21-1
Chapter 21
Audit of the Inventory and Warehousing Cycle
Concept Checks
P. 694
1. Inventory is often the most difficult and time consuming part of many
audit engagements because:
to fully understand.
fairly complicated.
5. 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.
electronic files, ledgers, worksheets, and reports, which accumulate
material, labor, and overhead costs by job or process as the costs are
incurred.
inventories for financial statement purposes.
P. 701
1. A proper cutoff of purchases and sales is heavily dependent on the
To make sure the cutoff for sales is accurate, the following information
1. The last shipping document number should be recorded in the
21-2
Concept Check, P. 701 (continued)
2. A review should be made of shipping to test for the possibility of
cutoff problems.
3. When prenumbered shipping documents are not used, a careful
first step in testing the cutoff.
4. 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. The last receiving report number should be noted in the working
2. The auditor documents used, unused, and voided tag numbers at the end of
the physical inventory observation to partially satisfy the existence and
occurrence balance–related audit objectives during follow–up testing. To test
existence, the auditor will examine an inventory listing by tag number to
verify that inventory included in the final listing consists of only those items
3. The direct labor hours for an individual inventory item would be verified by
examining engineering specifications or similar information to determine
The manufacturing overhead rate is calculated by dividing the total
annual number of labor hours into total manufacturing overhead. These
21-3
Review Questions
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
cycle.
1. Compare the inventory cost entered into the inventory system to
the supporting invoice to determine that it was properly recorded
21–2 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. Tests of the purchases of raw materials and pricing thereof.
goods have been manufactured.
3. Tests of the reduction in the finished goods inventory through the
sale of goods to customers.
Assuming the perpetual records are determined to be effective, physical
inventory tests may be reduced, as well as tests of inventory cutoff. In addition,
21-4
21–3
SUBSTANTIVE ANALYTICAL
PROCEDURE
TYPE OF
POTENTIAL MISSTATEMENT
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.
business.
2. Review the perpetual records for slow–moving items.
inventory, inventory in unusual locations, and unusual amounts of
dust on the inventory.
7. Examine obsolescence reports, scrap sales, and other records in
at a reduced cost.
8. Calculate inventory ratios, by type of inventory if possible, and
compare them to previous years or industry standards.
21–5 The continuation of shipping operations during the physical inventory
will require the auditor to perform additional procedures to ensure that a
Since no second count is taken, the auditor must increase the number
21-5
21–6 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
21–7 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
21–8 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. Discuss ownership issues, such as inventory held on consignment,
with the client.
2. Obtain an understanding of the client’s operations.
3. Be alert for inventory set aside or specially marked.
21–9 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
21-6
21–10 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. Trace the tag numbers used to the final inventory summary to make
2. Trace the test counts recorded in the working papers to the final
3. Trace inventory items on the final inventory list to the tags as a
21–11
DATE
PURCHASE
QUANTITY
PRICE
TO BE INCLUDED IN
12–31–16 INVENTORY
EXTENSION
11–26–16
12–06–16
2,400
1,900
$2.07
$2.28
700 @ $2.07
1,900 @ $2.28
$1,449.00
4,332.00
$5,781.00
Assuming FIFO inventory valuation, the 12–31–16 inventory should be
valued at $5,781, and is thus currently overstated by $121.
If the 1–26–17 purchase was for 2,300 binders at $2.12 each, the 12–31–
21–12 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
Multiple Choice Questions From CPA Examinations
21–13 a. (2) b. (4) c. (2)
21–14 a. (3) b. (4) c. (3)
21–15 a. (4) b. (3) c. (1)
Discussion Questions and Problems
21–16
b.
TEST OF
CONTROL
Account for
a numerical
sequence of
shipping orders.
Review
procedures
for determining
standard costs.
Read policy
and discuss
procedures with
client.
Examine receiving
and requisition
documents,
trace to perpetual
records.
21–16 (continued)
b.
TEST OF
CONTROL
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.
Observe who
compiles the
inventory and
discuss with
client.
Account for a
numerical
sequence of
receiving reports
and observe
matching
invoices
received from
vendors.
Discuss with client
and observe
whether
personnel
prepare shipping
documents.
21–17
a.
TRANSACTION–
RELATED AUDIT
OBJECTIVE
b.
RELATED RISK
c.
TEST OF CONTROL
1. Inventory recorded in
the perpetual records
physically exists
(Occurrence).
Non–inventory warehouse
individuals may remove
inventory without
authorization.
Observe client personnel
in the inventory ware–
house and determine if
each person is authorized
to be in the warehouse.
2. 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.
3. Recording of inventory
in the client’s records
is valid (Occurrence).
Inventory held on
consignment may be
recorded as the client’s
inventory.
Observe whether
inventory held on
consignment is stored in
the same physical
space as inventory.
4. 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.
5. Recorded inventory
may not be recorded
at appropriate
amounts, due to
obsolescence
(Accuracy).
Without information about
the amount of time
inventory is in the ware–
house, 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.
6. 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.
21–17 (continued)
a.
TRANSACTION–
RELATED AUDIT
OBJECTIVE
b.
RELATED RISK
c.
TEST OF CONTROL
7. 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 client’s test
samples for accuracy
and reasonableness.
Inquire about the nature
of discrepancies
identified.
8. 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 client’s test
samples for accuracy
and reasonableness.
Inquire about the nature
of discrepancies
identified.
9. 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.
10. 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.
accuracy for the following reasons:
1. The cost accounting records determine unit costs that are
2. In many companies, there are many types of inventory items