Chapter 13 – Auditing the Inventory Management Process
13-1
CHAPTER 13
AUDITING THE INVENTORY MANAGEMENT PROCESS
Answers to Review Questions
13-1 Inventory represents one of the most complex parts of the audit because the assignment
of values to inventory quantities is difficult. There are also issues such as obsolescence
and “lower of cost or market” that affect the valuation of inventory. The complexity of
13-2 The inventory process is affected by control activities in the revenue, purchasing, and
human resource management processes. The purchasing process controls the acquisition
and payment of raw materials and overhead costs. The cost of direct and indirect labor
13-3 A production schedule is used to determine the quantity of goods needed and the time at
which they are required to meet the production scheduling. The materials requisition is
the document that authorizes the release of raw materials from the raw materials
department. The inventory master file contains all the important information related to
the entity’s inventory, including the perpetual inventory records for raw material, work
13-4 The following duties are performed within the inventory management, raw materials
stores, and cost accounting functions:
Inventory management: Maintenance of inventory at appropriate levels;
issuance of purchase requisitions to the
Chapter 13 – Auditing the Inventory Management Process
the accounting records.
13-5 The key segregation of duties in the inventory process and the errors or fraud that they
can prevent are:
Segregation of Duties
Possible Errors or Fraud as a
Result of Conflicts in Duties
The inventory management function
should be segregated from the cost-
accounting function.
Production and inventory costs can be
manipulated, leading to an over- or
understatement of inventory and net income.
The inventory stores function should be
segregated from the cost-accounting
function.
Unauthorized shipments can be made or the
theft of goods can be covered up.
The cost-accounting function should be
segregated from the general ledger
function.
Unauthorized shipments resulting in theft of
goods, leading to an overstatement of
inventory.
The responsibility for supervising the
taking of physical inventory should be
separated from the inventory
management and inventory stores
functions.
Inventory shortages can be covered up
through the adjustment of the inventory
records to the physical inventory resulting in
an overstatement of inventory.
13-6 Industry-related factors and operating and engagement inherent risk factors affect the
inventory process. Industry factors include industry competition and changes in
technology. Operating and engagement characteristics are (1) the susceptibility of the
13-7 The three major steps in assessing control risk in the inventory process are:
1. Understand and document the inventory internal control system based on the planned
13-8 The following control activities can be used by the entity to prevent unauthorized
inventory production:
13-3
13-9 Substantive analytical procedures that can be used to test inventory and related account
balances include:
• Compare raw material, finished goods, and total inventory turnover to previous
periods’ and industry averages.
• Compare actual manufacturing overhead costs with budgeted or standard
manufacturing overhead costs.
13-10 To audit standard costs, the auditor should first review the entity’s policies and
procedures for constructing standard costs. Once the policies and procedures are
understood, the auditor normally tests the component cost buildup for materials, labor,
and overhead for a representative sample of standard product costs. The material
component requires testing of the quantity and type of materials included in the product
and the price of the materials. The quantity and type of materials are tested by
reviewing the engineering specifications for the product. Labor costs require evidence
13-11 During the observation of the physical inventory count, the auditor should perform the
following procedures:
• Ensure that no production is scheduled. Or, if production is scheduled, ensure that
proper controls are established for movement between departments in order to
prevent double counting.
• Ensure that there is no movement of goods during the inventory count. If movement
is necessary, the auditor and entity personnel must ensure that the goods are not
Chapter 13 – Auditing the Inventory Management Process
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• Obtain tag control information for testing the entity’s inventory compilation. Tag
or carried in excess quantities.
• Inquire about goods held on consignment for others or held on a “bill-and-hold” basis.
The auditor must also inquire about goods held on consignment for the entity.
13-12 Possible causes of book-to-physical inventory differences include:
13-13 Example disclosure items for inventory and related accounts include:
• Cost method (e.g. FIFO, LIFO, retail method).
• Components of inventory.
• Long-term purchase contracts.
Answers to Multiple-Choice Questions
13-14
d
13-21
b
13-15
a
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d
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c
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d
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b
13-24
b
13-18
d
13-25
a
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c
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d
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d
Chapter 13 – Auditing the Inventory Management Process
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Solutions to Problems
13-27 The identification and explanation of the systems and control weaknesses are as follows:
• The purchase requisition is not approved. A responsible person in the stores
department should approve the purchase requisition. The approval should be
indicated on the purchase requisition after the approver is satisfied that it was
properly prepared based on a need to replace stores or the proper request from a user
department.
