Inventory Management and Cost of Goods Sold: A Comprehensive Guide for Auditors
CHAPTER 12
Inventories and Cost
of Goods Sold
Review Questions
12–1Substantiation of the figure for inventories is an especially challenging task because of the variety of acceptable methods of valuation.In addition, the variety of materials found in inventories calls for considerable experience and skill to do an efficient job of identifying and test-counting goods on hand.The possibilities of obsolescence and of excessive stocks also create problems.Finally, the relatively large size of inventories and their significance in the determination of net income make purposeful misstatement by the client a possibility that the auditors must guard against.
12–2Issuance of a purchase order requires approval signatures attesting that all established procedures have been observed for (a) determining the need for the item, (b) obtaining the competitive bids, and (c) obtaining approval of the financial aspect of the commitment.Since the issuance of a purchase order commits the company to a liability, the purchasing function is extremely important.
12–3Internal control over purchasing activities is strengthened by placing exclusive authority for purchases of all kinds in a separate purchasing department, and creating another independent department to handle the receiving function.In addition, the recording of purchase transactions should be assigned to an accounts payable section within the accounting department.
In a small concern, departmentalization of operations may not be feasible to this extent, but if internal control is to be achieved, it is necessary as a minimum requirement that the functions of purchasing, receiving, and recording be assigned to different employees not subordinate to one another.
12–4Adequate internal control of purchase transactions requires the preparation of serially numbered receiving reports by an independent receiving department and the comparison of these reports with vendors’ invoices and purchase orders by the accounts payable department prior to approval of the invoice for payment.To ascertain that these procedures are actually being followed, the auditors will make various tests including the examination of receiving reports to see that they are complete, current, legible, and controlled by serial numbers.
12–5During an audit of a manufacturing company, the auditors consider the cost system for the following purposes:
(1)To determine that costs are properly allocated to current and future periods and hence that cost figures used in arriving at balance sheet and income statement amounts are supported by internal records.The appropriate allocation of costs to finished goods, work in process, and cost of goods sold is essential to the preparation of financial statements in accordance with generally accepted accounting principles.
(2)To obtain assurance that the cost system, as an integral part of the system of internal control, provides proper control over costs incurred and related inventories.
(3)To ascertain, as a service to management, that the cost system is economical and effectively provides information for reducing or controlling costs and for determining the cost and profitability of products, and other related data necessary for informed managerial decisions.
12–6The independent auditors are key participants in the planning for a client’s physical inventory.Although the auditors do not actually do the planning for the client, they offer advice on such matters as the assignment of a key client employee to assume responsibility for the inventory; selection of the most advantageous dates for the inventory taking; scheduling operations to minimize goods-in-process; and so on.Most important is the auditors’ determination that the client’s inventory instructions are adequate.
12–7The auditors observe the taking of the physical inventory to obtain evidence supporting its existence.In addition, information relevant to valuation of and rights to inventory is obtained.Observation of the physical inventory is a major step in meeting the standard of fieldwork that requires the auditors to gather sufficient, competent, evidential matter to provide a reasonable basis for an opinion on the financial statements.
By observing the taking of the physical inventory, the auditors are seeking sufficient competent evidence as to the effectiveness of the methods of inventory taking and as to the measure of reliance that may be placed upon the client’s inventory records and its representations as to inventory quantities.The auditors must ascertain that the physical inventory actually exists, that the inventory quantities are being determined by reasonably accurate methods, and the inventory is in a saleable or usable condition.
12–8The auditors make test counts of inventory quantities during their observation of the taking of the physical inventory to ascertain that the individuals taking the inventory are making an accurate count. The extent of test counting will be determined by the inventory-taking procedures; for example, the number of the auditors’ test counts would be reduced if there were two teams, one verifying, the other taking the inventory.On the other hand, the auditors’ test counts would be expanded if they found errors in the inventory counts.Some test counts are recorded by the auditors for the purpose of subsequent comparison with the client’s compilation of the inventory.The auditors must determine that the compilation of the inventory from the tags, sheets, or computer readable forms is accurate.In addition, the auditors seek 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, and so on, is proper.
A secondary reason for recording test counts in the audit working papers is to provide evidence of the extent of the auditors’ tests in the event that audit procedures are questioned at some future date.
