Chapter 14 – Audit of the Inventory and Distribution Cycle

Overview of the Inventory and Distribution Cycle

 Inventory takes many different forms, depending on the nature of the business
 A manufacturing company has raw materials, goods in process, and finished goods
available for sale
 Inventory and distribution cycle is the transaction cycle that involves the physical flow
of goods through the organization, as well as related cost
 The linkage between the inventory and distribution cycle and the acquisition and payment
cycle, and between the inventory and distribution cycle and the human resources and
payroll cycle, can be seen by examining the debits to the raw materials, direct labour, and
manufacturing overhead T-accounts

Inventory Cycle Business Functions, Documents, and Records

 The inventory and distribution cycle can be thought of as comprising two separate but
closely related systems, with one involving the actual physical flow of goods and the
other the related costs
 An
Overview of the Audit Process for Inventory
 The overall objective in the audit of the inventory and distribution cycle is to determine
that raw materials, work in process, finished goods inventory, and cost of goods sold are
fairly stated on the financial statements
 Inventory is generally a major item on the balance sheet, and it is often the largest item
making up the accounts included in working capital, making it a high-risk audit area
requiring substantial audit effort

Identify Significant Risks

 The company has or is attempting to obtain financing secured by inventory
 The inventory is difficult to count or value
 The company is a manufacturer or has a complex system to determine the value of
inventory
 The company is involved in technology or another volatile or rapidly changing industry
  Some common sources of business risk for inventory include short product cycles,
potential obsolescence, use of just-in-time inventory and other potential vulnerabilities
created with suppliers’ practices, reliance on a few key suppliers, and use of sophisticated
inventory management technology
 Auditors often have a greater concern for misstatements when inventory is stored in
multiple locations, the costing method is complex, and the potential for inventory
obsolescence is great

Identify and Assess Fraud Risk

 Fictitious inventory has been at the centre of several major cases of fraudulent financial
reporting
 Many large companies have varied and extensive inventory in multiple locations, making
it relatively easy for the company to add fictitious inventory to the accounting records
 There are many potential warning signs or symptoms that point to inventory fraud
 Analytical procedures, especially gross margin percentage and inventory turnover, often
help uncover inventory fraud
Assess Inherent Risk for Inventory
 Some inherent risk factors affecting inventory include the following:
o Inventory is often stored in different locations, which makes physical control and
counting difficult
o Inventory is easily transportable, is easy to steal, and may be hard to access
 o Inventory that consists of items such as jewels, chemicals, and electronic parts is
often difficult for the auditor to observe and value
o The industry is categorized by rapid and significant technological innovation,
which increases the risk of obsolescence
o Customer returns are frequent, which causes accuracy, timing, and cutoff issues
with recording of the physical return and the corresponding credit in sales
o There are several acceptable inventory valuation methods under ASPE and IFRS,
which the auditor must determine have been applied consistently from year to
year

Understanding and Assessing Control Risk

 Inventory controls may be quite complex depending upon the type of inventory system
 In addition to transaction controls, the auditor is concerned about control related to
inventory observation

Acquiring and Recording Raw Materials, Labour, and Overhead

 The internal controls over these three functions are first studied, then tested, as part of
performing tests of controls in the acquisition and payment cycle and the human
resources and payroll cycle
 At the completion of the acquisition and payment cycle, the auditor is likely to be
satisfied that acquisitions of raw materials and manufacturing costs are correctly stated
Internal Storage, Production, and Transfer of Inventory and Costs
 Internal transfers include the fourth and fifth functions in Figure 14-2: processing the
goods and storing finished goods
 Cost accounting records are the accounting records concerned with the manufacture and
processing of the goods and storing finished goods
Shipping Goods and Recording Revenue and Costs
 The recording of shipments and related costs, the last function in Figure 14-2, is part of
the sales and collection cycle
 The internal controls over this function are studied and tested as part of auditing the
revenue cycle, including procedures to verify the accuracy of the perpetual inventory
master files
Physically Observing Inventory
 Observing the client taking a physical inventory count is necessary to determine whether
recorded inventory actually exists at the balance sheet date and is properly counted by the
client
 The procedures related to observing the client’s inventory count are both tests of controls
and substantive tests
Pricing and Compiling Inventory
 Costs used to value the physical inventory must be tested to determine whether the client
has correctly followed an inventory method that is in accordance with generally accepted
accounting principles and is consistent with the method of previous years
 Audit procedures to verify these costs are called price tests

