21–11
21–18 (continued)
records than the costs themselves).
3. The cost accounting records also deal with transferring
inventories through the production cycle and then from
b. 1. Examine engineering specifications for expected (standard)
labor hours. Examine time records for hours worked on the
test reasonableness of standard.
2. Review specifications for types of labor required to produce
parts, or observe production. Review union contracts or
3. Identify appropriate overhead accounts, paying careful
attention to consistent application. Determine amounts for
these accounts for a measured period. Determine direct
4. Review engineering specifications. Review material usage
variance.
21–19
AUDIT
PROCEDURE
a.
TYPE OF TEST
b.
PURPOSE
1
Test of Control
To make sure that proper controls exist and are
being followed in the taking of the physical
inventory. (Existence, completeness, accuracy,
and classification)
2
Substantive Test
To identify slow–moving inventory that may need
to be written down. (Realizable value)
3
Substantive Test
To ensure that all inventory represented by an
inventory tag actually exists. (Existence)
4
Substantive Test
To test the accuracy of the client’s perpetual
inventory records. (Existence, completeness,
and accuracy)
5
Substantive Test
To test client’s final inventory compilation.
(Existence, completeness, accuracy, and
classification)
21–12
21–19 (continued)
AUDIT
PROCEDURE
a.
TYPE OF TEST
b.
PURPOSE
6
Substantive Test
To test that the final inventory was valued at its
proper cost. (Accuracy)
7
Test of Control
To ensure that no raw material was issued
without proper approval. (Existence)
8
Test of Control
or
Substantive Test
To ensure that additions recorded on the finished
goods perpetual records were recorded on the
books as completed production. (Accuracy and
classification)
21–20
a.
CONTROL THAT SHOULD HAVE
PREVENTED THE MISSTATEMENT
FROM OCCURRING
b.
SUBSTANTIVE
AUDIT PROCEDURE THAT
COULD BE USED TO UNCOVER
THE MISSTATEMENT
Perform independent second counts
on all merchandise. All persons
responsible for inventory tags and
compilation of physical inventory
should be independent of custody
of perpetual inventory records.
Record test counts and trace to
compiled inventory.
Use of prenumbered tags and
accounting for numerical sequence.
Account for all prenumbered
tags during the physical
examination and during
compilation tests.
3
Internal verification of perpetual
inventory prices.
Compare vendor invoice prices
to perpetual inventory prices.
Segregation of obsolete inventory.
Perform net realizable value
and lower of cost or market
tests of inventory, including
tests of the perpetual inventory.
Periodic review of reasonableness of
manufacturing overhead rate.
Test reasonableness of
manufacturing overhead rate.
21-20 (continued)
a.
CONTROL THAT SHOULD HAVE
PREVENTED THE MISSTATEMENT
FROM OCCURRING
b.
SUBSTANTIVE
AUDIT PROCEDURE THAT
COULD BE USED TO UNCOVER
THE MISSTATEMENT
Internal verification by another
person.
Examine vendors’ invoices in
support of prices used.
7
Keep a record of the last shipping
report number shipped before the
inventory count.
Examine bills of lading for first
shipments recorded after the
physical inventory to determine
that they were shipped after
year–end.
21–21 Note: The PCAOB reorganized their auditing standards effective
December 31, 2016. PCAOB AU Section 336 is identified in the
reorganized standards as AS 1210.
a. There are many types of inventory items for which auditors may
need to use a specialist for testing existence or valuation including
oil and gas reserves, rare gems, pharmaceutical product
b. According to AS 1210.08, the auditor should consider the following
characteristics to ensure a specialist is qualified:
(1) The certification, license, or other evidence of competence of
c. According to AS 1210.09, the auditor should gain an
understanding of the following:
(1) The objective and scope of the work performed
21–14
21–21 (continued)
(4) A comparison of the methods and assumptions to those used
in prior periods, if relevant
d. According to AS 1210.10–1210.11, an auditor may rely on work
performed by a specialist hired by the client; however, in all cases
the auditor should ensure that the specialist can be objective in
21–22 a.
INTERNAL CONTROLS
TESTS OF CONTROLS
1.
Inventory purchases are used
to update the perpetual
Atlanta inventory records.
Trace inventory quantities for a sample of
purchase transactions to the perpetual
inventory records as a part of tests of
controls and substantive tests of
acquisition transactions.
2.
Transfers of inventory are used
to update the Atlanta and local
distribution center perpetual
inventory records.
Trace inventory quantities for a sample of
shipments from Atlanta to local
distribution centers to the perpetual
inventory records.
3.
Inventory sales are used to
update the local distribution
center perpetual inventory
records.
Trace inventory quantities for a sample of
sales transactions to the perpetual
inventory records as a part of tests of
controls and substantive tests of sales
transactions.
4.
Local distribution centers
access to perpetual records is
restricted to processing sales
transactions.
Test the effectiveness of the perpetual
records access restrictions using the CPA
firm’s computer audit specialists.
5.
Quarterly physical inventory is
taken for comparison to and
adjustment of perpetual
records.
Examine local distribution center physical
inventory count records and adjustments
to the perpetual records.
21–15
21-22 (continued)
INTERNAL CONTROLS
TESTS OF CONTROLS
6.
Internal auditors test the
perpetual records
continuously.
Examine internal auditor audit programs
and working papers for their tests of the
perpetual records and the findings.
7.
Internal auditors sample
inventory counts and test
inventory adjustments.
Examine internal auditor audit programs
and working papers for their tests of the
physical observation of inventory and the
findings.
these to use.
counting and do test counts of inventory.
counting at each location.
3. Reduce the sample sizes for test counts inventory.
4. Perform the physical observation of inventory at an interim
date.
21–23 a.
