0:06 [Music]
0:09 hello and welcome to chapter nine of
0:12 auditing and Assurance services in this
0:14 chapter we are going to discuss the
0:17 production cycle and how to audit
0:20 inventory and here we see a quote from
0:23 Henry Ford there is one rule for
0:26 industrialists and that is make the best
0:29 quality of goods possible at the lowest
0:33 cost possible paying the highest wages
0:37 possible so these are our chapter nine
0:39 learning objectives where we are going
0:41 to learn how to describe the production
0:44 cycle including those typical Source
0:47 documents that we as external Auditors
0:50 will be investigating we're going to
0:52 identify the significant accounts and
0:54 the relevant management assertions that
0:58 relate to the audit of inventory as
1:00 always we are going to consider material
1:03 misstatement in the audit of inventory
1:06 and identify those important control
1:09 internal control activities that are
1:11 present in a properly designed internal
1:14 control system to hopefully mitigate
1:17 that risk of material misstatement for
1:19 each of those Management assertions in
1:22 the inventory management process we're
1:25 going to give examples for those tests
1:27 of controls to test that they are
1:31 operating effectively and are able to
1:33 manage inventory then we're also going
1:36 to give examples of those substantive
1:39 procedures in the audits of inventory
1:41 and those related assertions that those
1:45 substantive procedures are testing and
1:47 lastly we are going to actually perform
1:50 some audit procedures on inventory and
1:53 then hopefully learn how to evaluate the
1:55 results of those
1:57 tests so let's start with our inventory
1:59 management and the relationship between
2:03 those business Cycles so here we see in this
2:04 this
2:07 visualization that the production cycle
2:11 links the acquisition cycle which is in
2:12 which the goods and services are
2:16 purchased and it links it to the revenue
2:19 cycle which is where the inventory is
2:22 sold and these Cycles coincide with the payroll
2:24 payroll
2:27 cycle as well and that accounts for all
2:29 of the additions and reductions of the
2:32 ventory items so we're looking at the
2:34 production cycle which is mostly
2:36 concerned with how we account for
2:38 inventory as it moves through the
2:41 production stages where we're looking at
2:44 raw materials work in process and
2:47 finished goods the three inventory items
2:50 in a manufacturing
2:53 process so when we're thinking of
2:55 inventory management we have several
2:57 typical activities as you can see we do
3:00 some sales forecast we also have to do
3:02 some production planning where we look
3:04 at the production plan and the bill of
3:07 materials we also have to look at
3:09 production and inventory controls such
3:12 as the purchase order the materials
3:14 requisition and the materials transfer
3:17 ticket then we have to think of our cost
3:19 accounting as we are accounting for the
3:22 standard costs and those allocations of manufacturing
3:24 manufacturing
3:27 overhead so now we are in the risk
3:29 assessment process and so when you think
3:30 of the significant accounts we're
3:33 looking at inventory and expenses and
3:36 then the relevant assertions such as
3:39 existence completeness cut off valuation
3:42 and allowances valuation and allocation
3:45 rights presentations and disclosure as
3:47 they relate to inventory and
3:49 completeness and accuracy as they relate to
3:50 to
3:53 expenses so when we're considering the
3:56 risk of material misstatement we're
3:58 really just considering what could go
4:01 wrong in the production cycle so as
4:03 Auditors we need to be concerned with
4:07 several primary concerns first the items
4:10 included in inventory were in inventory
4:12 on the balance sheet date so that would
4:15 help us to understand the management
4:17 assertions of existence and cut off
4:20 secondly all inventory items have been
4:23 included which would test completeness
4:25 third we would see that inventory has
4:28 been properly accounted for and valued
4:30 using those Gap accounts methods which
4:33 would substantiate valuation that the
4:36 inventory items included in inventory
4:38 were the property of the client which
4:42 gives us rights proper presentation and
4:44 disclosures have been provided for as
4:46 relates to inventory testing the
4:48 presentation and disclosure management
4:51 assertion cost of goods sold includes
