Chapter 21

Audit of Inventory Cycle

Key objectives:
1. Describe the business functions and the related documents and records
in the inventory and warehousing cycle.
3. Explain the significance of the five parts of the inventory and
warehousing cycle.
5. Apply analytical procedures to the accounts in the inventory and
warehousing cycle.
6. Design and perform physical observation tests for inventory.
7. Design and perform audit tests of the pricing and compilation of
inventory.
8. Understand the interrelationships of the inventory and warehousing
cycle with other cycles, especially sales.

1. Introduction
For most companies, inventory is the largest
asset on the balance sheet, and cost of sales is
the largest expense on the income statement.
Further, inherent risk for inventory is fairly high.
Accordingly, inventory is usually the most
significant audit area for most audits.
Inventory is also an interesting area because of
the importance of physical observation of
inventory. It is important that inventory
observation procedures are adequate because it
is difficult to reperform these audit procedures if
they are not done correctly the first time.
We start on the next page with a brief refresher
on the accounting for inventory. The example is
for a manufacturing operation with perpetual
inventories, since this is the complex case. Note
that purchases are recorded directly in the
inventory account, rather than a purchases
account.
The example highlights the importance of the
year-end physical inventory. Not all companies
take an annual physical inventory, especially if
they have adequate perpetual records. Most of
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our remaining discussion relates to the

observation and testing of year-end inventory
balances.

152

Inventory Transactions
Manufacturer - Perpetual Inventory
Raw Material
1. Purchases

Direct Labor

2. Transfer to
WIP

1. Payroll

2. Transfer to
WIP

6. Physical
inventory
adjustment

Work in Process (WIP)

2. Transfer from
RM, DL & MOH

Finished Goods

3. Transfer to
Finished Goods

3. Transfer from
WIP

6. Physical
inventory
adjustment

4. Transfer to
Cost of Sales
6. Physical
inventory
adjustment

Cost of Sales

Manufacturing overhead

4. COS Transfer from

FG

1. Purchases

5. Underapplied
overhead

2. Applied to
WIP
5. Underapplied
OH applied to
COS

6. Book to
physical
inventory
adjustment
1. Purchases of raw materials are tested as part of the acquisition cycle. Direct
labor is tested as part of the payroll cycle.
2. Raw material, labor and overhead are added to work-in-process as incurred.
Although management needs a sound system of recording costs for internal
purposes, the auditor can usually perform minimal tests of this system (see
#5).
3. Upon completion, the completed items are transferred from WIP to finished
goods. The auditor also usually performs minimal tests of this process (see
#5).
4. Upon sale, finished goods are relieved from inventory and transferred to cost of
sales. This is tested as part of the sales cycle.

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5. Overapplied or underapplied overhead is applied to cost of sales.

6. At year-end, the inventory accounts are adjusted to their actual balances based
on the priced year-end inventory, and the difference adjusted to cost of sales
(The example above assumes that the physical inventory was less than the
general ledger values. In practice, the adjustment could be in either direction.)

2.

Analytical Procedures - Analytical procedures

play an important role in planning and testing
inventory and cost of sales.
Inventory is
complex and susceptible to fraud, so analytical
procedures are critical for assessing whether
errors in inventory are likely.
A.

Gross margin percentage - As discussed

in Ch. 16 the gross margin percentage is one
of the most critical ratios for auditors to
review.
Some issues in reviewing gross
margin include:
1. Convert change in ratio to dollars What appear to be very small changes in
gross margin can be highly material.
2. Trends - Look at changes in the ratio
over time, especially in relation to the
industry or auditor expectations.
3. Disaggregation - If possible, try to
obtain gross margin information by
product line. It is easier to uncover
errors in disaggregated data (see
example below).
4. Use turnover and other ratios Changes in gross margin can be due to
many factors. Inventory and accounts
receivable turnover can help identify
whether an error is more likely in sales or
cost of sales.

