This chapter focuses on auditing the production cycle, specifically the inventory management process, by detailing the typical business activities, significant accounts, relevant management assertions, potential risks of material misstatement, internal control activities, and the substantive audit procedures required to ensure the accuracy and completeness of inventory records.
Mind Map
Click to expand
Click to explore the full interactive mind map • Zoom, pan, and navigate
[Music]
hello and welcome to chapter nine of
auditing and Assurance services in this
chapter we are going to discuss the
production cycle and how to audit
inventory and here we see a quote from
Henry Ford there is one rule for
industrialists and that is make the best
quality of goods possible at the lowest
cost possible paying the highest wages
possible so these are our chapter nine
learning objectives where we are going
to learn how to describe the production
cycle including those typical Source
documents that we as external Auditors
will be investigating we're going to
identify the significant accounts and
the relevant management assertions that
relate to the audit of inventory as
always we are going to consider material
misstatement in the audit of inventory
and identify those important control
internal control activities that are
present in a properly designed internal
control system to hopefully mitigate
that risk of material misstatement for
each of those Management assertions in
the inventory management process we're
going to give examples for those tests
of controls to test that they are
operating effectively and are able to
manage inventory then we're also going
to give examples of those substantive
procedures in the audits of inventory
and those related assertions that those
substantive procedures are testing and
lastly we are going to actually perform
some audit procedures on inventory and
then hopefully learn how to evaluate the
results of those
tests so let's start with our inventory
management and the relationship between
those business Cycles so here we see in this
this
visualization that the production cycle
links the acquisition cycle which is in
which the goods and services are
purchased and it links it to the revenue
cycle which is where the inventory is
sold and these Cycles coincide with the payroll
payroll
cycle as well and that accounts for all
of the additions and reductions of the
ventory items so we're looking at the
production cycle which is mostly
concerned with how we account for
inventory as it moves through the
production stages where we're looking at
raw materials work in process and
finished goods the three inventory items
in a manufacturing
process so when we're thinking of
inventory management we have several
typical activities as you can see we do
some sales forecast we also have to do
some production planning where we look
at the production plan and the bill of
materials we also have to look at
production and inventory controls such
as the purchase order the materials
requisition and the materials transfer
ticket then we have to think of our cost
accounting as we are accounting for the
standard costs and those allocations of manufacturing
manufacturing
overhead so now we are in the risk
assessment process and so when you think
of the significant accounts we're
looking at inventory and expenses and
then the relevant assertions such as
existence completeness cut off valuation
and allowances valuation and allocation
rights presentations and disclosure as
they relate to inventory and
completeness and accuracy as they relate to
to
expenses so when we're considering the
risk of material misstatement we're
really just considering what could go
wrong in the production cycle so as
Auditors we need to be concerned with
several primary concerns first the items
included in inventory were in inventory
on the balance sheet date so that would
help us to understand the management
assertions of existence and cut off
secondly all inventory items have been
included which would test completeness
third we would see that inventory has
been properly accounted for and valued
using those Gap accounts methods which
would substantiate valuation that the
inventory items included in inventory
were the property of the client which
gives us rights proper presentation and
disclosures have been provided for as
relates to inventory testing the
presentation and disclosure management
assertion cost of goods sold includes
all of the costs of the inventory item
sold which would test completeness and
the amount of cost of goods sold has
been properly accounted for using those
acceptable Gap accounting methods to test
test
accuracy so here we see the significant
accounts such as inventory and cost of
goods sold and each of the management
assertions and what could go wrong so
for example when we look at existence we
have items that are included in the
inventory records are not actual items
in inventory when we're looking at
completeness that means that some items
may not be in inventory
as it relates to the management
assertions of cut off we're looking at
inventory transactions that occurred
near year end but we're not recorded in
the correct period as for valuation
we're looking at the in inventory cost
flow assumptions such as fifo or lifo
that they have been applied incorrectly
or the proper costs for direct materials
direct labor and Manufacturing overhead
are not allocated to the actual
inventory that was produced when it
comes to presentations and disclosures
we're looking at inventory that might be
pledged as collateral that has not been
disclosed or cost flow assumptions that
are not disclosed because they're
misclassified among the raw materials
work in process or finished goods
inventory balance sheet accounts when
we're looking at cost of goods sold
we're thinking of the labor or materials
that may be omitted which would test the
relevant assertion of completeness and
for accuracy we're making sure that the
cost of direct material direct labor and
Manufacturing overhead have been
properly calculated so when we're
considering internal control activities
