Inventory and Cost of Goods Sold Audit Procedures

Posted on Aug 9, 2024 in Mathematics

Chapter 12: Inventories and Cost of Goods Sold

Review Questions

Question 12-1

Substantiation of the figure for inventories is an especially challenging task due to the variety of acceptable valuation methods. The diverse materials found in inventories require considerable experience and skill to efficiently identify and test-count goods on hand. The possibilities of obsolescence and excessive stocks also create problems. Finally, the significant size of inventories and their impact on net income make purposeful misstatement by the client a possibility that auditors must guard against.

Question 12-2

Issuance of a purchase order requires approval signatures ensuring that established procedures have been followed for: (a) determining the need for the item, (b) obtaining competitive bids, and (c) obtaining approval of the financial aspect of the commitment. Since issuing a purchase order creates a liability for the company, the purchasing function is crucial.

Question 12-3

Internal control over purchasing is strengthened by:

  • Assigning exclusive purchasing authority to a separate purchasing department.
  • Creating an independent receiving department.
  • Assigning purchase transaction recording to an accounts payable section within the accounting department.

In smaller companies, this level of departmentalization may not be feasible. However, separating the purchasing, receiving, and recording functions among different, non-subordinate employees is crucial for internal control.

Question 12-4

Adequate internal control over purchases requires:

  • Preparation of serially numbered receiving reports by an independent receiving department.
  • Comparison of these reports with vendors’ invoices and purchase orders by the accounts payable department before payment approval.

Auditors will test these procedures by examining receiving reports for completeness, currency, legibility, and serial number control.

Question 12-5

During a manufacturing company audit, auditors consider the cost system for these purposes:

  1. **Cost Allocation:** Ensuring proper cost allocation to current and future periods, supporting balance sheet and income statement amounts with internal records. Accurate cost allocation to finished goods, work in process, and cost of goods sold is essential for GAAP-compliant financial statements.
  2. **Internal Control:** Ensuring the cost system, as part of the internal control system, provides proper control over costs incurred and related inventories.
  3. **Management Service:** Ascertaining the cost system’s efficiency and effectiveness in providing information for cost reduction, control, and profitability analysis, supporting informed managerial decisions.

Question 12-6

Independent auditors play a key role in planning a client’s physical inventory. While not directly responsible for planning, they advise on matters like assigning a responsible employee, selecting advantageous inventory dates, scheduling to minimize goods-in-process, and ensuring adequate inventory instructions.

Question 12-7

Auditors observe the physical inventory to obtain evidence supporting its existence and gather information relevant to valuation and rights to inventory. This observation is crucial for meeting the fieldwork standard of gathering sufficient, competent evidence for a reasonable opinion on the financial statements.

By observing the physical inventory, auditors seek evidence regarding the effectiveness of inventory-taking methods and the reliability of the client’s inventory records and representations. They must ascertain the inventory’s existence, accurate quantity determination, and saleable or usable condition.

Question 12-8

Auditors perform test counts during the physical inventory observation to verify the accuracy of the count. The extent of testing depends on the inventory-taking procedures. Auditors record some test counts for later comparison with the client’s inventory compilation, ensuring accurate transcription from tags, sheets, or computer forms. They also verify the accuracy of item descriptions and conditions for pricing and proper quantity information.

Recording test counts also provides evidence of the audit’s extent if procedures are questioned later.

Question 12-9

Auditors list test counts and tag numbers in their working papers and trace them to the client’s inventory summary sheets. This verifies the accurate transcription of tag quantities to the summary sheets for the total inventory valuation. Significant discrepancies may require re-examining original tags or requesting the client to recompile the inventory.

Question 12-10

An annual physical inventory is generally essential, even with perpetual inventory systems. However, with perpetual inventories and strong internal control, the count can occur at a date other than year-end. Some companies with reliable perpetual records prefer to count one department at a time, spreading the work throughout the year. Statistical sampling techniques, if appropriately planned and executed, can also eliminate the need for a complete count.

Question 12-11

A bill and hold scheme involves improperly billing customers for merchandise before delivery, with the seller retaining the goods. This practice overstates revenues and net income. Bill and hold transactions must meet strict requirements to be considered legitimate sales.