Example of value of disaggregated data:

Acme Sports Co. (000's)
Error in recording cassette shoes inventory of 200,000

Other
Sports

Shoes

Shoes
154

Total

Total

Equip

Report
ed

Correct

Report
ed

Correct

Sales
COS
GM

10,000
6,000
4,000

5,000
3,000
2,000

5,000
3,200
1,800

15,000
9,000
6,000

15,000
9,200
5,800

GM%

40%

40%

36%

40%

38.7%

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B.

Identifying reasons for a change in gross margin (gross profit)

Gross profit = (sales - cost of sales)
Sales
List as many reasons as possible for an increase in gross profit.
Error explanations

Non-error explanations

Sample Multiple Choice

Substantive tests designed to meet audit objectives
for inventories include comparison to prior years, to
budget expectations, and to industry averages.
Which of the following would cause an unusually low
gross profit rate?
1.
2.
3.
4.

Overstatement of ending inventory.

Overstatement of sales.
Understatement of ending inventory.
Overstatement of variable selling costs.

C.

Book to physical adjustment - The bookto-physical

adjustment
represents
the
cumulative effects of errors in the perpetual
system, as well as shrinkage and loss due to
theft (the client may periodically adjust for
this). We would expect this adjustment to be
small, if the client has adequate inventory
control and records.

D. Turnover Slower turnover primarily

indicates
obsolescence
problems.
In
conjunction with gross profit margin, may
indicate fictitious inventory.
E.

Individual
reasonableness
tests
Compare prices and quantities of individual
inventory items to prior year to test the
reasonableness of year-end inventory.
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3. Physical Inventory Observation

A.

Required Procedure by SAS #1 as a result

of the 1938 McKesson Robbins case.
Fraudulent or nonexistent inventory has
been at the heart of many massive reporting
frauds, and lower of cost or market issues
have been a problem for many other
companies.
The term "inventory observation" is
appropriate since a key element is the
observation and testing of client control
procedures, in addition to substantive tests.

B.

Timing
Many companies take a complete physical
inventory at year-end, although it may be
taken earlier. As with receivables, it is then
necessary to test activity between the
physical inventory and the balance sheet
date.
Perpetual systems - A complete physical is
not necessary if the client has adequate
perpetual records, and takes periodic cycle
counts. The auditor would then test the
accuracy of the perpetual records.

C.

Observation Specifics (See Table 21-2 on

page 696)
1. Tags - inventory tags are desirable for
many reasons.
a.
b.
c.

Clearly indicates that inventory was

counted (completeness).
Provides opportunity for written
indication of internal verification
of inventory (accuracy).
Provides a prenumbered
document for later tests of
existence for inventory compilation.
Tags are not necessary if there are
other methods to identify counted
inventory.
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2. Test counts - Primary means of testing

quantities in compilation.
a.
b.

Client should not know which items

were counted to prevent subsequent
altering of quantities.
Quantity, description and unit of
measure are important for price
tests.

3. Monitoring tag sequence - The auditor

should monitor the use of tags to ensure
that all tags are accounted for. This is
critical to determining that the client's
inventory summary only contains valid
tags.
Discussion of Doughties Foods Case

4. Existence and Completeness

A.

Perpetual system (Note: perpetual must

be able to identify quantities and locations of
inventory.)

1. Trace from inventory counts to perpetual

records.
2. Trace from perpetual records to
inventory.
Which test is for existence?

B.

Physical inventory
1. Determine all goods are tagged and
counted, trace test counts into inventory
compilation. (Primarily a completeness
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test)
2. How do we test existence for the
inventory compilation? (Discussion)

Sample Multiple Choice

The physical inventory count of a retailer is higher
than shown by the perpetual records. Which of the
following could explain the difference?
1.
2.
3.
4.

Inventory items had been counted but the tags

placed on the items had not been removed and
added to the inventory compilation sheets.
Credit memos for several items returned by
customers had not been recorded.
No journal entry had been made on the retailer's
books for several items returned to its suppliers.
An item purchased "FOB shipping point" had not
arrived at the date of the inventory count and
had not been reflected in the perpetual records.

