothing is
counted twice:
1.
All materials should be cleared from the receiving area and stored
in the appropriate space before the count.
2.
Incoming shipments of unassembled parts and supplies should be

held in the receiving area until the end of the day and then inventoried.
3.
If possible, the day's shipments of finished appliances should be

taken to the shipping area before the count. (Unshipped items
remaining in the shipping area should be inventoried at the end of
the day.)
4.
Great care must be exercised over goods removed from the

warehouse itself. These may be unassembled parts and supplies
requisitioned on an emergency basis or unscheduled shipments of
finished appliances. Alternative methods for recording these removals
are:
a)
b)
c)
Keep a list of all items removed and indicate on the list whether
the item had been counted.
Record the removal on the inventory tag if the item has been
inventoried.
Indicate on the material requisition or the shipping order that
the item had been inventoried. For any of these alternatives,
a warehouse employee or the perpetual inventory clerk must
adjust the recorded counts.
5.
The finished appliances remaining in the warehouse should be

inventoried at the end of the day.
6.
The warehouse should be instructed to date all documents as of

the day the materials are received, issued, or shipped.
21-16
21-28 (continued)
7.
The inventory clerk should post the May 31 production and shipment
of finished goods to the inventory record based upon the dates
shown on the plant production report and the shipping report. This
will provide a proper cutoff because provisions have been made to
adjust all counts for goods manufactured and shipped on May 31.
8.
The listing of inventory differences should be reviewed by the controller

and warehouse supervisor prior to booking the adjustment. Abnormal
differences should be investigated, and recounts (with appropriate
reconciliation) should be made where appropriate.
a.
Ratios are calculated as follows
21-29
b.
c.
d.
e.
Gross margin %
52%
52%
51%
Inventory turnover
5.6
5.9
5.9
This ratio should be compared against industry averages. The

gross margin represents the percent of total sales revenue that the
company retains after incurring the direct costs associated with
producing the goods and services sold by a company. The higher
the percentage, the more the company retains on each dollar of
sales to service its other costs and obligations.
This ratio should be compared against industry averages. A low
turnover implies poor sales and, therefore, excess inventory. A high
ratio implies either strong sales or ineffective buying.
Inquiry with management, review supporting documentation
There are no wide swings in the ratios, and the ratios are close to
industry average. Assuming there is no other reason to expect
changes (major changes within the company structure, major
changes to the economy), the analytical procedures seem
reasonable and most likely do no warrant changes to the overall
audit plan.
21-17
21-30
a.
b.
1.
2.
3.
4.
5.
Exclude
Exclude
Include
Include
Exclude
1.
This merchandise would be excluded because title does not

pass to buyer on an F.O.B. destination shipment until delivery
to the buyer. Since it was not received until January 2010,
there is no basis for including it in inventory.
Goods held "on consignment" do not belong to the consignee,
and should not be included in inventory.
Normally title to a stock item does not pass to the customer
until shipment, even though it has been set aside. Therefore
it should be included in inventory.
Title to goods shipped F.O.B. shipping point normally passes
to the buyer on delivery to the transportation agency, and in
this instance the goods belong to your client at December
31, 2009. There is an error in recording the acquisition.
Since this machine is fabricated to the customer's order, title
to customer made-merchandise passes to the buyer as
materials and labor are appropriated to the job. When the job
is completed and ready for shipment as in this case, it may
be considered as a completed sale.
2.
3.
4.
5.
21-18
21-31
a.
Inventory observation locations are unannounced so that the

client does not have the opportunity to move inventory
around in order to present a more favorable situation, if they
were inclined to do so.
b.
Sheet to Floor tests for existence, floor to sheet tests for

completeness. Existence tests that items recorded on the
F/S physically exist on the floor; completeness tests that all
items on the floor are recorded on the F/S. Generally
existence is the more relevant assertion for assets such as
inventory, but there are always exceptions to the rule.
c.
Exceptions noted:
a)
d.
e.
Client count differs from client records. Will be

