CHAPTER 18

Audit of the
Inventory and
Warehousing
CycleCopyright 2003 Pearson Education Canada Inc. 18 - 1
What is the sequence of functions in the

inventory and warehousing cycle?

Copyright 2003 Pearson Education Canada Inc. 18 - 2

1. An employee recognizes a
need for a purchase; com-
pletes a requisition and sends
it to purchasing.
Ace Company PURCHASING
PURCHASE DEPARTMENT
REQUISITION
The production
dept. needs 200
kgs. of dry #4
solvent.
authorized
employee
Copyright 2003 Pearson Education Canada Inc. 18 - 3
2. Purchasing shops for the ap-
propriate quality at the best
price, then prepares a pur-
chase order.
Ace Company
PURCHASE BIG
PURCHASING
DEPARTMENT ORDER Chemical Co.
To: Big Chemical Co.
Please ship 200
kgs. of dry #4 sol-
vent by 6/2/04
Price $38.40/kg.
purchasing agent
Copyright 2003 Pearson Education Canada Inc. 18 - 4
3. When goods arrive from the
vendor, the receiving dept.
inspects, counts, and pre-
pares a receiving report.
Ace Company
RECEIVING
BIG RECEIVING REPORT
Chemical Co. DEPARTMENT Received 200
kgs. of dry #4
solvent on 6/1/04.
Condition: OK

BIG receiving employee

Chemical Co.
Copyright 2003 Pearson Education Canada Inc. 18 - 5
4. Goods are moved from re-
ceiving to a warehouse; per-
petual inventory is updated.
RECEIVING WAREHOUSE
DEPARTMENT

perpetual inventory
description $$
6/1/04-dry #4
solvent-200 kgs.7680

Copyright 2003 Pearson Education Canada Inc. 18 - 6

5. When needed, goods are moved from
the warehouse to production; perpetu-
al inventory and cost accounting re-
cords are updated.

WAREHOUSE PRODUCTION
DEPARTMENT

perpetual inventory cost acctg. system

description $$ description _ $$ _
6/1/01-dry #4 June 8, 2004
solvent-200 kgs.7680 Raw mat’l added
6/8/04-trans.200 - dry #4 solvent
kgs.to prod. -7680 (200 kgs.) 7680

Copyright 2003 Pearson Education Canada Inc. 18 - 7

6. When finished, goods are moved from
production to the warehouse; perpetu-
al inventory and cost accounting re-
cords are updated.

WAREHOUSE PRODUCTION
DEPARTMENT

cost acctg. system

perpetual inventory description _ $$ _
description $$ 6/9/04-trans.
6/9/04-fin.goods 50 litres of
50 litres x7g 9680 finished x7g
to warehouse 9680

Copyright 2003 Pearson Education Canada Inc. 18 - 8

7. When sold, goods are shipped
and perpetual inventory re-
cords are updated.
A Ace Co.
C
E
perpetual inventory
description $$
6/9/04-fin.goods
50 litres-x7g 9680
8/5/03- sold 30
litres-x7g -5808

Copyright 2003 Pearson Education Canada Inc. 18 - 9

 What are the primary audit

objectives with regard to inventory?

Copyright 2003 Pearson Education Canada Inc. 18 - 10

 What are the primary audit
objectives with regard to inventory?

- existence

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 What are the primary audit
objectives with regard to inventory?

- existence
- rights
ABC Electronics Co.
Sales Invoice

Copyright 2003 Pearson Education Canada Inc. 18 - 12

 What are the primary audit
objectives with regard to inventory?

- existence
- rights
- accuracy
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 What are the primary audit
objectives with regard to inventory?

- existence
- rights
- accuracy
- realizable value
Copyright 2003 Pearson Education Canada Inc. 18 - 14
What is the primary audit procedure
with regard to inventory?

Copyright 2003 Pearson Education Canada Inc. 18 - 15

What is the primary audit procedure
with regard to inventory?

Observe the client’s

inventory-taking
procedures.
Copyright 2003 Pearson Education Canada Inc. 18 - 16
What is the primary audit procedure
with regard to inventory?
Observe the client’s
inventory-taking
procedures.

