CHAPTER 4

4. AUDIT OF INVENTORIES AND COST OF SALES

Chapter Outline
Meaning of Inventories and the Significance of Audit of Inventories
Functions making up the Inventory and Warehousing Cycle
Audit objectives for Inventories/Cost of Sales
Audit Program for Inventories/Cost of Sales
Verification of Inventories
4.1 Meaning of Inventories and the Significance of Audit of Inventories
Inventories are goods held for resale in the ordinary course of business or goods that will be used
or consumed in the production of goods to be sold. They are mainly divided into two major
categories:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses
Source of Inventories
Inventories include:
 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.
In auditing the purchases, cost of sales and cash disbursements system and related balances, the
auditor must be concerned with verification of transaction validity, existence, ownership, cutoff,
valuation and appropriate statement presentation. The primary asset accounts associated with the
cost of sales system are inventories.
Audit of cost of goods sold can be directly tied to the audit of inventory. If beginning and ending
inventories have been verified and acquisitions have been tested, cost of goods sold can be
directly calculated. Auditor should also apply analytic to cost of goods sold to see if there are any
significant variations - either overall or by product line.
Special significance of Audit of Inventories
The audit of inventory is quite complex and time consuming part for the following reasons:
1. Inventory is generally a major item on the balance sheet and it is often the largest item
making up the accounts included in the working capital. I.e., inventories often represent the
largest current asset of a company.
2. The inventory may be in different locations, which makes physical counting difficult. I.e.,
determining the quantities of inventories may require specialized techniques.
3. The diversity of items in inventory creates another difficulty for auditors.
4. The valuation of inventory is also difficult due to such factors as obsolescence and the need
to allocated manufacturing costs to inventories. I.e., the valuation of goods on hand and in
process often presents complex and difficult issues.

1
5. There are several acceptable inventory valuation methods but any given client must apply a
method consistently from year to year.
6. Misstatements of inventories directly affect cost of goods sold and, therefore, net income.
7. Management fraud has often involved the fraudulent overstatement of inventories.
Risks of Material Misstatements
i. Inventories constitute a large asset and are very susceptible to major errors and fraud.
ii. The accounting profession allows numerous alternative methods for valuation of
inventories, and different methods may be used for various classes of inventories.
iii. The determination of inventory value directly affects the cost of goods sold and has a
major impact on net income for the year.
iv. The determination of inventory quality, condition, and value is inherently a more
complex and difficult task than is the case with most other elements of financial position.
4.2 Functions making up the Inventory and Warehousing Cycle
Inventory takes many different forms, depending on the nature of the business. For retail or
wholesale businesses, the largest account in the financial statements is often merchandise
inventory available for sale. To study the inventory and warehousing cycle, we will use an
example of a manufacturing company, whose inventory may include raw materials, purchased
parts and supplies for use in production, goods in the process of being manufactured, and
finished goods available for sale. Still, most of the principles discussed apply to other types of
businesses as well.
The inventory and warehousing cycle can be thought of as comprising two separate but closely
related systems, one involving the physical flow of goods and the other the related costs. Six
functions make up the inventory and warehousing cycle. Each of these is discussed next.
1. Process Purchase Orders
2. Receive Raw Materials
3. Store Raw Materials
4. Process the Goods
5. Store Finished Goods
6. Ship Finished Goods
The following figure shows the above six functions in the inventory and warehousing cycle and
below the figure brief discussions have been made for each function.