adjusted by client
b)
Auditor count differs materially from client count.
Auditor will request client recount.
c)
Auditor count differs not materially from client count.
No recount or adjustment needed.
Task 2 is satisfied appropriately. Although subjective, if there
are 10 counters, I would speak to at least 3 counters if not
more.
The exceptions found in Task 3 could result in incorrect
counts as the purpose of having two people count the same
section is to verify if they count at the same time this
feature is lost. Also, if the counters dont remove the objects
from the shelves, they may miscount the items in the back
sometimes the shelf is not full or there are obstructions in the
back which mean there will be gaps in the stacks. It is more
important that the count is performed in accordance with
instructions rather than the physical count is absolutely
correct because you cant check all of the results, but you
can check the process. If the process is not correct you are
much more likely to have errors in the results. If the process
is sound, you are more likely to have more accurate results.
To follow up, you would speak to the Count Manager to
ensure that the count procedures are being followed
properly. Once this has occurred, you would continue to
observe count procedures to be sure that the procedures are
being followed correctly.
21-19
21-32
a.
Inventory per Schedule to Inventory Observed During Audit.

Existence testing tells you that all items listed in inventory, per the
books, actually exist on the lot. The risk is that inventory will be
overstated with inventory that does not actually exist. This is way for
companies to improve their balance sheets fraudulently.
b.
Inventory Observed During Audit to Inventory per Schedule.

Completeness testing tells you that all items seen on the lot are
recorded in the financial statements. The risk is that inventory will
be understated as inventory may be left off the financial statements.
This is generally considered a lower risk than existence, which is
the same for all other assets.
c.
See chart below:
Item number
Item Description
Tag No.
1001-08
1002-08
1003-08
1004-08
1005-08
1006-08
Earth mover, 1988, yellow

Front loader, 2002, green
Backhoe, 2000, yellow
Earth mover, 2004, green
Dump Truck, 2000, yellow
Steam Roller, 1997, yellow
AU05
AU06
AU03
AU02
AU04
AU01
d.
Item appears
on lot?
Yes
Yes
Yes
Yes
Yes
Yes
Auditor notes that no items with tag AU07 are found in records.
Auditor notes that all items appear to exist and list appears
complete. Auditor would follow up on possible obsolescence of old
inventory. No material changes noted, no changes to the audit plan
deemed necessary.
21-20
Case
21-33
a.
Assertion is accuracy. Audit purpose is to check that inventory is

properly valued. Risk is overstatement of asset.
b.
All items appear to be valued properly except for the bumpers. It

appears that the last price ($210) was applied to the entire 1,000
bumpers instead of applying 500 @ $200 and 500 @ $210 as per
the FIFO method.
qty per
invoice
$ per
invoice
3,000
$ 35.00
2,000
$ 40.00
Tires
4,000
$ 25.00
fastners
4,000
2.00
4,000
4,000
4,000
qty
FIFO
$ FIFO
3,000
$ 35.00
1,000
$ 40.00
4,000
4,000
$ 25.00
10,000
4,000
2.00
2.10
4,000
2.10
2.50
2,000
2.50
2.60
2.60
500
$ 200.00
500
$ 210.00
need
Struts
bumpers 500
$ 200.00
500
$ 210.00
c.
4,000
1,000
ext
$
105,000
$
40,000
$
100,000
$
8,000
$
8,400
$
5,000
$
$
100,000
$
105,000
The variance for the error found is $5,000, since this amount is
below tolerable misstatement, no changes to the audit plan are
deemed necessary. Had the variance been material, the auditor
would have to re-evaluate the audit plan, possibly perform
alternative procedures, expand the scope of testing, or request that
the client to reconcile and adjust the inventory pricing.
21-21
Internet Problem Solution: Using Inventory Count Specialists
21-1
Since 1938 when auditors failed to uncover fictitious inventory recorded
by the McKesson & Robbins Company, auditors have been ordinarily required to
physically observe the counting of inventory. It is important to recognize that
auditors are not required to actually count the inventory for inclusion on the
balance sheet, but they are required to observe the inventory being counted.
Occasionally, companies employ inventory specialists to perform their inventory
counts. One very large inventory counting specialist is Retail Grocery Inventory
Service, now known as RGIS. Visit RGISs [www.rgisinv.com] Web site and
answer the following questions.
1.
Does an auditors responsibility for observing the physical inventory