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When do client inventory-
taking procedures occur?

Copyright 2003 Pearson Education Canada Inc. 18 - 18

When do client inventory-
taking procedures occur?
December
If the client has a
periodic inventory
system, the
physical inventory
count determines
the balance in
inventory accounts and will probably
occur on the balance sheet date.
Copyright 2003 Pearson Education Canada Inc. 18 - 19
When do client inventory-
taking procedures occur?
If the client has a June
perpetual inventory
system, the
physical inventory
count may occur
any time during
the accounting period.
Whenever the count occurs, the auditor
is required to observe. Copyright 2003 Pearson Education Canada Inc. 18 - 20
 Some clients use
statistical sampling in their
inventory methods.

why?
Copyright 2003 Pearson Education Canada Inc. 18 - 21
 Some clients use
statistical sampling in their
inventory methods.
reduces
the need to count
every inventory item
(sample results can be
statistically extended
to the population)
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 Some clients use
statistical sampling in their
inventory methods.

What are the

auditor’s
concerns?
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 Some clients use
statistical sampling in their
inventory methods.

The auditor is concerned that

the statistical inventory plan:
- has statistical validity
- is properly applied
- achieves reasonable results
Copyright 2003 Pearson Education Canada Inc. 18 - 24
 Should the auditor test
beginning inventory balances?

January

Copyright 2003 Pearson Education Canada Inc. 18 - 25

 Should the auditor test
beginning inventory balances?
When the auditing firm has not audited
beginning balances, the auditors must
satisfy themselves as to the appropri-
ateness of beginning balances, if they
are satisfied as to the current balances.

Copyright 2003 Pearson Education Canada Inc. 18 - 26

 Should the auditor test
beginning inventory balances?
When the auditing firm has not audited
beginning balances, the auditors must
satisfy themselves as to the appropri-
ateness of beginning balances, if they
are satisfied as to the current balances.

how?
Copyright 2003 Pearson Education Canada Inc. 18 - 27
When the auditing firm has not audited
beginning balances, the auditors must
satisfy themselves as to the appropri-
ateness of beginning balances, if they
are satisfied as to the current balances.

how?
analytical review of prior tests of inventory
inventory transactions and
procedures documents
count records 18 - 28
Copyright 2003 Pearson Education Canada Inc.
 How should the auditor test
inventory held at a public
warehouse?
client head-
quarters &
auditor’s
office

public
warehouse

Copyright 2003 Pearson Education Canada Inc. 18 - 29

 How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse

Are additional
procedures
necessary?
Copyright 2003 Pearson Education Canada Inc. 18 - 30
 How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse

Confirmation, alone, will not be

sufficient if inventory quantities held
at the warehouse
are significant.

Copyright 2003 Pearson Education Canada Inc. 18 - 31

 How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse
- if inventory held at the public ware-
house is significant:
~ review client’s procedures for
investigating and evaluating the
warehouse

Copyright 2003 Pearson Education Canada Inc. 18 - 32

 How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse
- if inventory held at the public ware-
house is significant:
~ review client’s procedures for
investigating and evaluating the
warehouse
~ obtain report from warehouse’s
auditor regarding internal controls
Copyright 2003 Pearson Education Canada Inc. 18 - 33
How should the auditor test inventory
held at a public warehouse?
- direct written confirmation with the
public warehouse
- if inventory held at the public ware-
house is significant:
~ review client’s procedures for
investigating and evaluating the
warehouse
~ obtain report from warehouse’s
auditor regarding internal controls
~ observe warehouse’s physical
counts (if practical)
Copyright 2003 Pearson Education Canada Inc. 18 - 34
Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.

Copyright 2003 Pearson Education Canada Inc. 18 - 35

Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.

What are the

auditing
implications?

Copyright 2003 Pearson Education Canada Inc. 18 - 36

Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.

- since the inventory-taking company

is a third party, their work has greater
reliability than the client’s

Copyright 2003 Pearson Education Canada Inc. 18 - 37

Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.