2
 1. Process Purchase Orders

The inventory and warehousing cycle begins with the acquisition of raw materials for production.
Adequate controls over purchasing must be maintained whether inventory purchases are raw
materials for a manufacturer or finished goods for a retailer. Purchase requisitions are forms used
to request the purchasing department to order inventory. These requisitions may be initiated by
stockroom personnel as raw materials are needed, by automated computer software when raw
materials reach a predetermined level, by orders placed for the materials required to produce a
customer order, or by orders initiated on the basis of a periodic raw materials count.
2. Receive Raw Materials
Receipt of the ordered materials, which is also part of the acquisition and payment cycle,
involves the inspection of material received for quantity and quality. The receiving department
prepares a receiving report that becomes a part of the documentation before payment is made.
After inspection, the material is sent to the storeroom and copies of the receiving documents, or
electronic notifications of the receipt of goods, are typically sent to purchasing, the storeroom,
and accounts payable. Control and accountability are necessary for all transfers.
3. Store Raw Materials
Once received, materials are normally stored in a storeroom. When another department needs
materials for production, personnel submit a properly approved materials requisition, work order,
or similar document or electronic notice that indicates the type and quantity of materials needed.
3
This requisition document is used to update the perpetual inventory master files and record
transfers from raw materials to work in process accounts. These updates occur automatically in
organizations with integrated inventory management and accounting software systems.
4. Process the Goods
Processing inventory varies greatly from company to company. Companies determine the
finished goods items and quantities they will produce based on specific orders from customers,
sales forecasts, predetermined finished goods inventory levels, and economical production runs.
A separate production control department is often responsible for determining the type and
quantities to produce.
An adequate cost accounting system is an important part of the processing of goods function for
all manufacturing companies. The system shows the relative profitability of the products for
management planning and control and values inventories for preparing financial statements. Two
primary types of cost systems exist: job cost systems and process cost systems, but there are
many variations and combinations of these systems.
Cost accounting records consist of master files, spreadsheets, and reports that accumulate
material, labour, and overhead costs by job or process as those costs are incurred. When jobs or
products are completed, the related costs are transferred from work-in-process to finished goods
based on production department reports.
5. Store Finished Goods
When finished goods are completed, they are placed in the stockroom to await shipment. In
companies with good internal controls, finished goods are kept under physical control in a
separate, limited-access area. The control of finished goods is often considered part of the sales
and collection cycle.
6. Ship Finished Goods
Shipping completed goods is part of the sales and collection cycle. The actual shipment of goods
to customers in exchange for cash or other assets, such as accounts receivable, creates the
exchange of assets necessary for meeting revenue recognition criteria. For most sales
transactions, the actual shipment becomes the trigger for recognizing the related accounts
receivable and sales in the accounting system. Thus, shipments of finished goods must be
authorized by a properly approved shipping document.
4.3 Audit objectives for Inventories/Cost of Sales
1. Use the understanding of the client and its environment to consider inherent risks, including
fraud risks, related to inventories and cost of goods sold.
2. Obtain an understanding of internal control over inventories and cost of goods sold.
3. Assess the risks of material misstatement and design tests of controls and substantive
procedures that:
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.
4
 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.
4.4 Audit Program for Inventories/Cost of Sales
The auditor needs to design an appropriate audit program for inventories/cost of sales as follows.
The primary objective of an auditor is to verify effectiveness of internal of the client to enhance
efficient and effective utilization of inventory. The auditor depends primarily on the reliability of
the system of internal control in judging whether inventory, cost of sales and cash disbursement
transactions have been appropriately recorded, classified and accumulated in the accounting
records.
During the preliminary study and evaluation of the system of internal controls, the reliability of
the system can be evaluated in general by verifying the extent to which it included the desirable
internal control characteristics. If selected controls are found to be weak, related substantive tests
over inventory and related accounts should be expanded.
Internal Control over inventory includes
 Documentation of authorization and approval procedures
 Appropriate separation of responsibilities
 Safeguarding assets and records: Inventory Balances
a. Documentation of authorization and approval procedures
The more important procedures for inventory and cost of sales require that:
1. A properly approved purchase requisition be originated as the first document in support
of materials acquisition.
2. Purchase orders, originated in response to properly approved purchase requisitions, be
sequentially numbered and a procedure be established to account for the use of each of
the purchase order forms.
3. Debit memos, issued in connection with purchase returns and allowances, be
sequentially numbered and controlled in the same manner as are purchase orders.
4. Sequentially numbered vouchers be prepared and properly approved in support of all
cash disbursements. When a check is issued against a properly approved voucher, the
voucher should be cancelled by being stamped “paid” and should be initialed by the
person signing the check in payment of it.
5. A voucher register be maintained to record all approved vouchers.
6. Properly controlled, sequentially numbered receiving report forms be used to
acknowledge receipt of goods from vendors.
7. Job order cost sheets or cost of production reports be used to account for goods in the
process of being manufactured.
8. Subsidiary perpetual inventory records be maintained for raw materials and finished
goods.

5
 9. Bills of material or raw material requisitions be used to account for materials issued into
production.
10. Properly controlled, sequentially numbered paychecks be used to pay all employees.
b. Appropriate separation of responsibilities
The appropriate separation of responsibilities should be checked by making inquiries, observing
procedures, and examining policy and procedures manuals. This requires that many functions be
assigned to different employees to protect resources and provide reliable financial data, as
follows:
1. Persons preparing and approving the vouchers for payment should have no other
responsibilities relating to cash payments.
2. The person authorized to sign checks should have no responsibilities relating to the
preparation of vouchers and should have no access to cash receipts or the cash records.
3. The authority to borrow should be separated from the cash handling transactions.
4. The stores ledger clerk should not have access to the store room or to the handling of
inventory items.
5. The various authorization and approval functions associated with payments of accounts
should be divided among a number of different persons.
6. Persons having a responsibility for the purchase of goods or services should have no
access to cash.
c. Safeguarding assets and records: Inventory Balances
All assets and records associated with the cost of sales system should be appropriately protected
from physical loss or alteration. This requires that:
1. All payments be made by use of pre-numbered checks.
2. The inventory storage areas should be fitted to the goods stored in them.
3. Inventory records should be stored so as to protect them from damage or alteration.
(II) Substantive Audit Procedures for Inventories/Cost of Sales
Perform following Substantive procedures for inventories/cost of goods sold.
1. Obtain listings of inventory and reconcile to ledgers.
2. Evaluate the client’s planning of physical inventory.
3. Observe the taking of physical inventory and make test counts.
4. Review the year-end cutoff of purchases and sales transactions.
5. Obtain a copy of the completed physical inventory, test its clerical accuracy, and trace test
counts.
6. Evaluate the bases and methods of inventory pricing.
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.

