Ch 12

Question 1

Source of inventories (types of inventories too)

Answer 1

Goods on hand ready for sale.

Goods in the process of production.

Goods to be consumed directly or indirectly in production such as raw materials, purchased parts and supplies.

Question 2

Management fraud has often involved the fraudulent overstatement

Answer 2

of inventories

Question 3

The valuation of goods on hand and in process often presents

Answer 3

complex and difficult issues.

Question 4

Determining the quantities of inventories may require

Answer 4

specialized techniques

Question 5

Inventories often represent the largest

Answer 5

current asset of a company.

Question 6

Misstatements of inventories directly affect

Answer 6

cost of goods sold and, therefore, net income.

Question 7

Inventory methods

Answer 7

Periodic inventory system
Determine inventory quantities solely by an annual physical count

Perpetual inventory records
Inventory updated constantly
Strong internal control over inventories
May use test counts throughout the year
(“cycle counts” –but these should be accurate)

Question 8

McKesson & Robbins Fraud Case

Answer 8

Significant impact on responsibility of auditors with respect to validity of inventories

Case decided in 1939 – the audited financial statements contained $19 million of fictitious assets including $10 million of nonexistent inventories

• Auditors followed customary auditing practice which limited audit work on inventories to examining records only
• Statements on Auditing Procedures 1 and 2 – first formal auditing standards issued by AICPA affirmed the importance of auditors’ observation of physical inventories although other auditing procedures could be substituted

Question 9

3 audit steps

Answer 9

Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to inventories and cost of goods sold.
Obtain an understanding of internal control over inventories and cost of goods sold.
Assess the risks of material misstatement and design tests of controls and substantive procedures that:

Question 10

Assess the risks of material misstatement and design tests of controls and substantive procedures that:

Answer 10

a. Substantiate the existence of inventories and the occurrence
of transactions affecting cost of goods sold.
b. Establish the completeness of recorded inventories.
c. Verify the cutoff of transactions affecting cost of goods sold.
d. Determine that the client has rights to the recorded inventories.
e. Establish the proper valuation of inventories and the accuracy of transactions affecting cost of goods sold.
f. Determine that the presentation and disclosure of information about inventories and cost of goods sold are appropriate, including disclosure of the classification of inventories, accounting methods used, and inventories pledged as collateral for debt.

Question 11

Internal controls in the control environment (management)

Answer 11

Control environment:
Commitment to competence and human resource policies and practices.
Appropriately qualified and trained personnel assigned to inventory.

Integrity and ethical values:
For example, company purchasing agents are discouraged from accepting “kickbacks”.

Organizational structure and assignment of authority and responsibility:
Purchasing, receiving and production personnel understand roles

Question 12

Risk assessment; risks related to (things for inventory related stuff):

Answer 12

Availability of a supply of goods, services, and skilled labor.
Stability of prices and labor rates.
Generation of sufficient cash flow to pay for purchases.
Changes in technology that affect manufacturing processes.
Obsolescence of inventory.

Question 13

Monitoring (management)

Answer 13

Observations by production supervisors of performance of various activities and functions.
Quality and performance reviews.
Management review controls, including reviews significant transactions and production activity.
Formal program to consider improvements in purchasing and production noted by internal auditors.

Question 14

Functions related to inventories

Answer 14

Purchasing.
Receiving.
Storing.
Issuing.
Production.
Shipping.

Question 15

Internal control for inventory

Answer 15

Segregation of purchasing, receiving and recording.

Question 16

Purchase requisition form completed by

Answer 16

department needing the goods.

Question 17

Purchasing prepares purchase order.
What are some parts of this, included or related

Answer 17

May require bids.
Item description and quantity.
Copy forwarded to accounting.
Copy forwarded to receiving should not include quantity.

Question 18

Receiving:

What does this department do?

Answer 18

Determines quantity of goods received.
Detects damaged or defective merchandise.
Prepares receiving report.
Prompt transmittal of goods received to stores department.

Question 19

Storing:

Answer 19

Counts, inspects and receives goods.
Notifies accounting of receipt.
Physically secures inventory.

Question 20

Stores department issues goods to requesting department.

Answer 20

Prenumbered requisition.

Question 21

Production:

Answer 21

Controlled with master production schedule.
Production orders.
Materials requisitions and move tickets.
Job time tickets.

Question 22

Shipment upon authorized sales order approved by credit department.
What does it generate and what happens to that item?

Answer 22

Generates a prenumbered shipping document.
One copy in shipping.
One copy to billing.
Third copy used as packing slip.
For goods shipped common carrier – fourth copy services as bill of lading.

Question 23

Cost Accounting

Answer 23

Accounts for usage of raw materials.
Determines content and value of goods in progress.
Compute finished inventory.

Question 24

Perpetual inventory system:

Answer 24

Provide information essential to purchasing, sales and production-planning policies.
Allows companies to control high costs of holding excessive inventory.

Question 25

I T systems:

Answer 25

Easier to control inventories.
E D I to coordinate production and purchasing.

Question 26

Inventories constitute a large asset and very susceptible to

Answer 26

to major errors and fraud.

Question 27

The accounting profession allows numerous alternative methods for

Answer 27

valuation of inventories, and different methods may be used for various classes of inventories.