4:53 all of the costs of the inventory item
4:55 sold which would test completeness and
4:58 the amount of cost of goods sold has
5:00 been properly accounted for using those
5:03 acceptable Gap accounting methods to test
5:04 test
5:07 accuracy so here we see the significant
5:11 accounts such as inventory and cost of
5:13 goods sold and each of the management
5:16 assertions and what could go wrong so
5:19 for example when we look at existence we
5:21 have items that are included in the
5:23 inventory records are not actual items
5:25 in inventory when we're looking at
5:27 completeness that means that some items
5:30 may not be in inventory
5:31 as it relates to the management
5:33 assertions of cut off we're looking at
5:36 inventory transactions that occurred
5:38 near year end but we're not recorded in
5:41 the correct period as for valuation
5:43 we're looking at the in inventory cost
5:46 flow assumptions such as fifo or lifo
5:49 that they have been applied incorrectly
5:52 or the proper costs for direct materials
5:54 direct labor and Manufacturing overhead
5:57 are not allocated to the actual
5:59 inventory that was produced when it
6:01 comes to presentations and disclosures
6:03 we're looking at inventory that might be
6:05 pledged as collateral that has not been
6:08 disclosed or cost flow assumptions that
6:09 are not disclosed because they're
6:12 misclassified among the raw materials
6:14 work in process or finished goods
6:17 inventory balance sheet accounts when
6:18 we're looking at cost of goods sold
6:20 we're thinking of the labor or materials
6:23 that may be omitted which would test the
6:27 relevant assertion of completeness and
6:29 for accuracy we're making sure that the
6:31 cost of direct material direct labor and
6:33 Manufacturing overhead have been
6:36 properly calculated so when we're
6:39 considering internal control activities
6:42 and design evaluations we are looking at
6:45 entity level controls here and those
6:48 considerations are that production runs
6:51 are authorized raw materials should be
6:54 counted and inspected as production is
6:56 undertaken the material and labor
6:59 quantities are summarized all inv
7:01 ventory items should be accounted for
7:03 whether they're used in production or
7:08 scrap or returned to inventory as
7:10 well then we're looking at production
7:12 labor reports that should be approved
7:15 and reconciled with the payroll records
7:17 and finished goods inventory production
7:20 records should be reviewed by the
7:22 production supervisor and then forwarded
7:24 by that individual to the accounting
7:26 department and we should count and
7:27 inspect the items and compare those
7:30 quantities to our perpetual inventory
7:33 records so when we're looking at the
7:35 cost accounting department reviews we're
7:37 looking at the quantity of the raw
7:39 materials and checking that to the
7:42 materials requisition we're looking at
7:44 the direct labor in the time sheets and
7:46 making sure that they coincide with the
7:48 labor distribution report we're also
7:51 looking for the application of overhead
7:54 costs and how that is allocated in the
7:57 overhead tickets and an overall cost
8:00 summary so when you're looking at the
8:02 internal control activities as they
8:05 relate to inventory we still have the
8:08 same management assertions and now we've
8:10 added we've already discussed what can
8:12 go wrong so now we're looking at the
8:14 internal control activity that we can
8:17 put in place to hopefully help us with
8:19 those relevant assertions so for example
8:22 any transfer of inventory must be
8:25 authorized right so if it's a periodic
8:27 physical inventory counts with the
8:29 reconciliations of records are performed
8:31 form that would help us with the
8:33 management assertion of existence and
8:35 then for example with cut off the
8:37 receiving reports if they're prenumbered
8:39 and use and sequenced and they're
8:41 reconciled that will help us with the
8:44 cut off and additionally for the Rights
8:46 Management assertion we would have a
8:49 separate account number to track those
8:52 inventory that is on
8:54 consignment and then when we're looking
8:57 at the assertion of presentation and
8:59 disclosure we would want to make sure
9:01 that management reviews those financial
9:03 statement disclosures and we might want
9:05 to possibly have a disclosure checklist
9:08 that's completed before we issue those
9:11 financials then for costs of good sold