and design evaluations we are looking at
entity level controls here and those
considerations are that production runs
are authorized raw materials should be
counted and inspected as production is
undertaken the material and labor
quantities are summarized all inv
ventory items should be accounted for
whether they're used in production or
scrap or returned to inventory as
well then we're looking at production
labor reports that should be approved
and reconciled with the payroll records
and finished goods inventory production
records should be reviewed by the
production supervisor and then forwarded
by that individual to the accounting
department and we should count and
inspect the items and compare those
quantities to our perpetual inventory
records so when we're looking at the
cost accounting department reviews we're
looking at the quantity of the raw
materials and checking that to the
materials requisition we're looking at
the direct labor in the time sheets and
making sure that they coincide with the
labor distribution report we're also
looking for the application of overhead
costs and how that is allocated in the
overhead tickets and an overall cost
summary so when you're looking at the
internal control activities as they
relate to inventory we still have the
same management assertions and now we've
added we've already discussed what can
go wrong so now we're looking at the
internal control activity that we can
put in place to hopefully help us with
those relevant assertions so for example
any transfer of inventory must be
authorized right so if it's a periodic
physical inventory counts with the
reconciliations of records are performed
form that would help us with the
management assertion of existence and
then for example with cut off the
receiving reports if they're prenumbered
and use and sequenced and they're
reconciled that will help us with the
cut off and additionally for the Rights
Management assertion we would have a
separate account number to track those
inventory that is on
consignment and then when we're looking
at the assertion of presentation and
disclosure we would want to make sure
that management reviews those financial
statement disclosures and we might want
to possibly have a disclosure checklist
that's completed before we issue those
financials then for costs of good sold
our expense as it relates to the
management assertion of completeness we
would check the cost sheets are reviewed
for all the projects and the production
runs that way we're including all of the
relevant costs and we would also look at
the bill of materials and direct labor
requirements that they're approved D and
make sure that the correct cost
allocation calculations are
used as we relate to inventory as our
significant account and if we're looking
at existence we would want to inspect
the documentation of that authorization
for those inventory transfers or or
inspect the documentation of periodic
inventory accounts in that
reconciliation when we're looking at the
cut off assertion we might want to look
at those receiving reports make sure
that they are sequentially numbered and
also reconcile
them as we are looking at for example
presentation and disclosures we would
want to inspect those disclosure
checklists and look at the documentation
to make sure that it was reviewed by
management as
well and when we're looking our at cost
of good solds or cogs and if we're
looking at the completeness assertion we
would examine the documentation
of the cost sheets we would also inspect
the documentation of authorization of
the bill of materials and direct labor
requirements we want to trace that fill
of materials and those labor reports to
the job cost sheets and make sure that
included then when we look at additional
risks and additional controls as they
relate to the production cycle we would
look at the occurrence and the
completeness and then look at the
internal control activities that might
be in place but more importantly conduct
those tests of internal controls which
tests so if you're looking at occurrence
of production and those related events
that have been recorded but haven't
really occurred we would want to observe
separation of cost accounting functions
from those of the production payroll and
inventory control functions and also
look for
reconciliations when we are thinking of
the completeness that some production
documents have actually not been
recorded we would want to inspect
evidence of possibly reviewing the
numerical sequence maybe looking at the
inventory counts and comparing those to
the Perpetual records uh investigating
the reconciliation of the production
cost to the work in process inventory
tracing those receiving reports and to
the inventory and tracing materials used
to the production cost reports to make
sure everything ticks and
ties and then when we're looking at the
accuracy here where the production
information and the costs possibly
haven't been recorded properly or
calculated properly we would want to do
comparisons we would also want to
investigate the material and labor usage
reports and then look at evidence that
the act the client actually reconciled
the inventory counts to the Perpetual
records when we are looking at cut offs
so this is that the production events
have not really been recorded in the
correct accounting period Then what we
would do as external Auditors is to
vouch the dates of the inventory records
to those receiving reports and inspect
the production data make sure that that
agrees with our finished goods inventory
and then also inspect the production
reports and make sure they agree with
the journal entry that were posted then
when we're looking at classification
which basically tells us that the
production materials have not been
recorded in the correct account we'd
want to look for some supervisor
allocations test that allocations and
make sure that the supervisor signature
was there as some sort of attribute to
show that they reviewed it so when we're
looking to test the production cost
controls we're going to look for the
completeness direction so here you see