Key Controls
Physical Controls
 Physical controls over assets prevent loss from misuse and theft
 The use of physically segregated, limited-access storage areas for raw materials, work in
process, and finished goods is one major control for protecting assets
 In some instances, the assignment of custody of inventory to specific responsible
individuals may be necessary to protect the assets
 Approved pre-numbered documents for authorizing movement of inventory also protects
the assets from improper use
Perpetual Records
 Perpetual inventory data files maintained by persons who do not have custody of or
access to assets are another important cost accounting control
 Perpetual inventory data files provide a record of items on hand, which is used to initiate
production or purchase of additional materials or goods; they provide a record of the use
 of raw materials and the sale of finished goods, which can be reviewed for obsolete or
slow-moving items; and they provide a record that can be used to pinpoint responsibility
for custody as part of the investigation of differences between physical counts and the
amounts shown on the records
Inventory Counts
 The physical count may be performed at or near the balance sheet date, at an interim date,
or on a cycle basis throughout the year
 Adequate controls over the physical count of inventory include proper instructions for the
physical count, supervision by responsible company personnel, independent internal
verification of the counts by other client personnel, independent reconciliations of the
physical counts with perpetual inventory master files, and adequate control over count
sheets or tags used to record inventory counts
Inventory Compilation and Pricing
 Standard cost records that indicate variances in material, labour, and overhead costs to
help evaluate the reasonableness of production records;
 A review of the reasonableness of costs conducted by someone independent of the
department responsible for determining the costs
 A formal review, conducted by a knowledgeable employee, of obsolete, slow-moving,
damaged, and overstated inventory items
 Inventory compilation internal controls to ensure that the physical counts are correctly
summarized, priced at the same amount as the unit records, correctly extended and
totaled, and included in the perpetual inventory master file and related general ledger
inventory accounts at the proper amount;
 Adequate controls over the programs that perform calculations, with internal verification
or review of entry of prices and of output reports by a competent, independent person

Develop an Audit Approach (Strategy) for Inventory

 Example

Design and Perform Test of Controls

Physical Controls Over Inventory
 The auditor’s tests of physical controls over raw materials, work in process, and finished
goods are usually limited to observation and inquiry
 The existence of an adequate storeroom with a competent custodian in charge also results
in the orderly storage of inventory
  If the auditor concludes that the physical controls are so inadequate that the inventory
will be difficult to count, the auditor should expand his or her observation of physical
inventory tests to ensure that an adequate count is carried out
Documents and Records for Transferring Inventory
 The auditor’s primary concerns in verifying the transfer of inventory from one location to
another are that recorded transfers exist, all actual transfers are recorded, and the quantity,
description, and date of all recorded transfers are accurate
 Products labelled with standardized bar codes that can be scanned by laser bar-code
readers and other technologies make it easier for clients to track the movement of goods
through production
 After auditors understand the internal controls, they can easily perform tests of controls
or substantive tests of transactions by examining documents and records to test the
occurrence and accuracy objectives for the transfer of goods from the raw material
storeroom to manufacturing
Perpetual Inventory Master and Transaction Files
 When perpetual inventory master files are accurate, auditors can test the physical
inventory before the balance sheet date
o An interim physical inventory or use of cycle counts throughout the year can
result in significant cost savings for both the client and the auditor, and it enables
the audit to be completed earlier
 Auditors test perpetual inventory master files by examining documentation that supports
changes to inventory amounts in the master files
Unit Cost Records
 Adequate cost accounting records must be integrated with production and other
accounting records in order to produce accurate costs of all product
 Auditors should design appropriate tests based on their understanding of the cost
accounting records and the extent to which they will be relied on to reduce substantive
tests