12–9The test counts and tag numbers should be listed by the auditors in their working papers and later traced to the client’s inventory summary sheets.By this procedure, the auditors obtain evidence that the quantities on the tags have been accurately transcribed to the summary sheets by the client employees in developing the total valuation for inventory.If a significant number of differences are found, the auditors may need to reexamine the original tags or request that the client recompile the inventory.
12–10A physical inventory at least once a year is generally essential regardless of whether perpetual inventories are maintained.However, when perpetual inventories and good internal control are maintained, the annual physical count may be taken at a date other than the year-end.Some companies with good perpetual inventory records prefer to take a physical inventory in one department at a time with the counting work thereby spread throughout the year.Furthermore, if statistical sampling techniques are applied in the periodic counting process and the sampling is appropriately planned and executed, the entire inventory need not be counted.
12–11A bill and hold scheme involves transactions in which sales of merchandise are improperly billed to customers prior to delivery, with the goods being held by the seller.These transactions overstate revenues and net income.Bill and hold transactions have to meet rigorous requirements to be recognized as legitimate sales.
12–12The auditors’ analysis of the Cost of Goods Sold account of a manufacturing concern might disclose charges and credits for amounts transferred from the goods-in-process or finished goods inventory accounts, proceeds from sales of scrap, charges for idle plant and equipment, underabsorbed or overabsorbed factory overhead, variances from standard costs, writedowns for inventory shortages and obsolescence, and losses on firm fixed-price contracts.
12–13Two general conditions must exist for the auditors to render an unqualified opinion when the physical inventory is taken on a sampling basis.First, the sampling plan must have statistical validity.Second, the allowance for sampling risk (precision) and the sampling risk (confidence) level must provide an estimate that allows a materially accurate valuation of the inventory.
12–14The client should be asked to designate an employee to assume responsibility for the physical inventory.A written plan should be developed covering such points as exact dates of the count, possible closing of the plant, segregation of obsolete or damaged goods, design of inventory tags and summary sheets, control of incoming and outgoing shipments during the count, drafting of written instructions, and training of staff in the counting procedures.
12–15The statement is misleading.Inventories are to be reported at the lower of cost or market.Also, the expression”valued at cos” is not sufficiently specific; the method of determining cost should be indicated.
12–16The use of different methods of inventory valuation for different components of the company’s inventory is acceptable practice and would not prevent the issuance of an unqualified audit report.Generally accepted accounting principles allow the use of different valuation methods for different components of a company’s inventory.
12–17The statement is not true.The auditors’
responsibilities with respect to inventories include not only quantities and pricing, but also the quality or condition of the goods, the accuracy of extensions, footings, and summaries, and the consideration of internal control.Weakness in internal control may cause large losses from excessive stockpiling, obsolescence, inaccurate cost data, and other sources, even though the ending inventory is properly counted and priced.
12–18The independent auditors utilize the client’s backlog of unfilled sales orders in the determination of net realizable value of finished goods and goods-in-process, and in the determination of losses, if any, on firm sales commitments for which no production has yet been undertaken.
12–19No.Inspection of the warehouse receipts does not constitute sufficient verification.The inventories should be confirmed in writing directly to the auditors by the custodians of the stored goods.If the inventories stored in public warehouses are substantial in relation to other assets, the auditors should also review client records regarding selection and performance of the warehouses, and any available reports on the warehouses’ internal control.The auditors also should consider observing substantial inventories stored in public warehouses.
12–20In the confirmation of bank accounts and bank loans, the reply from the bank may disclose a lien on inventory.Also in examining insurance policies on inventory, the auditors may find a “loss payable clause” to a third party indicating inventories have been pledged.Finally, the client officials should be asked to disclose any lien on inventory as part of the written representations furnished to the auditors.
Questions Requiring Analysis
12–21Weaknesses in internal control of Nolan Manufacturing Company include the following:
(1)Organization structure is poor.The receiving department should not be under the authority of the purchasing agent.
(2)Copies of purchase orders sent to receiving department should not show quantities.This encourages careless counting.
(3)The receiving department should prepare a receiving report for each shipment received.These documents will permit evaluation of the department’s work, indicate proportion of returns, and establish accountability for goods.