the purchase orders and we would take a
sample and make sure that they were
authorized and then we would match that
sample to the bill of materials and then
make sure that the issue slips those
materials used in the production reports
we test it back and also to the labor
reports as
well then when we're looking at the
occurrence uh management assertion we
might have the issue slips for the
materials that were using used then make
sure that those material used are
actually in the production cost Reports
look at the overhead analysis and labor
reports and make sure that everything
was recorded properly so we would vouch
the labor and vouch the overhead and compare
compare
those and now when we're looking at our
substantive procedures in order to audit
inventory obviously our significant
account is inventory and then each of
the management assertions that we disc
us so we already know what could go
wrong the internal act control activity
and the test of controls so now what
we're focusing on is our possible
substantive analytical procedures and
our test of details so for the Existence
management assertions of inventory we
would compare inventory turnover ratios
to possibly budgets and year over year
we can also compare the gross profit
percentage to budget and previous years
and then in terms of substantive test of
details we would have to observe the
client's physical inventory count that
is required by the pcaob auditing
standards then we would confirm any
inventory that was held on consignment
and vouch the in items that are listed
in inventory to those inventory count
tacts that were conducted during the
physical inventory
observation when we're looking at
completeness then we would look for to
observe not only the client's physical
inventory count but then ensure that all
items were counted and then Trace those
counts to the inventory listing when we
are looking at the management assertion
of cut off we're going to look at the
sales and purchase and perform cut off
tests by possibly looking at the last
few invoices 5 to 10 in the first few
and making sure they were recorded in
the correct
period Then when we're looking at
valuation as the relevant manag
management assertion in order to perform
analytical procedures we would possibly
compare the average unit costs of
inventory with prior periods and the
purchase records and when we are looking
at the possible substantive test of
details we're going to actually test
that mathematical accuracy of the
application for the cost flow
assumptions and then additionally we can
vouch the inventory cost to the standard
costs and then recalculate those
standard costs as well when we are
looking at the right management
assertion here we would inquire of
management whether any inventory was
held on consignment for anyone
else and then when we look at
presentation and disclosure when we're
looking at the possible substantive test
of details we're going to inquire
whether inventory has been pledged as
collateral or security for some form
we're also going to perform the bank and
Loan confirmations and inspect those
lending agreements or any other
contracts that might have used inventory
as collateral additionally we are going
to review the inventory calculations to
make sure that there is proper
classification for the raw materials the
work in process and the finished goods
which are the three inventory accounts
entity and then we might also vouch the
classification of the inventory records
to those subsidiary records as
well and now we're looking at cost of
good sold or
cogs if we're looking at the
completeness assertion then when we're
looking at our analytical procedures we
might compare the unit costs of
production with prior periods or with
budget and then compare the actual
production units to what was budgeted
and then when it comes to sub stantive
test of details we will trace the labor
costs from the payroll reports to the
production cost
sheets and then if we're looking at the
cost of goods sold as it relates to
accuracy we will recalculate those standard
standard
costs and now when we talk about the
physical inventory which is the client
that they're going to do the count we
would have certain instructions for them
such as like how many what are the names
of the team members what are the dat
what are the instructions to the team
members are making sure that there isn't
any obsolete or damaged items we're
going to look at the tag control making
sure that everything was counted we're
going to ensure that the client has shut
down production we are also going to
control the inventory movement such as
shipping and receiving nothing can come
in or go out so it stays so we can get a
a pH like an accurate physical count
we're going to look at the instructions
for the supervisory approval and then
make any changes or corrections as they are
are
necessary and then when it comes we're
going to observe the inventory count
then we're going to test the prices and
the compilation of those counts and then
perform our own analytical procedures
making sure do we have excessive
inventory what are those slow moving
inventory items and will we have to
write them
off and then we are required as external
auditors to make or observe some
physical count of the inventory and then
apply the appropriate tests of those
transaction so usually we would make
some test counts at the time and then
either roll forward or roll back those
test counts to ensure that that count
was accurate we're also going to review
the client instructions hopefully stop
the flow of goods and when we make these
test counts we're going to do them from
the inventory listing or from the
warehouse floor and then or and then
record everything in our workpaper so
from sheet which is the warehouse list
the inventory listing to floor or floor to
to
sheet and then we want to make sure that
we listen to the instructions that were
provided to the count team and then
understand if the client is using some
type of control tags or count sheets and
we don't want any Hollow squares or
empty boxes so we want to make sure that
we ensure that we want toate tour
