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Chapter
13
CHAPTER 13
AUDITING THE INVENTORY
CYCLE AND RELATED
ACCOUNTS

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OVERVIEW OF THE
INVENTORY CYCLE
 Figure 13-1 shows how other cycles interact with the
inventory cycle.
 Figure 13-2 presents a flowchart for a reasonably
sophisticated inventory cycle.

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DOCUMENTS AND RECORDS
 Production schedule.
 Receiving report.
 Material requisition.
 Inventory master file.
 Production data information.
 Cost accumulation and variance report.
 Inventory status report.
 Shipping order.

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SEGREGATION OF DUTIES
 The inventory management function should be
segregated from the cost accounting function.
 The inventory stores function should be segregated
from the cost-accounting function.
 The cost-accounting function should be segregated
from the general ledger function.
 The responsibility of supervising physical
inventory taking should be separated from the
inventory management and inventory stores
functions.

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INHERENT RISK ASSESSMENT
 Industry-related factors
 Competition
 Inventory valuation issues
 Rapid technology changes
 Engagement and Operating Characteristics
 Types of product
 Valuation can lead to disagreements with client
 Possible related-parties transactions

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CONTROL RISK ASSESSMENT
Planning and performing tests of controls
on inventory cycle transactions
Understanding and documenting
the inventory internal control system based
on the planned level of control risk
Assessing and documenting the
control risk for the inventory cycle

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AUDITING INVENTORY
 Substantive tests of transactions
 Analytical procedures
 Tests of account balances

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SUBSTANTIVE TESTS OF
TRANSACTIONS
 Because the inventory cycle interacts with the
revenue, purchasing, and payroll cycles, control
procedures over the receipt of raw materials,
shipment of goods, and assignment of labor costs are
normally tested as part of those cycles.
 If the auditor intends to obtain substantive evidence
on the perpetual inventory records, the tests of
receipt and shipment of goods can be extended by
tracing the transactions into the perpetual inventory
records.

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ANALYTICAL PROCEDURES
 Compare raw material, finished goods, and total
inventory turnover to previous years’ and industry
averages.
 Compare days outstanding in inventory to previous
years’ and industry averages.
 Compare gross profit percentage by product line with
previous years and industry data.
 Compare actual cost of goods sold to budgeted
amounts.

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ANALYTICAL PROCEDURE
(continued)
 Compare current year standard costs with prior
years’ after considering current conditions.
 Compare actual manufacturing overhead costs with
budgeted or standard manufacturing overhead costs.

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AUDITING STANDARD COSTS
 Materials costs
 Labor costs
 Overhead costs

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OBSERVATION OF PHYSICAL
INVENTORY
 The auditor's observation of inventory is a generally
accepted auditing procedure.
 The observation of the physical inventory provides
evidence primarily on the validity audit objective
(also ownership and valuation).

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OBSERVATION PROCEDURES
 Insure that no production is scheduled.
 Ensure that there is no movement of goods during
the inventory count.
 Make sure that the client's count teams are
following the inventory count instructions.
 Perform test counts and record a sample of counts
in the working papers.

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OBSERVATION PROCEDURES
(continued)
 Obtain tag control information for testing the
client's inventory compilation.
 Obtain cutoff information.
 Observe the condition of the inventory for items
that may be obsolete, slow moving, or in excess
quantities.
 Inquiry about goods held on consignment for
others or held on a "bill and hold" basis.

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TESTS OF ACCOUNT BALANCES
Table 13-8 summarizes the tests of the inventory
account balance for each audit objective.

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POSSIBLE CAUSES OF BOOK-TO-
PHYSICAL DIFFERENCES
 Inventory cutoff errors.
 Unreported scrap or spoilage.
 Pilferage or theft.

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SAMPLE DISCLOSURE ITEMS FOR
INVENTORYAND RELATED
ACCOUNTS
 Cost method (FIFO, LIFO, retail method).
 Components of inventory.
 Long-term purchase contracts.
 Consigned inventory.
 Purchases from related parties.
 LIFO liquidations.
 Pledged or assigned inventory.
 Disclosure of unusual losses from writedowns of
inventory or losses on long-term purchase commitments.
 Warranty obligations.