• Purchase requisition number 2 is not required. Purchase requisitions are
need for the specific materials requisitioned and approve the request.
• The purchase office should attempt to obtain the highest-quality merchandise at the
lowest possible price, and the procedures that are followed to achieve this should be
included on the flowchart. There is no indication that the purchase office submits
purchase orders to competitive bidding when appropriate. That office should be
directly involved with vendors in determining the cost of materials ordered and
should be primarily responsible for deciding at what price materials should be
ordered and which vendors should be used.
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• The purchase office does not review the invoice prior to processing approval. The
purchase office should review the vendor’s invoice for overall accuracy and
completeness, verifying quantity, prices, specifications, terms, dates, etc., and if the
should be maintained, and a copy of the vouchers should be filed in an alphabetical
vendor reference file.
• There is no indication of control over dollar amounts on vouchers. Accounts payable
personnel should prepare and maintain control sheets on the dollar amounts of
vouchers. Such sheets should be sent to departments posting transactions to general
and subsidiary ledgers.
• There is no examination of documents prior to voucher preparation. In addition to the
matching procedure, the mathematical accuracy of all documents should be verified
prior to preparation of vouchers.
• The controller should not be responsible for cash disbursements. The cash
disbursement function should be the responsibility of the treasurer, not the controller,
13-7
13-28 a. Evidence found in the working papers to support the fact that the audit was
adequately planned and assistants were properly supervised would be:
• Documentation indicating discussions with entity personnel concerning
developments affecting the entity that require recognition in the audit plan.
• Documentation of a pre-audit planning conference among audit firm personnel to
• Individual working papers signed by reviewers to document review, approval, and
responsibility.
• Confirmations that all questions raised by assistants were answered.
b. Substantive tests that would document management’s completeness assertion as it
relates to inventory quantities would be:
• Observation of physical inventory counts.
• Analytical procedures for the relationship of inventory balances to purchase,
production, and sales activities.
• Reconciliation of physical counts to perpetual records and general ledger balances
and investigation of significant differences.
13-29 a. When an entity uses statistical sampling to estimate inventories, the auditor should
perform procedures similar to the following:
• The auditor should review the entity’s procedures and methods for determining
inventories to ascertain if they are sufficiently reliable to produce results
reasonable in the circumstances.
• The auditor should ascertain that proper steps have been taken to ensure that all
Chapter 13 – Auditing the Inventory Management Process
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parts and supplies in the warehouse are included in the perpetual inventory
records. This would normally be checked in advance of the physical count.
• The auditor should be present when the sample is drawn to make sure that the
requirements set for the audit.
b. In addition to the above, the following standard audit procedures for verification of
physical quantities should be performed whether the entity conducts a periodic
physical count for all or part of its inventory:
• Review and be satisfied with the entity’s physical inventory-taking procedures.
• Observe the physical count.
• Make test counts where appropriate.
• Trace selected count data to the inventory compilation.
• Perform analytical procedures for inventories.
• Account for all entity inventory count sheets.
• Be sure inventory items are properly classified, in good condition, and of proper
quality.
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13-30 The substantive auditing procedures Kachelmeier may consider performing include:
(a) Using the perpetual inventory file
• Recalculate the beginning and ending balances (prices x quantities), foot, and create a
report to be used to reconcile the totals with the general ledger or agree beginning
balance with the prior year’s working papers.
• Calculate the quantity balances as of the physical inventory date for comparison to the
physical inventory file. Alternatively, update the physical inventory file for purchases
number of days’ sales in inventory for selected items.
• Select items noted as possibly unsalable or obsolete during the physical inventory
observation and print out information about purchases and sales for further consideration.
• Recalculate the prices used to value the year-end FIFO inventory by matching prices and
quantities to the most recent purchases.
(b) Using the physical inventory and test count files
• Account for all inventory tag numbers used and print out a report of missing or duplicate
numbers for follow-up.
for comparison to the perpetual file.
