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Chapter 13 Audit Notes

by: Victoria Andreski

Chapter 13 Audit Notes ACCT 4150

Marketplace > Clemson University > Accounting > ACCT 4150 > Chapter 13 Audit Notes
Victoria Andreski

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Chapter 13: Auditing the Inventory Management Process
Nancy Harp
Class Notes
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This 7 page Class Notes was uploaded by Victoria Andreski on Thursday April 7, 2016. The Class Notes belongs to ACCT 4150 at Clemson University taught by Nancy Harp in Spring 2016. Since its upload, it has received 21 views. For similar materials see Auditing in Accounting at Clemson University.


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Date Created: 04/07/16
CHAPTER 13—Auditing the Inventory Management Process Types of Documents & Records • Production Schedule—based on the expected demand for the entity’s products (based on backlog) • Receiving Report—records the receipt of goods from vendors • Materials Requisition—used to track materials during the production process o Ask to get raw materials to get out of storage area to put into production • Inventory Master File—contains all the important information related to the entity’s inventory, including the perpetual inventory records o List of everything you have, where it’s located, which vendor you used to buy it, etc. • Production Data Information—contains information about the transfer of goods & related cost accumulation at each stage of production • Cost Accumulation & Variance Report—material, labor, & overhead costs are charged to inventory as part of the manufacturing process o The variance report compares actual costs to standard or budgeted costs § Variance—what did we actually spend on this product • Inventory Status Report—shows the type & amount of products on hand o See a snapshot of all the inventory we have & where it’s located on a specific day • Shipping Order—used to remove goods from the perpetual inventory records o Document the transfer Major Functions • Inventory Management—authorization of production activity & maintenance of inventory at appropriate levels o Issuance of purchase requisitions to the purchasing department • Raw Materials Stores—custody of raw materials & issuance of raw materials to manufacturing departments • Manufacturing—production of goods • Finished Goods Stores—custody of finished goods & issuance of goods to the shipping department • Cost Accounting—maintenance of the costs of manufacturing & inventory in cost records • General Ledger—proper accumulation, classification, & summarization of inventory & related costs in the GL Inherent Risk Assessment • The auditor should consider industry-related factors & operating & engagement characteristics when assessing the possibility of a material misstatement • If industry competition is intense, there may be problems w/ the proper valuation of inventory o Technology changes in certain industries may also promote material misstatement due to obsolescence • Products that are small & of high value are more susceptible to theft o The auditor must be alert to related-party transactions for acquiring raw materials & selling finished products o Prior-year misstatements are good indicators of potential misstatements in the current year • Issue for inventory is usually valuation—worry about obsolescence (valuation assertion) o Inventory may exist & be complete but should it be discounted? (some may be written off to zero) o Inventory—inherently risky that it will be stolen—smaller things have a greater risk of being stolenà things that are easy to sell (iPhones, jewelry, etc.) o If buying from related party, make sure you’re buying at a reasonable price Control Risk Assessment • Major steps in setting the CR in the inventory management process: o Understand & document the inventory management process based on a reliance strategy § Reliance strategy—you are relying on controls to avoid doing as much substantive testing • Bucket is filled up w/ CONTROL testing • Need less substantive testing • Rely on controls so you have to test them • If you test them, you hope to make CR low, making DR high, requiring less substantive testing § Substantive strategy—more filled with substantive testing; less control testing o Plan & perform tests of controls on inventory transactions o Set & document the CR for the inventory management process Assertions—Inventory Transactions • Occurrence o Observe & evaluate proper segregation of duties o Review & test procedures for transfer of inventory o Review & test procedures for issuing materials to manufacturing departments o Review & test client procedures for account for numerical sequence of materials requisitions o Observe the physical safeguards over inventory o Auditor’s main concern is that all record inventory exists & that goods may be stolen § Review & observation are the main tests of controls used by the auditor to test the control procedures • Completeness o Review & test client’s procedures for consignment goods o The primary control procedure relates to recording inventory that has been received o Did documents sampled actually get recorded? • Authorization o Review authorized production schedules o Review & test