Question 12-12

Analyzing a manufacturing company’s Cost of Goods Sold account might reveal charges and credits for transfers from goods-in-process or finished goods inventory, scrap sales proceeds, idle plant and equipment charges, under/overabsorbed factory overhead, standard cost variances, inventory shortage and obsolescence write-downs, and losses on firm fixed-price contracts.

Question 12-13

Two conditions must exist for an unqualified opinion when inventory is sampled:

  1. The sampling plan must be statistically valid.
  2. The allowance for sampling risk (precision) and the sampling risk (confidence) level must provide a materially accurate inventory valuation estimate.

Question 12-14

The client should designate an employee responsible for the physical inventory. A written plan should cover dates, potential plant closure, segregation of obsolete or damaged goods, tag and summary sheet design, shipment control during the count, written instructions, and staff training.

Question 12-15

The statement that “Inventories are valued at cost” is misleading. Inventories should be reported at the lower of cost or market. The phrase “valued at cost” lacks specificity; the cost determination method should be indicated.

Question 12-16

Using different inventory valuation methods for different inventory components is acceptable and doesn’t preclude an unqualified audit report. GAAP allows this practice.

Question 12-17

The statement that auditors are only concerned with inventory quantities and pricing is false. Their responsibilities also include the goods’ quality or condition, the accuracy of extensions, footings, and summaries, and consideration of internal control. Weak internal control can lead to significant losses from excessive stockpiling, obsolescence, inaccurate cost data, and other sources, even with accurate inventory counts and pricing.

Question 12-18

Independent auditors use the client’s unfilled sales order backlog to determine the net realizable value of finished goods and goods-in-process and to identify potential losses on firm sales commitments without production.

Question 12-19

Inspecting warehouse receipts is insufficient verification for inventory stored in public warehouses. Auditors should obtain written confirmations directly from the custodians. For substantial inventories, they should also review client records regarding warehouse selection and performance, available internal control reports, and consider observing the inventory.

Question 12-20

Inventory liens might be disclosed through bank confirmations for accounts and loans, insurance policy loss payable clauses, and client representations regarding liens.

Questions Requiring Analysis

Question 12-21

Weaknesses in Nolan Manufacturing Company’s internal control include:

  1. **Poor Organization:** The receiving department should not report to the purchasing agent.
  2. **Quantity Omission:** Purchase order copies sent to the receiving department should not omit quantities to encourage accurate counting.
  3. **Missing Receiving Reports:** The receiving department should prepare receiving reports for each shipment to evaluate performance, track returns, and establish accountability.
  4. **Error Concealment:** The current system allows buyers to cover up errors as the receiving department only reports discrepancies to them.
  5. **Direct to Production:** Goods should be stored before production, not sent directly to the factory floor.
  6. **Lack of Control Over Raw Materials:** There is no control over raw materials movement into goods-in-process or record of goods-in-process quantities.
  7. **Unintegrated Perpetual Inventory:** Perpetual inventory records for finished goods (physical units only) are not integrated with accounting records.
  8. **Custody and Recordkeeping Conflict:** The same employee handles finished goods custody and recordkeeping.

Question 12-22

a. Auditors do not consider an outside service company’s inventory certificate a satisfactory substitute for their own audit. The service company merely performs the client’s inventory-taking, pricing, and extension functions. While potentially strengthening internal control, auditors would still investigate and observe the inventory-taking process and test pricing and calculations.

b. The outside specialist’s certificate wouldn’t affect the audit report. Auditors must verify the inventory’s fair presentation through observation and testing. Without observation and testing, a disclaimer of opinion or qualification might be necessary if the inventory is material.

If observation is impossible but other procedures provide sufficient assurance, the inventory should not be mentioned in the audit report.

c. The certificate wouldn’t be mentioned in the audit report. The outside specialists are not independent auditors but act as temporary employees. While auditor reports may mention other independent auditor reports, this doesn’t extend to non-independent specialists.

Question 12-23

a. Observing the physical inventory is generally mandatory as it provides strong evidence of the inventory’s existence and quality.

b. Observation is generally impossible if auditors are appointed after the inventory is taken. Rare circumstances like weather or terrain might also prevent observation.

c. Reviewing the client’s control for inventory tags is crucial to prevent the creation of fictitious tags after the observation.