9:13 our expense as it relates to the
9:16 management assertion of completeness we
9:18 would check the cost sheets are reviewed
9:20 for all the projects and the production
9:23 runs that way we're including all of the
9:25 relevant costs and we would also look at
9:27 the bill of materials and direct labor
9:29 requirements that they're approved D and
9:31 make sure that the correct cost
9:33 allocation calculations are
9:36 used as we relate to inventory as our
9:38 significant account and if we're looking
9:41 at existence we would want to inspect
9:44 the documentation of that authorization
9:47 for those inventory transfers or or
9:50 inspect the documentation of periodic
9:52 inventory accounts in that
9:54 reconciliation when we're looking at the
9:56 cut off assertion we might want to look
9:59 at those receiving reports make sure
10:01 that they are sequentially numbered and
10:03 also reconcile
10:06 them as we are looking at for example
10:09 presentation and disclosures we would
10:11 want to inspect those disclosure
10:14 checklists and look at the documentation
10:16 to make sure that it was reviewed by
10:17 management as
10:20 well and when we're looking our at cost
10:23 of good solds or cogs and if we're
10:26 looking at the completeness assertion we
10:29 would examine the documentation
10:32 of the cost sheets we would also inspect
10:34 the documentation of authorization of
10:36 the bill of materials and direct labor
10:39 requirements we want to trace that fill
10:42 of materials and those labor reports to
10:44 the job cost sheets and make sure that
10:50 included then when we look at additional
10:52 risks and additional controls as they
10:55 relate to the production cycle we would
10:57 look at the occurrence and the
10:59 completeness and then look at the
11:01 internal control activities that might
11:04 be in place but more importantly conduct
11:07 those tests of internal controls which
11:14 tests so if you're looking at occurrence
11:16 of production and those related events
11:18 that have been recorded but haven't
11:21 really occurred we would want to observe
11:23 separation of cost accounting functions
11:26 from those of the production payroll and
11:28 inventory control functions and also
11:29 look for
11:32 reconciliations when we are thinking of
11:34 the completeness that some production
11:36 documents have actually not been
11:39 recorded we would want to inspect
11:41 evidence of possibly reviewing the
11:45 numerical sequence maybe looking at the
11:47 inventory counts and comparing those to
11:50 the Perpetual records uh investigating
11:53 the reconciliation of the production
11:56 cost to the work in process inventory
11:59 tracing those receiving reports and to
12:02 the inventory and tracing materials used
12:04 to the production cost reports to make
12:07 sure everything ticks and
12:09 ties and then when we're looking at the
12:12 accuracy here where the production
12:14 information and the costs possibly
12:16 haven't been recorded properly or
12:19 calculated properly we would want to do
12:21 comparisons we would also want to
12:24 investigate the material and labor usage
12:27 reports and then look at evidence that
12:29 the act the client actually reconciled
12:31 the inventory counts to the Perpetual
12:34 records when we are looking at cut offs
12:36 so this is that the production events
12:38 have not really been recorded in the
12:40 correct accounting period Then what we
12:43 would do as external Auditors is to
12:45 vouch the dates of the inventory records
12:49 to those receiving reports and inspect
12:50 the production data make sure that that
12:53 agrees with our finished goods inventory
12:56 and then also inspect the production
12:57 reports and make sure they agree with
13:01 the journal entry that were posted then
13:03 when we're looking at classification
13:04 which basically tells us that the
13:07 production materials have not been
13:09 recorded in the correct account we'd
13:11 want to look for some supervisor
13:13 allocations test that allocations and
13:15 make sure that the supervisor signature
13:18 was there as some sort of attribute to
13:22 show that they reviewed it so when we're
13:24 looking to test the production cost
13:26 controls we're going to look for the
13:29 completeness direction so here you see
13:31 the purchase orders and we would take a
13:33 sample and make sure that they were
13:36 authorized and then we would match that