5. Test of the Inventory Compilation

A.

Quantities - Summarize tags to arrive at

total quantity.
1. Tag sequences should be valid
sequences noted during inventory
observation (existence). Auditor may
also trace from listing to actual tags.
2. Summarization of quantities should be
correct (detail tie-in).
3. Quantities on individual tags should be
reasonable (scan entire listing for
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reasonableness of quantities), and in

total (compare quantities of individual
inventory items to prior year).
B.

Pricing
1.

Cost method - Almost all inventory is

initially priced using FIFO. LIFO is recorded
as an adjustment (the LIFO reserve) to
recorded FIFO amounts using indices of the
amount of inflation in inventory. A client may
use both methods (or other multiple
methods) depending on the type of
inventory.

2.

Cost for Inventory Types

a. Purchased - Invoice cost (primarily raw
materials for a manufacturer, essentially
all inventories for other companies).
Prices are established by tracing prices to
recent invoices, including freight.
b. Manufactured inventory - Standard
cost. Prices are based on standard costs
from the company's cost system. The
auditor normally will perform some tests
of the unit costs assigned to product.

3.

Layering - Prices need to be tested for the

full quantity of items in ending inventory.
Some companies use the most recent
purchase price for all quantities in ending
inventory. This will overstate inventory if
prices have increased and inventory includes
quantities purchased at lower prices.

4.

Lower of Cost or Market

a. Finished goods - examine the prices and
quantities of recent sales and orders in
relation to ending inventory.
b. Purchased items - Examine recent
purchase prices.

5.

Manufacturing Overhead (cost accounting

refresher)
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Overapplied or underapplied overhead is

usually closed to cost of sales. If the amount
is large, this indicates that inventory is
overpriced (overapplied OH), or underpriced
(underapplied OH), and the over- or
underapplied overhead should theoretically
be allocated proportionately to cost of sales
and ending inventory.
6. Cutof - Cutoff errors are relatively common, and
are one reason for unexpected changes in gross
profit.
A.

A key concern is the matching of sales and

cost of sales.
If the inventory was properly included in the
physical inventory, then a sales cutoff error
only affects sales (i.e, income is overstated
by the full amount of the error).

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Adjustment examples:
1. January sale ($10,000; GP margin 25%) recorded in December
detected by sales cutoff tests.
Goods included in
inventory (physical
taken)

Goods excluded from

inventory (perpetual
system)

Sales

Sales
Inventory
COS
AR

10,000

AR

10,000

10,000
7,500

7,500
10,000

2. December purchase of $10,000 recorded in January detected by

purchase cutoff tests.
Goods included in
inventory (physical
taken)

Goods excluded from

inventory (perpetual
system)

COS

Inventory

10,000

Accts. Pay

10,000

Accts. Pay

Chapter 21
Discussion Case Doughties Foods
Homework Problems
21-24
21-25
21-29
Sample Multiple Choice
Text
162

10,000
10,000

21-19 (a), (b)

Problem 21-23

Audit procedure

Type of
test

Objective(s)

1.

Read client's inventory

instructions and observe
whether they are being
followed.

Test of
control

Existence
Completeness
Accuracy
Classification

2.

Account for a sequence of

inventory tags and trace each
tag to the physical inventory to
make sure it exists.

Substantive

Existence

3.

Compare client's count of

physical inventory at an
interim date with the
perpetual master file.

4.

Trace test counts to final

inventory compilation
comparing tag, description and
quantity.

Substantive

Substantive

Completeness
Existence
Accuracy
(Since test is a comparison of the
count with the recorded inventory,
rather than a directional test, it has
multiple objectives. In contrast,
tracing tests counts to the
perpetual is primarily a
completeness test, tracing from
the perpetual to the inventory
items is an existence test.)
Completeness (test count is
included)
Existence (tag is from valid
sequence)
Accuracy (quantity agrees)
Classification (description)

5.