shipping and receiving areas look for
any obsolete or slow moving inventory
confirm if any inventory is on
consignment and if we need to we might
use Specialists and then we also have to
look at inventory in transit as an external
external
auditor so most companies thankfully use
some sort of Technology when they are
doing inventory accounts such as
scanners or the rfids we also have now
drone technology
and that can be used for example if you
want to do physical observations of farm
animals like cattle or do consistent
loan Ware uh locations of warehouses as
well so new technology is helping us be better
better
Auditors and then when we're looking at
the valuation or the price tests we're
going to look at the vendor invoices and
get our inventory valuation which is
fifo or lifo or weighted average or
specific identification and then
remember to make sure that we apply the
lower of Coster Market to our inventory
valuation check all of the extensions
and footings and make sure that we agree
the valuation to our general
ledger and then when we're looking at
the presentation and disclosure
assertions we're going to make sure we
look for occurrence rights and
obligations completeness
classification and understanding and
accuracy and
valuation so when we consider the
application of the audit risk model so
basically what we're trying to do here
is apply the audit risk model to test
the assertion of existence in the
production cycle so as you can see below
we have the extent of the substantive
inventory procedures that we would
conduct for the Existence assertions and
that can be accomplished based on the
detection risk so if we have low
detection risk then we would observe the
physical inventory count at year end
we're going to take a substantial number
of test counts and we're going to use
large samples for vouching those
inventory purchases we're also going to
perform analytical procedures during
planning and at the audit completion now
if we have a high detection risk then
we're going to rely heavily on the those
analytical procedures we're going to
observe these cycle counts in inventory
but then rely on the roll forward
much so some fraud red flags as they
relate to inventory if we see
uncontrolled access to inventory that
means inventory can possibly be stolen
if we have several high dollar items
that with market value if we have
unexpected count during the inventory
that might be of concern if there are
large differences between the counts and
the inventory records that could also be
considered a red flag if the inventory
shows signs of damage or obsolescence or
too much quantities that could be a red
flag if there are some type of unusual
internal plant transfers during physical
inventory at the end of the year that
could be of concern as well and if the
client is reluctant to move merchandise
to allow for the inspection or if the
merchandises are located behind
something and you don't get access to it
as an external auditor that could also
be considered a red
flag so one of the key tools is idea and
that is a data mining software that is
typically used in auditing and now we
also use altrix as well and so those are
both data mining softwares and what we
can do in terms of inventory testing we
can actually apply this equation right
beginning balance plus purchases minus
inventory usage equals our ending
balance and we can actually practice
with what would happen and if you look
in your textbook these exercises here
will walk you through step by step on
how to use ID and I highly recommend
it then we have what the pcaob the
public Company accounting oversight
board tells us in terms of expection de
deficiencies so if the fa firm failed to
perform those sufficient procedures as
they relate to inventory a significant
portion of that issuer's inventory was
Lo located in one warehouse and the firm
selected for testing a control over the
existence of this inventory so the
control required that at least 80% of
the inventory storage locations at this
Warehouse be counted at at least once a
year the firm failed to evaluate whether
this control was designed to
appropriately address the risk as it
relates to the existence of inventory so
specifically what happened here is that
the audit firm did not evaluate whether
this control which required that only
80% of the inventory storage locations
be counted could effectively prevent or
detect a material misstatement of the
inventory that was located in this
particular particular
Warehouse so then we have substantive
tests of inventory so the PCA will be
requires external Auditors to perform
detailed inspections of the audit
process employed by each firm auditing
publicly traded corporations so a formal
inspection report would be issued by the
pcaob for each firm that they inspected
and in a recent inspection report the
pcaob highlighted the importance of
substantive testing of the client's
inventory so the first listed deficiency
was identical in multiple inspection
reports indicating the focus of the
sample size by the pcaob so the sample
size The Firm used in certain of its
substantive procedures to test certain
items of inventory were too small to
provide that sufficient and appropriate
audit evidence because those procedures
were designed design based on the level
of control Reliance that was not
supported due to the deficiency in the
firm's control and testing so in the
substantive testing the firm identified
differences in those unit costs of
inventory between the system but really
didn't perform anything to see what
caused that difference and this was of
KPMG as you can see here and recently in 2021
2021
Click on any text or timestamp to jump to that moment in the video
Share:
Most transcripts ready in under 5 seconds
One-Click Copy125+ LanguagesSearch ContentJump to Timestamps
Paste YouTube URL
Enter any YouTube video link to get the full transcript
Transcript Extraction Form
Most transcripts ready in under 5 seconds
Get Our Chrome Extension
Get transcripts instantly without leaving YouTube. Install our Chrome extension for one-click access to any video's transcript directly on the watch page.
