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Auditing- A Practical Approach
Chapter 11: AUDITING INVENTORIES, and PROPERTY, PLANT and EQUIPMENT
FMGT 4310
Auditing 2
Chapter 10 Learning Objectives
1. Identify the audit objectives applicable to inventories
2. Describe the functions and control procedures normally found for custody and maintenance of inventory records
3. Discuss considerations relevant to determining the audit strategy for inventories
4. Design a substantive audit program for inventories
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Chapter 10 Learning Objectives
5. Identify the audit objectives applicable to properly, plant, and equipment
6. Discuss considerations relevant to determining the audit strategy for property, plant, and equipment
7. Design a substantive audit program for property, plant, and equipment
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Property Plant and Equipment (PPE)
• Expected lives > one year
• Used in the business
• Not acquired for resale
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Fixed assets vs. Current asset accounts
• How does the nature of fixed asset accounts (e.g. building) differ from other current assets (e.g. inventory)?
• Consider: – Frequency of transactions
– Size of transactions
CR assessment?
Other Audit considerations
IR considerations: –Vulnerability to theft
–Estimates for useful life
–Depreciation methods
Other Audit considerations
• Emphasis is on auditing current period acquisitions
• Why?
Tracking Fixed Assets
• How do large organizations track fixed assets?
• How do smaller organizations track fixed assets?
Other Audit considerations
• Traced to the capital cost allowance section of the tax working papers
• Amortization and accumulated amortization accounts are also verified
• Other accounts that are verified in a similar manner include: patents, copyrights, catalogue costs
Categories of audit tests conducted for fixed assets and related accounts
• Verification of:
– Current-year acquisitions
– Current-year disposals
– The ending balance in the asset account
– Amortization expense
– The ending balance in accumulated amortization
Verification of current year acquisitions
• WCGW?
• Capitalization policy
• Continuity schedule
• Examination of supporting documentation
• Important Assertions?
Verification of current year disposals
• WCGW?
• The most important internal control?
• The most important audit procedures?
• Important Assertions?
Verification of asset balances
• Is it necessary to verify fixed assets acquired in prior years?
• Important Assertions?
• Impairment?
Verification of amortization expense
• Internal allocations vs. exchange transactions with outside parties
• Primary audit objectives:
– Consistent amortization policy (occurrence)
– Accurate calculations (accuracy)
Verification of accumulated amortization
• Opening balances
• Debits to account
• Credits to account
Analytical procedures for Fixed Assets
Analytical procedure Potential misstatement detected
Compare amortization expense divided by gross fixed asset cost with previous years
Misstatement in amortization expense and accumulated amortization
Compare accumulated amortization divided by gross fixed asset cost with previous years
Misstatement in accumulated amortization
Analytical procedures for Fixed Assets
Analytical procedure Potential misstatement detected
Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with previous years
Expensing amounts that should be capital items
Compare gross manufacturing cost divided by some measure of production with previous years
Idle equipment or equipment that has been disposed of but not written off
Inventory
• Used in the business
• Acquired for resale
Audit Objectives
Key Issues • Inventory
– EXISTS – Is OWNED – Properly VALUED
E, R, V
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Purchases
Sales
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Business functions in the Inventory cycle
• Process purchase orders
• Receive new materials
• Store materials
• Process goods
• Store finished goods
• Ship finished goods 10-25Manufacturing entity
Inventory Audit Transaction Cycle
Acquire/record raw materials, labour
Internally transfer assets and costs
Ship goods, record revenue/costs
Physically observe inventory
Price and compile inventory
Purchases, Payroll
Inventory
Sales receipts
Inventory
Inventory
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Inventory Audit Transaction Cycle
Acquire/record raw materials, labour
Internally transfer assets and costs
Ship goods, record revenue/costs
Physically observe inventory
Price and compile inventory
Purchases, Payroll
Inventory
Sales receipts
Inventory
Inventory
Cost accounting
Physical controls
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Business functions in the Inventory cycle
Consider:
• Perpetual vs. Periodic inventory systems
• Cost accounting systems – E.G. Job costing, standard costing
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Key Internal Controls in the Inventory cycle
• Segregate CUSTODY and RECORDING
WCGW?
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Key Internal Controls in the Inventory cycle
• Receiving reports
• WCGW?
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Key Internal Controls in the Inventory cycle
• Internal transfers
WCGW?