(4)Errors by buyers are covered up by the existing system since any deficiency in goods received is not reported by the receiving department to anyone but the buyer.
(5)Goods should be kept in storerooms until required for production, not sent directly to the factory production area.
(6)There is apparently no control over the movement of raw materials into goods-in-process and no record of the quantities of goods-in-process.
(7)The perpetual inventory records (physical units only) for finished goods are apparently not integrated with the accounting records.
(8)The custody of finished goods and the recordkeeping for these goods are assigned to the same employee.
12–22a.The auditors do not regard the inventory certificate of an outside service company as a satisfactory substitute for their 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 internal control with regard to the inventory has been strengthened.Nevertheless, as with any internal control system, the auditors would investigate the internal control to ascertain that it is operating in a satisfactory manner.The auditors’ investigation would necessarily entail an observation of the taking of the inventory and testing the pricing and calculation of the inventory.
b.The inventory certificate of the outside specialists would have no effect upon the audit report. The auditors must determine that the inventory was fairly stated by observing the taking of the inventory and testing the pricing and calculation 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 auditors would be compelled to disclaim an opinion (or qualify their opinion) on the financial statements as a whole if the amount of the inventory is material.
If it has been impossible for the auditors to observe the taking of the physical inventory, but they have been able to satisfy themselves by the application of other auditing procedures, they should not refer to the inventory in the audit report.
c.The auditors would make no reference to the certificate of the outside specialists in their report.The outside specialists are serving as adjuncts of the company’s permanent employees and, as such, are in somewhat the same guise as temporary employees.The outside specialists are not independent in that they do not have third-party interests.The auditors, under certain circumstances, mention in their report the reports of other independent auditors, but this practice does not extend to the certificate of outside specialists who are not independent auditors.
12–23a.Observation of physical inventory is generally mandatory because it provides strong evidence as to existence and quality of the client’s inventories.
b.Observation of physical inventory generally is impossible when the independent auditors were not appointed by the client until after the physical inventory had been taken.There may also be conditions where weather conditions, terrains, or some other circumstances make it impossible for the independent auditors to be present at the site of the client’s inventory-taking; but such circumstances should be rare.
c.The auditors’ review of the client’s control for inventory tags is important because of the danger that fictitious inventory tags might be created by dishonest client personnel after the auditors have completed their observation of the physical inventory.
12–24The following procedures should be undertaken:
a.The oral evidence that the motors are on consignment should be substantiated by a review of the client’s records of consigned inventory, examination of contracts and correspondence with consignors, and confirmation of consigned stocks by direct communication with consignors.
b.The location of the machine in the receiving department, together with the presence of the “REWORK” tag, suggests that the machine had been shipped to a customer but rejected and returned.The auditors should examine the receiving report for the machine, the accounts receivable confirmation from the customer, and records of the client’s quality control department, to ascertain who has title to the machine.If the customer has title, the machine should not be included in inventory, and a liability for rework costs should be established.If the client has title, the customer’s account should be credited for the sales return and the machine should be included in the client’s inventory at estimated realizable value.
c.The “Material Inspection and Receiving Report” signed by the Navy Source Inspector is evidence that title to the machine passed to the U.S. Naval Base on November 30.Accordingly, the auditors should ascertain that the sales value of the machine is included in accounts receivable, and that the cost of the machine is not in the inventory.
d.The location of the storeroom and the dusty condition of the goods suggest that the items may be obsolete, or at least slow moving.The auditors should inspect perpetual inventory records for usage of the materials, and should inquire of production personnel whether the materials are currently useful in production.The materials may have to be valued at scrap value.
12–25Auditing procedures that the auditors would employ to determine whether slow-moving or obsolete items are included in the inventory are the following:
(1)During the observation of physical inventory, make note of any dusty or rusted items, or other items in obviously poor condition.In addition, investigate any inventory stored in out-of-the-way locations.
(2)If the client maintains reliable perpetual inventory records, review them for raw materials that have not been requisitioned and for finished goods that have not been shipped for extended periods.
(3)Compare the raw materials physical inventory listings with bills of material for products currently in production or on order.
(4)Compare the backlog of unfilled sales orders at the audit date to the finished goods inventory list.