• Compare the quantities on the file to the calculated quantity balances on the perpetual
inventory file as of January 5, 2015. Alternatively, compare the physical inventory file
updated to year end to the perpetual inventory file.
• Calculate the quantities and dollar amounts of the book-to-physical adjustments for each
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2015, and print out a report of differences for follow-up.
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Basic Inventory-Auditing Procedures
How a Generalized Audit Software
Package and Tape of the Inventory File
Data Might Be Helpful
1. Observation of the physical count,
making and recording test counts
where applicable.
1. By determining which items are to be
test counted by selecting a random
sample of a representative number of
items from the inventory file as of the
date of the physical count.
2. Testing of the mathematical
accuracy of the inventory
compilation.
2. By mathematically computing the
dollar value of each inventory item
counted by multiplying the quantity on
hand by the cost per unit and verifying
the addition of the extended dollar
values.
3. Comparison of the auditor’s test
counts to the inventory records.
3. By arranging test counts in an
electronic file format identical to the
inventory file and matching the data
files.
4. Comparison of physical count data
to inventory records.
4. By comparing the total extended
values of all inventory items counted
and the extended values of each
inventory item counted to the
inventory records.
5. Testing of the inventory pricing by
obtaining a list of costs per item
from buyers, vendors, or other
sources.
5. By preparing an electronic data file in
a format identical to the inventory file
and matching the data files.
6. Examination of purchases and
sales cutoff.
6. By listing a sample of items on the
inventory file for which the date of last
purchase and date of last sale are on or
immediately prior to the date of the
physical count.
7. Ascertainment of the propriety of
items of inventory located in
public warehouses.
7. By listing items located in public
warehouses.
8. Analysis of inventory for evidence
of possible obsolescence.
8. By listing items on the inventory file
for which the quantity on hand is
excessive in relation to the quantity
sold during the year.
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9. Analysis of inventory for evidence
of possible overstocking or slow-
moving items.
9. By listing items on the inventory file
for which the quantity on hand is
excessive in relation to the quantity
sold during the year.
10. Performance of an overall test for
accuracy of inventory master file.
10. By listing items, if any, with negative
quantities or costs.
13-32 a. 6
Solution to Discussion Case
13-33 a. The auditors did not follow several audit procedures in a satisfactory manner,
including:
• Control of count sheets during and after the inventory. There may not have been
adequate supervision and instruction of the inventory observation teams by the
auditors. There is no evidence that there was adequate preplanning of the
inventory count. Even though it is difficult to spend continuous time in the upper
decks, there must be a careful control over their contents and planned counting
must still be observed.
• Although the late addition of such sheets is highly irregular, the auditors did very
little to satisfy themselves of their accuracy. The altering of count sheets after
balances in specific inventory items, a review of the inventory balances and
comparison with previous years’ would have indicated unusual increases.
Because of the weaknesses in inventory control, audit procedures should have
been expanded.
b. Failure to obtain adequate evidence to support management’s assertions can result in
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legal liability from injured third parties and in fines and sanctions by the PCAOB and
the SEC. Possible PCAOB and SEC sanctions are discussed in Chapter 20. For
example, SEC sanctions can involve prohibition of appearing before the commission,
prohibition from accepting new SEC entities, and/or required peer reviews.
c. The following auditing standards (AICPA Clarified Standards) require that the
auditor communicate specific information to the audit committee. AU-C 265,
“Communicating Internal Control-Related Matters Identified in an Audit,” requires
that the auditor report to the audit committee, or to a similar level of authority if the
entity does not have an audit committee, matters which are referred to as reportable
conditions. AU-C 240, “Consideration of Fraud in a Financial Statement Audit,” and
• Consultation with other accountants.
• Major issues discussed with management prior to retention.
• Difficulties encountered during the audit.
AS No. 16 requires the following communications:
• Terms of the engagement (objectives and responsibilities)
• Information from the audit committee relevant to the audit
• An overview of the audit strategy, significant risks, and timing of the audit
Solutions to Internet Assignment
13-34 A search of the SEC’s website should identify a recent company that has been cited by
the SEC for financial reporting problems related to inventory. For example SEC v. Thor
Industries is a litigation case where the SEC alleges that a fraud at the company resulted
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