Question 12-24

The following procedures should be undertaken:

a. Verify the consignment status of the motors through records, contracts, correspondence, and confirmations with consignors.

b. Investigate the returned machine’s ownership through receiving reports, customer confirmations, and quality control records. Determine the appropriate accounting treatment based on ownership.

c. Verify the sale and removal of the machine delivered to the U.S. Naval Base from inventory and accounts receivable.

d. Assess the potential obsolescence of the dusty materials through usage records, inquiries with production personnel, and potential valuation adjustments.

Question 12-25

Audit procedures for identifying slow-moving or obsolete inventory include:

  1. **Physical Observation:** Note dusty, rusted, or poorly conditioned items and investigate inventory in unusual locations.
  2. **Perpetual Record Review:** Review perpetual records for long periods of inactivity for raw materials and finished goods.
  3. **Bill of Material Comparison:** Compare raw materials listings with bills of material for current production or orders.
  4. **Sales Order Backlog Comparison:** Compare the unfilled sales order backlog with the finished goods inventory list.
  5. **Sales Publication Review:** Review catalogs and sales publications for currently advertised finished goods.
  6. **Goods-in-Process Review:** Identify dormant or incomplete jobs in goods-in-process records.
  7. **Post-Audit Date Transaction Examination:** Examine post-audit date sales orders and material requisitions for activity.
  8. **Management Inquiry:** Inquire about recent obsolescence surveys.
  9. **Inventory Listing Comparison:** Compare beginning and ending inventory listings for items with minimal quantity changes.
  10. **Inventory Turnover Analysis:** Compute and compare inventory turnover by product line with prior periods.
  11. **Analytical Procedures:** Perform analytical procedures like comparing gross profit trends by product line.

Question 12-26

Since Reed Company acquired its entire inventory from the president in a related party transaction, auditors should consider the cost of merchandise to the president in his similar sole proprietorship. The substance of the transaction should be evaluated, ensuring the inventory is not valued excessively. Any excess charged by the president represents unamortized discount on notes payable. Full disclosure of the transaction is required in the financial statement notes.

Question 12-27

a. To establish proper inventory cutoff, auditors use shipping and receiving information from the physical inventory and:

  1. **Pre-Inventory Sales Examination:** Examine sales transactions before the physical inventory to ensure proper inclusion in sales and cost of sales.
  2. **Pre-Inventory Receiving Report Selection:** Select receiving reports before the physical inventory to ensure proper inclusion in inventory and liabilities.
  3. **Inventory in Transit Review:** Review documentation for goods not physically counted but included in the general ledger inventory control account.
  4. **Post-Inventory Transaction Examination:** Examine purchase and sales transactions after the physical inventory to ensure proper period reflection.
  5. **Returns and Claims Review:** Review records of returned goods and claims against suppliers before and after the cutoff date for proper period entry.

b. Upon arrival for observation, auditors will inspect the premises to determine:

  1. **Inventory Arrangement:** Whether the inventory arrangement allows for an accurate count.
  2. **Segregation of Goods:** Whether scrap, obsolete, and damaged goods are adequately identified and segregated.
  3. **Identification of Owned Inventory:** Whether inventory owned by other companies is adequately identified and segregated.
  4. **Inventory Safeguarding:** Whether inventories are adequately protected against unauthorized access and deterioration.

Question 12-28

Audit procedures for verifying the acceptability of standard costs and related variance accounts for materials include:

  1. **Internal Control Consideration:** Consider internal control, determine appropriate tests, and assess control risk.
  2. **Standard Cost Computation Testing:** Test the arithmetic computations of standard cost records.
  3. **Standard Cost Data Currency:** Ensure the data on standard cost records are reasonably current.
  4. **Standard Cost Specification Accuracy:** Verify the accuracy of standard cost record specifications against engineering specifications or other independent sources.
  5. **Standard Material Price Establishment:** Determine the consideration of factors like normal quality, quantity, sources, and delivery in establishing standard material prices.
  6. **Standard Cost Accounting System Review:** Review the accounting system for recording standard costs for reasonableness and test its effectiveness.
  7. **Material Variance Account Review:** Review material price and usage variance accounts for overall reasonableness and investigate excessive variations.
  8. **Variance Impact Consideration:** Consider the impact of variances on financial statements and potential allocation to cost of goods sold and inventories if significant.