(5)Review catalogs and other sales department publications for finished goods currently being advertised and offered for sale.
(6)Be alert for any incomplete jobs that are dormant in the review of goods-in-process inventory records.
(7)Examine post-audit date sales orders and materials requisitions to determine what finished goods and raw materials were active in the subsequent period.
(8)Inquire of the client management as to any recent survey for obsolete or slow-moving inventory.
(9)Compare the beginning and ending inventory listings are compared for items showing little if any quantity changes.
(10)Compute the turnover of inventory by product line and compare it to that of prior periods for an indication of an adverse trend.
(11)Perform other analytical procedures, such as comparing the trend of gross profit by product line.
12–26Since Reed Company obtained its entire merchandise inventory from the president of the company in a related party transaction, the auditors should consider the cost of the merchandise to the president in his operation of a similar business as a sole proprietor.In this related party transaction, the auditors must look beyond form—a total cost of $100,000 for the original stock of merchandise—to substance.Substantively, the merchandise of Reed Company should not be valued at excessive amounts, that is, amounts beyond what it could be acquired for directly from vendors.Any excess amount charged by the president to Reed Company represents unamortized discount on the notes payable.The entire transaction should be fully disclosed in a note to the financial statements of Reed Company.
12–27 a.To establish proper inventory cutoff, the auditors use the shipping and receiving information obtained at the physical inventory and:
(1)Examine sales transactions and supporting documentation for a period before the physical inventory and determine that goods shipped before the physical inventory have been included in sales and cost of sales, and that goods included in inventory are not included in sales and cost of sales.
(2)Select receiving reports for goods received before the physical inventory and determine that all goods received before the inventory have been included in inventory and liabilities.
(3)Review supporting documentation for goods not included in the physical count but included in the general ledger inventory control account (e.g., inventory in transit) and determine that the goods are properly included in inventory.
(4)Examine purchase and sales transactions and detailed supporting documents for the period after the physical inventory to determine that they have been reflected in the proper period.
(5)Review records of returned goods and claims against suppliers and related memoranda for periods before and after the cutoff date to determine that returns and claims against suppliers made after the cutoff date have been entered in the appropriate period.
b.When the auditors arrive for the observation, they will inspect the premises to determine whether:
(1)The arrangement of inventory is such that an accurate count is possible.
(2)Scrap, obsolete, and damaged goods are adequately identified and segregated.
(3)Inventory owned by other companies are adequately identified and segregated.
(4)Inventories appear to be adequately safeguarded against access by unauthorized persons and protected against deterioration.
12–28The audit procedures to be applied to determine that standard costs and related variance accounts applicable to materials are acceptable and have not distorted the financial statements would include the following:
(1)Consider the internal control, determine appropriate tests of controls, and assess control risk.
(2)Test the arithmetic computations of the standard cost records.
(3)Determine that the data on the standard cost records are reasonably current.Out-of-date standards may result in abnormal variances.
(4)Ascertain the accuracy of the specifications on the standard cost records by comparison with engineering specifications or other independent sources.Determine that the procedure for establishing standard material cost gives consideration to spoilage, scrap loss, and by-products of the process.
(5)Determine that, in establishing standard material prices, consideration was given to the following factors:normal quality, normal quantity, normal sources, and delivery by normal carrier.The treatment in the accounts of discounts, whether excluded or included in the standard costs, should be investigated for consistency.
(6)The accounting system for recording standard costs should be reviewed for reasonableness, and tests should be applied to determine that the system is functioning effectively.Source documents (vendors’ invoices, requisitions, production reports, and other internally generated accounting evidence) should be examined and related to the transactions flowing through the cost system.In this connection, reference should be made to the standard cost records to determine that standard cost data flowing through the accounting system are being accurately compiled.
(7)Review the material price variance and material usage variance accounts for overall reasonableness.The variance accounts should also be reviewed for excessive variations in the month-to-month charges, and satisfactory explanations should be obtained where necessary.
(8)The impact of the variances on the financial statements should be considered.If the variances are of amounts so substantial that placing them in the income statement would distort current operating results and inventory valuation, then consideration should be given to allocating them on a pro rata basis to cost of goods sold and inventories.