13:39 sample to the bill of materials and then
13:42 make sure that the issue slips those
13:44 materials used in the production reports
13:47 we test it back and also to the labor
13:49 reports as
13:52 well then when we're looking at the
13:55 occurrence uh management assertion we
13:57 might have the issue slips for the
13:59 materials that were using used then make
14:01 sure that those material used are
14:04 actually in the production cost Reports
14:07 look at the overhead analysis and labor
14:09 reports and make sure that everything
14:11 was recorded properly so we would vouch
14:14 the labor and vouch the overhead and compare
14:16 compare
14:19 those and now when we're looking at our
14:22 substantive procedures in order to audit
14:24 inventory obviously our significant
14:26 account is inventory and then each of
14:28 the management assertions that we disc
14:30 us so we already know what could go
14:33 wrong the internal act control activity
14:36 and the test of controls so now what
14:39 we're focusing on is our possible
14:41 substantive analytical procedures and
14:44 our test of details so for the Existence
14:47 management assertions of inventory we
14:49 would compare inventory turnover ratios
14:53 to possibly budgets and year over year
14:55 we can also compare the gross profit
14:58 percentage to budget and previous years
15:02 and then in terms of substantive test of
15:04 details we would have to observe the
15:06 client's physical inventory count that
15:09 is required by the pcaob auditing
15:11 standards then we would confirm any
15:14 inventory that was held on consignment
15:17 and vouch the in items that are listed
15:19 in inventory to those inventory count
15:21 tacts that were conducted during the
15:24 physical inventory
15:26 observation when we're looking at
15:28 completeness then we would look for to
15:30 observe not only the client's physical
15:33 inventory count but then ensure that all
15:36 items were counted and then Trace those
15:39 counts to the inventory listing when we
15:42 are looking at the management assertion
15:43 of cut off we're going to look at the
15:46 sales and purchase and perform cut off
15:48 tests by possibly looking at the last
15:51 few invoices 5 to 10 in the first few
15:52 and making sure they were recorded in
15:54 the correct
15:56 period Then when we're looking at
15:58 valuation as the relevant manag
16:01 management assertion in order to perform
16:03 analytical procedures we would possibly
16:06 compare the average unit costs of
16:08 inventory with prior periods and the
16:11 purchase records and when we are looking
16:13 at the possible substantive test of
16:16 details we're going to actually test
16:18 that mathematical accuracy of the
16:20 application for the cost flow
16:22 assumptions and then additionally we can
16:25 vouch the inventory cost to the standard
16:27 costs and then recalculate those
16:31 standard costs as well when we are
16:33 looking at the right management
16:36 assertion here we would inquire of
16:38 management whether any inventory was
16:41 held on consignment for anyone
16:44 else and then when we look at
16:46 presentation and disclosure when we're
16:49 looking at the possible substantive test
16:51 of details we're going to inquire
16:54 whether inventory has been pledged as
16:56 collateral or security for some form
16:58 we're also going to perform the bank and
17:01 Loan confirmations and inspect those
17:02 lending agreements or any other
17:05 contracts that might have used inventory
17:08 as collateral additionally we are going
17:10 to review the inventory calculations to
17:12 make sure that there is proper
17:15 classification for the raw materials the
17:17 work in process and the finished goods
17:20 which are the three inventory accounts
17:27 entity and then we might also vouch the
17:29 classification of the inventory records
17:32 to those subsidiary records as
17:35 well and now we're looking at cost of
17:38 good sold or
17:41 cogs if we're looking at the
17:44 completeness assertion then when we're
17:46 looking at our analytical procedures we
17:49 might compare the unit costs of
17:52 production with prior periods or with
17:54 budget and then compare the actual
17:56 production units to what was budgeted
17:58 and then when it comes to sub stantive
18:01 test of details we will trace the labor
18:03 costs from the payroll reports to the
18:05 production cost
18:07 sheets and then if we're looking at the