Question 28

The determination of inventory value directly affects the

Answer 28

cost of goods sold and has a major impact on net income for the year.

Question 29

The determination of inventory quality, condition, and value is inherently a more

Answer 29

complex and difficult task than is the case with most other elements of financial position.

Question 30

D. Perform further audit procedures—tests of controls.
Examples of tests of controls:

Answer 30

a. Test controls over of purchase transactions.
b. Test controls over the cost accounting system.
c. Test management review controls.
d. Test controls over inventory estimates.

Question 31

Perform further audit procedures—substantive procedures for inventories and cost of goods sold.

Answer 31

1. Obtain listings of inventory and reconcile to ledgers.
2. Evaluate the client’s planning of physical inventory.
   (Need specialists? Will obsolete inventory be segregated?)
   tags, scanners?
3. Observe the taking of physical inventory and make test counts.
   (all locations should expect an auditor even though they may not show up at all locations)
   (clients should not know which items were test counted)
   Record serial number of final receiving and shipping documents before the taking of the inventory
   If count discrepancies, may have to recount entire section or even the warehouse
4. Review the year-end cutoff of purchases and sales transactions.
   *(cutoff at time of physical inventory)
   (example– compare dates of receipt of goods from receiving reports to dates that related purchase invoices were recorded. Also—compare dates of shipment of goods per shipping documents to dates related sales invoices were recorded)
5. Obtain a copy of the completed physical inventory, test its clerical accuracy, and trace test counts to the final inventory schedule.
   (errors may indicate intentional alterations or fictitious tags)
   (clerical accuracy)
6. Evaluate the bases and methods of inventory pricing (LIFO, FIFO,etc).
7. Test the pricing of inventories.
8. Perform analytical procedures.
9. Determine whether any inventories have been pledged and review purchase and sales commitments.
10. Evaluate financial statement presentation of inventories and cost of goods sold, including the adequacy of disclosure.

Question 32

Inventory at outside warehouses or on consignment –

Answer 32

CONFIRM

Question 33

Obtain listings of inventory and reconcile to ledgers.

Answer 33

Existence, occurrence, and rights

Question 34

Evaluate the client’s planning of physical inventory.
Observe the taking of the physical inventory.
Review the year-end cutoff of purchase and sales transactions.
Obtain a copy of the completed physical inventory and
test its accuracy.

Answer 34

Existence, occurrence, and rights
Completeness
Valuation
Cutoff

Question 35

Evaluate the bases and methods of inventory pricing.

Answer 35

Valuation

Question 36

Test the pricing of inventories.

Answer 36

Valuation
Accuracy

Question 37

Perform analytical procedures or data analytics.

Answer 37

Existence and rights
Completeness
Valuation
Accuracy

Question 38

Determine whether any inventories have been pledged and review commitments.

Answer 38

Valuation
Presentation and disclosure

Question 39

Evaluate financial statement presentation and disclosure.

Answer 39

Presentation and disclosure

Question 40

Client counts and supervises inventory.
Auditors observe:

What do auditors observe/do when client is counting/supervising inv?

Answer 40

Determine all items included.

Employees comply with instructions.

Be alert for inclusion of obsolete or damaged merchandise.

Record numbers of final receiving and shipping documents (data) issued before inventory taking.

Make test counts.

Make sure that inventory counting includes procedures to determine that at items are included and none are included more than once (For example, tag control).

Question 41

Inventory verification when auditor unable to observe taking of inventory at close of year:

Answer 41

May conclude that sufficient appropriate evidence cannot be obtained to express an opinion, or.

Could obtain satisfaction with alternative auditing procedures.
Existence of strong internal control.
Perpetual inventory records.
Documentation of well-planned and executed physical inventory.
Making of test counts.

Question 42

Proper Cut-off of Inventory:

Answer 42

Examine on a test basis the purchase invoices and receiving reports for several days before and after the inventory date.
- Determine that liability has been recorded for all goods in inventory.
- Make sure shipments and purchases recorded in proper period.

Question 43

Inventory pricing: Emphasize:

Answer 43

Emphasize:
What method of pricing does the client use?
Is the method appropriate?
Is the method of pricing the same as that used in prior years?
Has the method selected by the client been applied consistently and accurately in practice?
Test the pricing of inventories.

Question 44

Disclosure of inventory pricing methods or methods in use.
Other important disclosures:

Answer 44

Changes in methods.
Classifications of inventory.
Details of pledged inventory.
Deduction of valuation allowance for inventory losses.
Existence and terms of inventory purchase commitments.

Question 45

Procedures to obtain evidence that beginning inventory is fairly stated. IF

Answer 45

AN AUDIT WAS PERFORMED:

Question 46

with First Year Clients:

Answer 46

Review predecessor’s working papers—
If it looks like predecessor properly observed and audited inventory –then accept the beginning balance as fairly stated.

If find that predecessor’ papers indicate NO SATISFACTORY AUDIT WAS PERFORMED AT BEGINNING OF YEAR:

Discuss with person who supervised physical inventory at beginning
Study written instructions in planning
Trace numerous items from inventory tags to final summary sheets
Test perpetual inventory records for previous year
Test overall reasonableness of beginning inventory