procedures for developing inventory levels & procedures used to control them o Auditor’s concern w/ authorization in the inventory system is w/ unauthorized purchase or production activity that may lead to excess levels of certain types of finished goods § Make sure there aren’t unauthorized purchases § Make sure PO’s are approved § If you’re producing too much, it can lead to obsolescence § Authorize purchase & production of things • Accuracy o Review & test procedures for taking physical inventory o Review & test procedures used to develop standard costs o Review & test cost accumulation & variance reports o Review & test procedures for identifying obsolete, slow-moving, & excess quantities o Review the reconciliation of perpetual inventory to GL control account o Inventory transactions that are not properly recorded result in misstatements that directly affect the amounts reported in the financial statements o Inventory purchases must be recorded at the correct price & actual quantity received § Pull inventory used for invoices § Make sure math is correct § Make sure inventory that is shipped is recorded correctly in COGS o Inventory shipped must be properly recorded in COGS & the related revenue recognized • Cutoff o Review & test procedures for processing inventory included on receiving reports into the perpetual records based on shipments of goods o Inventory transactions recorded in the improper period could affect a # of accounts, including inventory, purchases, & COGS • Classification o Review the procedures & forms used to classify inventory o The client must have control procedures to ensure that inventory is properly classified as raw materials, work in process, or finished goods o By knowing which manufacturing department holds the inventory, the auditor is able to classify it by type Assertions about Classes of Transactions & Events • Occurrence—inventory transactions & events are valid • Completeness—all inventory transactions & events have been recorded • Authorization—all inventory transactions are properly authorized • Accuracy—inventory transactions have been properly computed & recorded • Cutoff—inventory receipts & shipments are recorded in the correct accounting period • Classification—inventory is recorded in the proper accounts Assertions about Account Balances at the Period End • Existence—inventory recorded on the books & records actually exists • Rights & Obligations—the entity has the legal right to the recorded inventory • Completeness—all inventory is recorded • Valuation & Allocation—inventory is properly recorded in accordance w/ GAAP (e.g. lower of cost or market) o Valuation—bigger issue—obsolescence reserve o Accuracy—take vendor’s invoice Assertions about Presentation & Disclosure • Occurrence & Rights & Obligations—all disclosed events, transactions, & other matters relating to inventory have occurred & pertain to the entity • Completeness—all disclosures relating to inventory that should have been included in the financial statements have been included • Classification & Understandability—financial information relating to inventory us appropriately presented & described, & disclosures are clearly expressed • Accuracy & Valuation—financial & other information relating to inventory are disclosed fairly & in appropriate amounts Substantive Analytical Procedures • You don’t have to do substantive analytical procedures—not required o Simply an option • You can do test of details as well • Can do a combination • Look at inventory turnover from last year—is inventory moving slower this year than last year? o If yes, it may be a sign of obsolescence Auditing Standard Costs • Materials o Test the quantity & type of materials included in the profit & the price of the materials o Make a sample of all invoices of material bought during the year § Make sure prices are right • Labor o Gather evidence about the type & amount of labor needed for production & the labor rate o Talk to a lot of production people o How much labor is needed to produce items? • Overhead o Review the client’s method of overhead allocation for reasonableness, compliance w/ GAAP, & consistency o Is allocation a reasonable method? Observing Physical Inventory • During the observation of the physical inventory count, the auditor should do the following: o 1) Ensure that no production is scheduled § If production is scheduled, proper controls must be established for movement between departments in order to prevent double counting o 2) Ensure that there is no movement of goods during the inventory count o 3) Make sure that the client’s count teams are following the inventory count instructions o 4) Ensure that inventory tags are issued sequentially to individual departments o At the end of the year (NYE), go to client’s warehouse & go count § We aren’t counting everything § Section out different shelves & rows in warehouse—people must count everything in those areas § No production is scheduled before we do that inventory—shut down for the day so we can count § Observe the people who are counting the inventory—are they in the right teams and following the proper instructions? § We aren’t in charge of the countà just observing • It’s an internal control • It affects the # that goes on the balance sheet o 5) Perform test counts & record a sample of counts in the working papers o 6) Obtain tag control information for testing the client’s inventory compilation o 7) Obtain cutoff information, including the # of the last shipping & receiving documents issued § Make sure everything that were shipped off on last day are not recorded o 8) Observe the condition of the inventory for items that may be obsolete, show moving, or carried in excess quantities § Keep your eyes open & be skeptical § Consider opening boxes § Don’t trust what every box says on the outside (boxes could be empty) § Try to pick boxes that are more of a hassle b/c that may be where companies are trying to hide things o 9) Inquire about goods held on consignment for others or held on a “bill-and- hold” basis § on consignment—things we don’t actually own—make sure it isn’t included in inventory o Do test counts from TWO different directions o They’ll give us a list of everything counted § Pick 10 counts off the sheet of counts § Have someone help you & go to every location chosen & check • Floor checkingà sheet to floor o Go from something already recorded & go out & and check (occurrence/existence) o Is what was recorded right? • Floor to Sheetà wander around warehouse floor & choose locations to check o Could pick locations that are high up o Make sure it is actually on the floor & exists o Tests completeness § Make sure all tags are accounted for Substantive Tests of Transactions—Tests of Details • Occurrence—vouch a sample of inventory additions to receiving reports & purchase requisitions • Completeness—trace a sample of receiving reports to the inventory records o Do NOT start w/ journal or sheet or GL b/c you will never get the chance to find something not there o Take a sample of receiving report & see if it made it into inventory • Authorization—test a sample of inventory shipments to ensure there is an approved shipping ticket & customer sales • Accuracy—recompute the mathematical accuracy of a sample of inventory transactions o Audit standard costs or other methods used to price inventory • Cutoff—trace a sample of time cards before & after period end to the appropriate weekly inventory report • Classification—examine a sample of inventory checks for proper classification into expense accounts • When testing the physical, you’re getting assurance on quantity o Test price through vendor invoices, labor applied, & overhead Test of Details of Account Balances • Existence—observe count of physical inventory o Do test counts on inventory to make sure it actually exists • Rights & Obligations—verify that inventory held on consignment for others or “bill-and- hold” goods are not included in inventory • Completeness—trace test counts & tag control information to the inventory compilation o Take test counts from the floor & trace it into the tag & then into the compilation (records) • Valuation & Allocation—obtain a copy of the inventory compilation & agree totals to GL o Test mathematical accuracy of extensions & foot the inventory compilation o Inquire of management concerning obsolete, slow moving, or excess inventory o Review book-to-physical adjustment for possible misstatements Tests of Details of Disclosures • Occurrence & Rights and Obligations—inquire if management & review any loan agreements & BOD’s minutes for any indication that inventory has been pledged or assigned o Inquire of management about issues related to warranty obligations • Completeness—complete financial reporting checklist to ensure that all financial statement disclosures related to inventory are made • Classification & Understandability—review inventory compilation for proper classification amount raw materials, WIP, & FG o Read footnotes to ensure that required disclosures are understandable • Accuracy & Valuation—determine if the cost method is accurately disclosed o Inquire of management about issues related to LIFO liquidations § Read footnotes & other information to ensure that the information is accurate & properly presented at the appropriate amounts Possible causes of book-to-physical differences 1. Inventory cutoff errors 2. Unreported scrap or spoilage 3. Pilferage or theft • There will always be errors in inventory counts o People are moving things around & not accounting for it o Get sloppy o Too much shoved into boxes o Counting errors when receiving goods o Mostly human errors & laziness Possible Disclosure Items • Cost Method (FIFO, LIFO, retail method) • Components of inventory (raw materials, WIP, FG) • Long-term purchase contracts • Consigned inventory • Purchases from related parties • LIFO liquidations • Pledged or assigned inventory • Disclosure of unusual losses from write-downs or losses on long-term purchases commitments • Warranty obligations Evaluating the Audit Findings—Inventory • At the conclusion of testing, the auditor should aggregate all identified misstatements • The likely misstatement is compared to the tolerable misstatement is compared to the inventory account • Likely misstatement LESS THAN tolerable misstatement o The auditor may accept the inventory account as fairly presented • Likely misstatement GREATER THAN tolerable misstatement o The auditor must conclude the inventory is not fairly presented


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