- since the inventory-taking company

is a third party, their work has greater
reliability than the client’s
- the auditor still should observe the
physical inventory count

Copyright 2003 Pearson Education Canada Inc. 18 - 38

Some large merchandisers use outside
inventory-taking companies that
specialize in counting inventory.

- since the inventory-taking company

is a third party, their work has greater
reliability than the client’s
- the auditor still should observe the
physical inventory count
- the auditor must test the effectiveness
of the inventory-taking company’s
procedures
Copyright 2003 Pearson Education Canada Inc. 18 - 39
Inventory Audit Procedures

perform
analytical
procedures
to test inventory
reasonableness

Copyright 2003 Pearson Education Canada Inc. 18 - 40

Inventory Audit Procedures
regarding the client physical inventory count:
Review the client’s plan for counting
the physical inventory. Attend
client count planning
meetings.

Copyright 2003 Pearson Education Canada Inc. 18 - 41

Inventory Audit Procedures
regarding the client physical inventory count:
Observe the physical inventory count.
Determine whether client’s counting methods
are effective.

Copyright 2003 Pearson Education Canada Inc. 18 - 42

Inventory Audit Procedures
regarding the client physical inventory count:
Observe the quality and condition of the
inventory. Consider obsolescence.

Copyright 2003 Pearson Education Canada Inc. 18 - 43

Inventory Audit Procedures
regarding the client physical inventory count:
On a random basis:
- select a sample of inventory items from the
warehouse floor, count them, trace the
quantity to client count records

Copyright 2003 Pearson Education Canada Inc. 18 - 44

Inventory Audit Procedures
regarding the client physical inventory count:
On a random basis:
- select a sample of inventory items from the
client count records, find them in the
warehouse, count them

Copyright 2003 Pearson Education Canada Inc. 18 - 45

Inventory Audit Procedures
regarding the client physical inventory count:
On a random basis:
- select a sample of inventory items from the
client count records, trace them to the
perpetual inventory records
4/30/x7 Physical
4/30/04 Physical
Inventory
Inventory
4/30/04 Physical
perpetual inventory
Inventory
description qty
widgets - red 87
18# widgets widgets - green 4
18# widgets
- purple widgets - purple 18
18# widgets
- purple
- purple

Copyright 2003 Pearson Education Canada Inc. 18 - 46

Inventory Audit Procedures
regarding the client physical inventory count:
On a random basis:
- select a sample of inventory items from the
perpetual inventory records trace them to
the client count records
4/30/x7 Physical
4/30/04 Physical
Inventory
Inventory
4/30/04 Physical
Inventory perpetual inventory
description qty
18# widgets widgets - red 87
18# widgets widgets - green 4
- purple
18# widgets
- purple widgets - purple 18
- purple

Copyright 2003 Pearson Education Canada Inc. 18 - 47

Inventory Audit Procedures

determine whether any

inventory has been
pledged as collateral
(disclosure)
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Inventory Audit Procedures
Enquire of client management
regarding the existence of
consigned inventories.

consignments “R” us
ACE

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Inventory Audit Procedures
Enquire of client management
regarding the existence of
consigned inventories:
- if a consignee holds a portion of the
client’s inventory, confirm that amount
with the consignee

Copyright 2003 Pearson Education Canada Inc. 18 - 50

Inventory Audit Procedures
Enquire of client management
regarding the existence of
consigned inventories:
- if a consignee holds a portion of the
client’s inventory, confirm that amount
with the consignee
- if a client consignee holds a portion of
a consignor’s inventory, confirm that
amount with the consignor
Copyright 2003 Pearson Education Canada Inc. 18 - 51
Inventory Audit Procedures

Consider the effects of

sales and purchases
cutoff tests on
inventories.
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Inventory Audit Procedures
Test the client’s
application of their
inventory valuation
method (FIFO, LIFO) and
the lower-of-cost-or-
market rule.
Copyright 2003 Pearson Education Canada Inc. 18 - 53
Inventory Audit Procedures
For manufactured
inventories:
test the cost accumulation
process as it affects
valuation of ending
inventories and COGS
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