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Inventory Audit Transaction Cycle
Acquire/record raw materials, labour
Internally transfer assets and costs
Ship goods, record revenue/costs
Physically observe inventory
Price and compile inventory
Purchases, Payroll
Inventory
Sales receipts
Inventory
Inventory
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Key Internal Controls in the Inventory cycle
• Shipping reports
• WCGW?
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Inventory Audit Transaction Cycle
Acquire/record raw materials, labour
Internally transfer assets and costs
Ship goods, record revenue/costs
Physically observe inventory
Price and compile inventory
Purchases, Payroll
Inventory
Sales receipts
Inventory
Inventory
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Key Internal Controls in the Inventory cycle
• Compare Physical Inventory to Inventory Records
• WCGW?
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Consider:
• Assigning and communicating responsibility
• Preparing the warehouse
• Identifying the inventory
• Counting
Inventory Count Procedures
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Inventory Audit- Transaction Cycle
Acquire/record raw materials, labour
Internally transfer assets and costs
Ship goods, record revenue/costs
Physically observe inventory
Price and compile inventory
Purchases, Payroll
Inventory warehousing
Sales receipts
Inventory warehousing
Inventory warehousing
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Merchandise inventory, or
Manufactured inventory
Pricing and Compilation of Inventory
10-38
Units counted $$
For Manufactured inventory:
• Raw materials costing
• FIFO, LIFO, weighted average
• Direct labour
• Overhead
• WIP Finished goods
• Finished goods COGS
Pricing and Compilation of Inventory
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Auditing Strategy
– Usually a major item on the balance sheet
– Inventory items could be at different locations
– Very diverse items how can it be counted?
– Valuation obsolescence
– Valuation methods
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Assess materiality and IR
Methodology- Designing Test of Details
Assess CR (for various cycles)
Design/perform Control tests
Design/perform Analytics
Design Tests of Detail: •Audit procedures •Sample size •Items to select •Timing
Identify at risk assertions
FOR EACH ASSERTION:
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Incompatible functions?
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Inventory count
Compilation
Designing Tests of Controls for Cost Accounting
Important General Controls:
• Access control to cost accounting system software (passwords)
• Controls over systems updating and development
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Designing Tests of Controls for Cost Accounting
Important Specific Controls:
• Standard costing systems, variance analysis
• Independent review, reporting
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Designing Tests of Physical Controls
Important Physical Controls:
• Restricted access
• Environmental controls- temperature, etc.
• Controls over the allocation and use of inventory
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Inventory Audit- Transaction Cycle
Acquire/record raw materials, labour
Internally transfer assets and costs
Ship goods, record revenue/costs
Physically observe inventory
Price and compile inventory
Purchases, Payroll
Inventory warehousing
Sales receipts
Inventory warehousing
Inventory warehousing
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Substantive Procedures
Copyright John Wiley & Sons Canada, Ltd.
Auditing Strategy
How to audit Existence of inventory?
Rely on perpetual records?
CR must be LOW
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Auditing Strategy
How to audit Existence of inventory?
Observe count near YE, roll forward?
CR must be LOW-MODERATE
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Auditing Strategy
How to audit Existence of inventory?
Observe count at YE?
Substantive approach
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Consider:
• Checking the count
• Clearing the inventory
• Recording
• Cut-off
• Recounts?
Inventory Observation
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Inventory Observation
• It is essential that the auditor have a complete understanding of the client’s physical inventory procedures and controls before the inventory-taking begins.
Why?
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Tests of Details for Physical Inventory Observation: Existence
• Does the inventory counted as part of the inventory count actually exist?
“Sheet Floor”
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Tests of Details for Physical Inventory Observation:
Completeness
• Has all inventory been counted, and included in the inventory balance?
“Floor Sheet”
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Tests of Details for Physical Inventory Observation: Valuation &
Allocation
• Is there any damaged, non- saleable, or obsolete inventory?
(i.e. “rust or dust”)
• Has the counted inventory been classified correctly?
(e.g. raw materials, work in progress, finished goods)
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Tests of Details for Physical Inventory Observation: Rights and
Obligations
• How do we test that the company has a right (i.e. owns) to the inventory that is included in the count?
inquiry, observation
What evidence can we inspect?
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Tests of Details for Physical Inventory Observation:
(Purchases) Cut-off
• Have the sales (inventory consumption) and purchases (inventory accumulation) recorded in the correct period?
Matching Principle
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Tests of Details for Pricing and Compilation
• Inventory listing agrees with physical counts,
• additions/extensions are correct, (quantity x cost) and
• agrees with General Ledger
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