Compare unit prices on final

inventory with vendor's
invoices

Substantive

Accuracy

6.

Account for a sequence of raw

material requisitions and
examine them for approval.

Test of
control

Existence

7.

Trace recorded additions in

finished goods perpetual
inventory to production
records.

Substantive

Accuracy
Classification

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Problem 21-24

Error or omission

a.
Internal control to
prevent

b.
Substantive procedure

1.

Inventory priced at $12

each, rather than $12
per dozen.

Internal verification by
another person.
Computer limit checks

1) Compare prices to
vendor invoices, carefully
noting of units of
measure.
2) Reasonableness tests
comparing current year to
prior year.

2.

The last few shipments

were excluded from
inventory, but not
included as sale until
following year.

Record last shipping

report number before
inventory to ensure all
are recorded in proper
period.
Stamp shippers as
"before inventory" or
"after inventory" as
appropriate.

Obtain last shipping

number before inventory
for tests of sales cutoff.
Determine that all
inventory is counted, and
obtain shipping or other
information for inventory
not counted.

3.

Clerk in charge of the

perpetual inventory file
altered a tag to cover
up an inventory
shortage.

Separation of duties.
People responsible for
taking physical inventory
should be independent of
custody of records.
Independent second
counts.

Record test counts for

tracing into inventory
compilation.
Review inventory for
unusual quantities.

4.

Several tags were lost

and not included in the
final inventory.

Account for sequence of

prenumbered tags.

Account for sequence of

tags during observation
and trace to final
inventory compilation.

5.

Improper price for raw

material purchase
included in perpetual
inventory file.
Inventory was
misstated because it
was priced using the
perpetual records.

Internal verification of
prices.
Reporting of price
variances.

Compare vendor invoice

price to perpetual
inventory prices.

6.

Several obsolete items

were included in the
physical count.

Segregation of obsolete
inventory from regular
inventory.
Count by knowledgeable

1) Examination of quality
of inventory during
observation.
2) Perform net realizable

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7.

Due to increases in
volume and controlling
of costs, applied
overhead far exceed
actual cost.

personnel.

value test, examining

aging of inventory and
future sales.

Periodic review of
overhead rate.

Test reasonableness of
overhead rate.
Determine whether
amount overapplied to
inventory is material.

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Problem 21-29
a.

Gross margin %
Inventory turnover
(based on ave. inventory)

b.

2009

2008

2007

2006

26.3%

22.6%

22.4%

22.4%

6.6

7.6

7.6

7.9

Logical causes of increase in gross profit for 2009:

1.
2.
3.
4.

Increase in sales price.

Change in inventory method.
Improper sales cutoff (2010 sale recorded in 2009), or purchase cutoff
error (2009 purchase recorded in 2010).
Change in sales mix.

Logical causes of decrease in inventory turnover:

1.
2.
3.
4.
c.

Increase in selling prices also lowered demand for product.

Company is building inventory supplies.
Improper purchase cutoff.
Increase in obsolete or unsalable inventory.

Change in gross profit x sales = 3.7% x 23.2 million = $858,000

2009 CGS 2008 turnover = 17.1 million 7.6 = 2.25 million EI.

2009 EI - estimated based on 2008 turnover = 2.9 million - 2.25 million =

$650,000.
The possible misstatement indicated by each ratio is material.
d.

In testing these explanations, the auditor generally begins with a client

explanation. In evaluating the adequacy of the client's explanation, the
auditor should consider the joint relation of the two ratios. For example, an
increase in selling price which lowered demand is readily testable by looking
at price changes and sales volume.
Looking at possible errors, sales and purchase cutoff errors are common
errors that affect gross margin, but only purchase cutoff errors affect both
gross margin and inventory turnover.
Whether the explanation for the fluctuation is generated by the client or the

166

auditor, the auditor should obtain sufficient evidence to support the

explanation.

167