18:09 cost of goods sold as it relates to
18:12 accuracy we will recalculate those standard
18:14 standard
18:16 costs and now when we talk about the
18:19 physical inventory which is the client
18:21 that they're going to do the count we
18:24 would have certain instructions for them
18:26 such as like how many what are the names
18:29 of the team members what are the dat
18:31 what are the instructions to the team
18:33 members are making sure that there isn't
18:36 any obsolete or damaged items we're
18:38 going to look at the tag control making
18:41 sure that everything was counted we're
18:43 going to ensure that the client has shut
18:46 down production we are also going to
18:48 control the inventory movement such as
18:50 shipping and receiving nothing can come
18:54 in or go out so it stays so we can get a
18:56 a pH like an accurate physical count
18:58 we're going to look at the instructions
19:00 for the supervisory approval and then
19:02 make any changes or corrections as they are
19:04 are
19:07 necessary and then when it comes we're
19:09 going to observe the inventory count
19:11 then we're going to test the prices and
19:13 the compilation of those counts and then
19:16 perform our own analytical procedures
19:18 making sure do we have excessive
19:20 inventory what are those slow moving
19:21 inventory items and will we have to
19:24 write them
19:27 off and then we are required as external
19:31 auditors to make or observe some
19:33 physical count of the inventory and then
19:36 apply the appropriate tests of those
19:39 transaction so usually we would make
19:42 some test counts at the time and then
19:44 either roll forward or roll back those
19:46 test counts to ensure that that count
19:49 was accurate we're also going to review
19:51 the client instructions hopefully stop
19:54 the flow of goods and when we make these
19:56 test counts we're going to do them from
19:58 the inventory listing or from the
20:00 warehouse floor and then or and then
20:02 record everything in our workpaper so
20:05 from sheet which is the warehouse list
20:07 the inventory listing to floor or floor to
20:08 to
20:11 sheet and then we want to make sure that
20:13 we listen to the instructions that were
20:17 provided to the count team and then
20:18 understand if the client is using some
20:22 type of control tags or count sheets and
20:24 we don't want any Hollow squares or
20:26 empty boxes so we want to make sure that
20:29 we ensure that we want toate tour
20:31 shipping and receiving areas look for
20:34 any obsolete or slow moving inventory
20:37 confirm if any inventory is on
20:39 consignment and if we need to we might
20:42 use Specialists and then we also have to
20:44 look at inventory in transit as an external
20:46 external
20:49 auditor so most companies thankfully use
20:51 some sort of Technology when they are
20:53 doing inventory accounts such as
20:57 scanners or the rfids we also have now
20:58 drone technology
21:00 and that can be used for example if you
21:04 want to do physical observations of farm
21:07 animals like cattle or do consistent
21:10 loan Ware uh locations of warehouses as
21:12 well so new technology is helping us be better
21:14 better
21:17 Auditors and then when we're looking at
21:20 the valuation or the price tests we're
21:24 going to look at the vendor invoices and
21:27 get our inventory valuation which is
21:31 fifo or lifo or weighted average or
21:33 specific identification and then
21:36 remember to make sure that we apply the
21:39 lower of Coster Market to our inventory
21:41 valuation check all of the extensions
21:44 and footings and make sure that we agree
21:47 the valuation to our general
21:49 ledger and then when we're looking at
21:51 the presentation and disclosure
21:53 assertions we're going to make sure we
21:56 look for occurrence rights and
21:58 obligations completeness
22:01 classification and understanding and
22:03 accuracy and
22:06 valuation so when we consider the
22:09 application of the audit risk model so
22:10 basically what we're trying to do here
22:13 is apply the audit risk model to test
22:17 the assertion of existence in the
22:20 production cycle so as you can see below
22:22 we have the extent of the substantive
22:24 inventory procedures that we would
22:28 conduct for the Existence assertions and
22:30 that can be accomplished based on the
22:33 detection risk so if we have low
22:35 detection risk then we would observe the
22:38 physical inventory count at year end