INVENTORY
DESCRIPTION
UNITS
ON
HAND
DOLLARS
NUMBER
OF UNITS
REQUIRING
FLOOR
SPACE
PER UNIT
REQUIRED
SQ.
FOOTAGE
TOTAL SQ.
FOOTAGE
REQUIRED
TO STORE
INVENTORY
(Units x Sq ft)
AC Unit – Model 635
1240
$806,000
413.333a
16
6613.33
AC Unit – Model 770
1733
$1,940,960
577.667a
16
9242.67
Furnace – Model 223
1992
$2,589,600
996b
16
15936.00
Furnace – Model 225
2008
$2,761,000
1004b
16
16064.00
Air Handling Ducts
11883
$1,485,400
2970.75c
25
74,268.75
$9,582,960
122,124.75
a 2 pallets of AC units sit on top of 1 pallet that rests on the floor (1240/3 = 413.333; 1733/3 =
577.667).
b 1 furnace can sit on top of the unit that rests on the floor (1992/2 = 996; 2008/2 = 1004) .
c 3 boxes can be stored on top of the box that rests on the floor (11883/4 = 2971) .
21–16
21–23 (continued)
substantive tests to examine the existence of inventory at year
end.
21–24 a. The auditor in this situation should observe the recording of the
b. 1. There is no clear–cut answer to sample size for inventory
counts. The answer to the question depends on additional
factors, such as the randomness of your test counts and
whether the values of the merchandise are relatively stratified.
c. The auditor should determine how this inventory is valued and
after discussion with the client it may be determined to classify
it as obsolete. In all cases, the auditor must specifically identify
the merchandise in the working papers for subsequent
the inventory.
d. One of the important tasks the auditor undertakes during the
observation is to determine that inventory tags are physically
controlled. This assures that the inventory is not understated
21–25
CLIENT
a.
ISSUES
TO CONSIDER
b.
LOCATIONS TO VISIT
c.
POTENTIAL RISKS
OF MATERIAL
MISSTATEMENT
d.
AUDITOR
RESPONSES
TO RISKS
1. Colburn
Pharmacy
A majority of the inventory
amount on the balance
sheet is located at the
two distribution centers.
High dollar value
inventory is stored in
secure areas at the
stores and distribution
centers.
Inventory consists of a
large number of
products, with wide
variations in unit costs,
which could lead to
inaccurate amounts.
Given the significance of
the value of inventory
located in the
distribution centers, the
auditor would most
likely want to test
controls and observe
the physical inventory
counting at the two
distribution centers. The
auditor would likely test
controls related to
inventory at the store
level and select a
sample from among the
77 stores to visit. While
at the distribution
Due to the high cost and
demand for medicines,
there is a risk of theft of
inventory both at the
distribution centers and
stores. Additionally,
because some
medicines have
expiration dates, there
is a risk of obsolete
inventory. It will be
difficult for auditors to
identify specific types of
medicines since their
differences are not
visually noticeable but
rather dependent on
The auditor will likely
focus extensively on
inventory management
controls to determine
the effectiveness of
those controls in the
prevention of theft. The
auditor may also
engage a
pharmaceutical
specialist to assist with
the identification and
evaluation of various
medicines as part of the
inventory observation
process.
21–17
Copyright © 2017 Pearson Education, Inc.
21–25 (continued)
CLIENT
a.
ISSUES
TO CONSIDER
b.
LOCATIONS TO VISIT
c.
POTENTIAL RISKS
OF MATERIAL
MISSTATEMENT
d.
AUDITOR
RESPONSES
TO RISKS
2. Zenith, Inc.
Material amounts of
inventory are most likely
on site at all four
manufacturing locations.
Each motorcycle is of
high dollar value.
Most likely the auditor
would want to inspect
inventory at each of the
four manufacturing
facilities, assuming
similar amounts of
inventory are located
at each facility.
Because of the
manufacturing process
of converting raw
materials into a finished
motorcycle product,
there are a number of
risks associated with
assigning costs to the
raw materials, work–in–
process, and finished
goods inventory. Each
motorcycle may have
unique features, which
would mean each
motorcycle has a unique
inventory value. Thus,
The auditor would want
to extensively test
inventory costing
systems to evaluate the
operating effectiveness
of internal controls over
raw materials, work–in–
process, and finished
goods inventory.
The auditor would likely
test perpetual inventory
records to determine
that recorded raw
materials, work–in–
process, and finished
21–18
Copyright © 2017 Pearson Education, Inc.
21–25 (continued)
CLIENT
a.
ISSUES
TO CONSIDER
b.
LOCATIONS TO VISIT
c.
POTENTIAL RISKS
OF MATERIAL
MISSTATEMENT
d.
AUDITOR
RESPONSES
TO RISKS
3. Texide
Electronics
Inventory items are
unique, given that they
are dependent on
customer specifications.
Thus, inventory
valuations may be
especially difficult to
determine. Additionally,
it will be difficult for the
auditor to inspect
inventory given the
auditor’s lack of
knowledge and
expertise related to the
products on hand.
All inventory is located
at one manufacturing
facility.
Because the client’s
inventory is customized
to their customers’
product specifications,
there is risk that
inventory valuations
may be misstated due
to inaccurate pricing
information. Additionally,
there is a high risk of
inventory obsolescence,
if there is excess
inventory for a particular
customer’s product.
Because the individual
parts are quite small,
there is also a risk of
inventory loss or theft,
inventory recorded in
Because the interior
components of the
product are not visible
to the human eye, the
auditor cannot directly
observe whether the
inventory on hand is
legitimate electronic
parts. The auditor will
likely need to involve
electronics specialists to
assist in the inspection
and valuation of
inventory.
21–19
Copyright © 2017 Pearson Education, Inc.