6
Summary of Major Substantive Tests of Inventories
Substantive Test Preliminary Audit Objectives
Obtain listings of inventory and reconcile to ledgers Clerical Accuracy
Evaluate the client’s planning of physical inventory Existence and rights
Observe the taking of the physical inventory Completeness
Valuation
Review the year end cut-off of purchase and sales transactions Existence and rights
Obtain a copy of the completed physical inventory and test its Completeness
accuracy Clerical accuracy
Evaluate the bases and methods of inventory pricing Valuation
Determine whether any inventories have been pledged and Valuation Presentation and
review commitments disclosure
Evaluate financial statement presentation and disclosure Presentation and disclosure
4.5 Verification of Inventories
1. Verification of Existence: Inventory Balance
Auditors must observe the client taking a physical inventory count to determine whether
recorded inventory actually exists at the balance sheet date and is correctly counted by the client.
Physical examination is an essential type of evidence used to verify the existence and count of
inventory
When inventories exist and are material to the financial statements taken as a whole the auditor
must generally be present to observe and to take some test counts when the client physically
counts the inventory.
Observation of inventory ordinarily begins with an inspection of the client’s physical inventory
instructions. To making this inspection, the auditor should be alert for weaknesses that could
allow particular elements of the inventory to be counted twice or possibly be omitted during the
inventory taking process.
In some situations it may be impossible or impracticable for the auditor to observe and test count
inventories at the balance sheet date. In these situations, if the client has maintained proper
perpetual records, the auditor may still be able to verify the existence of year-end inventories by
the use of alternative procedures. These procedures must be performed as soon as possible after
the balance sheet date and include the following:
1. Review of client inventory instructions.
2. Inquiry of the client as to how counts were made.
3. Inspection of physical inventory records, noting that the proper procedures were performed
and adjustment were made where necessary.
4. Test counting of selected items, tracing the movement of inventories back through the
perpetual records by use of issue slips and receiving reports, and then reconciling the
resultant calculations with amounts shown on the perpetual records as of the balance sheet
date.
2. Verification of Valuation: Inventory Balance
7
 The verification of inventory valuation generally begins when the auditor investigates the
valuation method used by the client. The auditor must then determine whether that method
produces, within the limits of materiality, a valuation that is in accordance either with one of the
generally accepted cost-flow assumptions or with the lower of cost or market valuation
procedures.
Specifically, the investigation of inventory valuation (pricing) often will emphasize the following
questions:
1. What method of pricing (costing) does the client use? Inventories should be priced in
accordance either with one of the generally accepted cost-flow assumptions
2. Is the method of pricing the same as that used in prior years?
3. Has the method selected by the client been applied consistently and accurately in practice?
The auditor will then, on a test basis, inspect the values assigned to various inventory items. The
cost assigned to inventories should be the invoice cost less cash discounts taken. In verifying the
valuation of work in process and finished goods inventories, it is important for the auditor to
inspect the supporting records found within the cost accounting subsystem.
If the client is a retail store, the valuation involves vouching not only the unit cost of goods but
also the retail price. During the observation of inventory it is important for the auditor to give
special attention to inventory items that may be damaged, shopworn or obsolete. Slow moving
(obsolete) items are most likely to be discovered by examining the perpetual inventory records.
3. Verification of Ownership of inventory: Inventory Balance
The verification of ownership requires the auditor to inspect, on test basis, the documents
underlying to the acquisition of individual inventory items including purchase orders, receiving
reports and vender invoices. With respect to consigned goods, the auditor should inquire about
them and secure an inventory representation letter stating that such goods have been excluded
from the inventory accounts. He or she can then examine the final inventory listing to verify that
such goods have, in fact, been excluded from inventories.
4. Verification of cut off (Periodicity): Inventory Balance
Cut off errors occur near the beginning or end of the audit period when entries involving the
acquisition or disposal of merchandise are included as transactions in the wrong period. In
verifying proper cutoff the auditor must inspect the underlying documents relating to both
purchases and sales made near the end of the period under audit and during the first few days of
the succeeding period. This procedure is performed to determine that the transaction has been
recorded in the proper period and that he client held legal title to the goods as of the balance
sheet date. Ordinarily, merchandise acquisitions should be recorded at the date the title to the
goods passes to the purchaser, i.e., the FOB shipping point.
5. Verification of Statement Presentation
The verification of statement presentation primarily involves seeing that the disclosure
requirement relating to inventory has been met. The auditor must inquire of the client as to
whether any part of the inventory has been pledged as security against creditor claims. If so, the
auditor must ascertain that the amount of the pledged inventory has been appropriately disclosed
in the balance sheet. It is also necessary for the financial statement to disclose the method used in

8
valuing the inventory. Furthermore, in case of manufacturing firm, appropriate distinction should
be made between inventories of raw materials, work in process and finished goods.