Perform Substantive Analytical Procedures

Substantive Tests of Details for Inventory Balances
Physical Observation of Inventory
 Per CAS 501, Audit evidence: specific considerations for selected items, when inventory
is material, the auditor should attend the client’s physical inventory count unless it is
impractical to do so
 The CAS provides specific instructions for audit procedures that the auditor should
perform in evaluation of the processes used during the count, including methods to record
count results and tracking count results to their final recording into financial records
Controls
 An important aspect of the auditor’s understanding of the client’s physical inventory
controls is having a thorough understanding of the controls before the inventory-taking
begins
 This is necessary to evaluate the effectiveness of the client’s procedures, but it also
enables the auditor to make constructive suggestions before-hand
Timing
 The auditor decides whether the physical count can be taken prior to year-end primarily
on the basis of the accuracy of the perpetual inventory files
 When the perpetual(s) are accurate, it may be unnecessary for the client to count the
entire inventory every year
 When there are no perpetual(s) and the inventory is material, a complete physical
inventory must be taken by the client near the end of the accounting period and tested by
the auditor at the same time
Completeness and Cutoff
  The auditor performs cutoff tests of receipts and shipments of inventory at year-end to
ensure that all items are recorded in the correct period
 At the count, if the client continues shipping and receiving, the auditor will usually
ensure that the client has appropriate procedures in place to account for inventory
movement
 If client has inventory held at third-party locations, the auditor would obtain confirmation
from those third parties, thus negating the need to attend counts at those locations
Selection of Items
 Care should be taken to observe the counting of all of the most significant items and a
representative sample of typical inventory items
 The auditor also inquires about items that are likely to be obsolete or damaged, and
discusses with management the reasons for excluding any material items
Physical Observation Tests
 The auditor should be present while the physical count is taking place
 When the client’s employees are not following the inventory instructions, the auditor
must either contact the supervisor to correct the problem or modify the auditor’s physical
observation procedures
 A reasonableness test that is usually performed is a comparison of the high-dollar-value
inventory with counts in the previous year and inventory master files as a test of
reasonableness
Pricing and Compilation Substantive Tests
 The purpose of pricing and compilation substantive tests is to make certain the physical
counts were properly priced and compiled
 Pricing substantive tests includes the tests of the client’s unit prices to determine whether
they are correct
 Compilation substantive tests includes testing the summarization of the physical counts,
extending price times quantity, footing the inventory summary, and tracing the totals to
the general ledger
Substantive Tests of Product Costs
 In selecting specific inventory items for pricing, emphasis should be on those items that
have the greatest risk of material misstatement—larger dollar amounts, products that are
known to have wide price fluctuations, and slow moving inventory
 However, the auditor should ensure that there is a representative sample of all types of
inventory and all departments should be included
 In the case of manufactured goods, the auditor reviews direct labour rates and compares
to authorized wage rates, test computation of overhead rates, and examine analyses of
purchasing and manufacturing variances
Substantive Tests for Replacement Cost and Net Realizable Value
  Inventory is reduced, when appropriate, to net realizable value or replacement cost
 For purchased finished goods and raw materials, the most recent vendor’s invoice of the
subsequent period is a useful and straightforward means of testing for replacement cost

Designing Fraud Substantive Procedures for Inventory

 Perform surprise visits and counts to inventory locations
 Perform additional procedures at the count—for example, more rigorously exam-ine
contents of boxed items, how goods are stacked or labelled, and the quality of liquid
substances such as perfumes and specialty chemicals. Using an expert may be required to
perform an appropriate assessment
 Use computer-assisted audit techniques to further test compilation of inventory counts to
check for possible omissions or duplications
 Ensure that the audit plan is confidential and not discussed with the client, particularly
regarding the locations, times, and sampling amounts of the physical inventory counts
 Perform nonfinancial analytics to determine unusual relationships (e.g., calculating
volume required for holding reported inventory and comparing that to the actual space in
the existing warehouse to discover an overstatement or double counting)
 Inquire of personnel in the shipping department about recent shipments between
inventory warehouse locations close to the physical inventory count date