differ if a company hires an inventory specialist such as RGIS to
perform counts as opposed to having its own employees perform
inventory counts? (Hint: Read AU Section 331.)
Answer:
No, the auditors responsibility is unchanged by who does the
counting of the clients inventory. The auditor must be present during
the physical counting of the inventory.
2.
Would your expectations of the physical observation of a clients

inventory change if a client hired a company such as RGIS?
Answer:
Student responses will likely vary based upon their experience with
companies such as RGIS and whether they have participated in a
physical inventory. This question is meant to encourage students to
consider whether the hiring of an outside company such as RGIS
affects how the auditor executes his/her responsibilities during a
physical inventory. Most students have very likely never considered
who actually counts a companys inventory let alone the significance
of hiring another company to do the work. For example, the
instructor might ask the students to explain the difference between
hiring temporary employees to help with the counting of inventory
and hiring a company such as RGIS to count the inventory.
21-22
Internet Problem 21-1 (continued)

3.
What are the advantages and disadvantages of hiring an inventory

specialist such as RGIS?
Answer:
Student responses will vary. However, advantages and disadvantages
include the following:
Advantages: Experienced inventory specialists; No or
very limited management time required to train employees
on inventory procedures; Ability to continue business while the
counting proceeds; Company employees are free to continue
with their daily tasks, etc.
Disadvantages: Company may lose control over the counting
process; Management may experience a disconnect from
the inventory counting process which might lead to a loss of
information; Inventory specialists may not be familiar with
inventory if the company is in a unique industry; etc.
(Note: Internet problems address current issues using Internet sources. Because
Internet sites are subject to change, Internet problems and solutions may change. Current
information on Internet problems is available at www.pearsonglobaleditions.com/arens.)
21-23

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Inventory is generally a major item on the balance sheet and often

Compare the inventory cost entered into the inventory system to

Tests of the purchases of raw materials and pricing thereof.

Assuming the perpetuals are determined to be effective, physical inventory tests

Discuss with the client.

Review contracts with suppliers and customers to test for the

Obtain a sufficient understanding of the client's business to aid in

The last shipping document number should be recorded in the

For the purchase cutoff, the following information should be noted:

The last receiving report number should be noted in the working

2. Compare inventory turnover with

3. Compare unit costs with previous

Overstatement or understatement of unit

4. Compare extended inventory value

Errors in compilation, unit costs, or

5. Compare current year manufacturing

Misstatement of unit costs of inventory,

Assuming FIFO inventory valuation, the 12-31-09 inventory should be

 Discussion Questions and Problems

1. For a proper valuation

5. To make sure physical

7. To make sure obsolete

8. To make sure inventory

If purchasing agents can

Enter non-valid vendor

Without information about

Select a sample of items

Observe client personnel

Inspect the clients test

There is a risk that

Inspect the clients test

There could be errors in

Recalculate the inventory

Inventory could be added

Enter an addition to the

10. Recording of inventory

It is important to review the cost accounting records and test their

The cost accounting records determine unit costs that are

To make sure that proper

To ensure that all inventory

To test the accuracy of the

To test client's final inventory

To test that the final inventory

To ensure that no raw material

To ensure that additions

Examine vendors' invoices in

Keep a record of the last

Examine bills of lading for first

Record test counts and trace to

Use of prenumbered tags

Account for all prenumbered

Compare vendor invoice prices

Perform net realizable value

Inventory purchases are

Trace inventory quantities for a sample

Transfers of inventory are

Trace inventory quantities for a sample

Inventory sales are used to

Trace inventory quantities for a sample

Local distribution centers

Test the effectiveness of the perpetual

Discussion Questions and Problems

Internet Problem Solution: Using Inventory Count Specialists