22:39 we're going to take a substantial number
22:41 of test counts and we're going to use
22:44 large samples for vouching those
22:47 inventory purchases we're also going to
22:50 perform analytical procedures during
22:53 planning and at the audit completion now
22:56 if we have a high detection risk then
22:58 we're going to rely heavily on the those
23:00 analytical procedures we're going to
23:02 observe these cycle counts in inventory
23:05 but then rely on the roll forward
23:12 much so some fraud red flags as they
23:15 relate to inventory if we see
23:17 uncontrolled access to inventory that
23:20 means inventory can possibly be stolen
23:23 if we have several high dollar items
23:26 that with market value if we have
23:29 unexpected count during the inventory
23:31 that might be of concern if there are
23:33 large differences between the counts and
23:36 the inventory records that could also be
23:39 considered a red flag if the inventory
23:42 shows signs of damage or obsolescence or
23:45 too much quantities that could be a red
23:48 flag if there are some type of unusual
23:51 internal plant transfers during physical
23:54 inventory at the end of the year that
23:56 could be of concern as well and if the
23:59 client is reluctant to move merchandise
24:02 to allow for the inspection or if the
24:04 merchandises are located behind
24:06 something and you don't get access to it
24:08 as an external auditor that could also
24:10 be considered a red
24:15 flag so one of the key tools is idea and
24:17 that is a data mining software that is
24:19 typically used in auditing and now we
24:23 also use altrix as well and so those are
24:24 both data mining softwares and what we
24:28 can do in terms of inventory testing we
24:31 can actually apply this equation right
24:34 beginning balance plus purchases minus
24:36 inventory usage equals our ending
24:40 balance and we can actually practice
24:42 with what would happen and if you look
24:44 in your textbook these exercises here
24:46 will walk you through step by step on
24:50 how to use ID and I highly recommend
24:54 it then we have what the pcaob the
24:57 public Company accounting oversight
25:00 board tells us in terms of expection de
25:04 deficiencies so if the fa firm failed to
25:07 perform those sufficient procedures as
25:10 they relate to inventory a significant
25:13 portion of that issuer's inventory was
25:16 Lo located in one warehouse and the firm
25:18 selected for testing a control over the
25:21 existence of this inventory so the
25:23 control required that at least 80% of
25:26 the inventory storage locations at this
25:28 Warehouse be counted at at least once a
25:31 year the firm failed to evaluate whether
25:34 this control was designed to
25:36 appropriately address the risk as it
25:39 relates to the existence of inventory so
25:41 specifically what happened here is that
25:44 the audit firm did not evaluate whether
25:47 this control which required that only
25:49 80% of the inventory storage locations
25:52 be counted could effectively prevent or
25:55 detect a material misstatement of the
25:57 inventory that was located in this
25:59 particular particular
26:03 Warehouse so then we have substantive
26:05 tests of inventory so the PCA will be
26:08 requires external Auditors to perform
26:11 detailed inspections of the audit
26:13 process employed by each firm auditing
26:16 publicly traded corporations so a formal
26:19 inspection report would be issued by the
26:22 pcaob for each firm that they inspected
26:24 and in a recent inspection report the
26:27 pcaob highlighted the importance of
26:30 substantive testing of the client's
26:34 inventory so the first listed deficiency
26:37 was identical in multiple inspection
26:39 reports indicating the focus of the
26:42 sample size by the pcaob so the sample
26:45 size The Firm used in certain of its
26:48 substantive procedures to test certain
26:51 items of inventory were too small to
26:54 provide that sufficient and appropriate
26:57 audit evidence because those procedures
26:58 were designed design based on the level
27:01 of control Reliance that was not
27:04 supported due to the deficiency in the
27:07 firm's control and testing so in the
27:10 substantive testing the firm identified
27:13 differences in those unit costs of
27:16 inventory between the system but really
27:18 didn't perform anything to see what
27:21 caused that difference and this was of
27:26 KPMG as you can see here and recently in 2021
27:29 2021
