CHAPTER FIVE

AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE

1. NATURE OF INVENTORY AUDIT

A number of factors complicates audit of inventory:

 Variety (diversity) of items
 High volume of activity
 Various (sometimes complex) valuation
 Difficulty in identifying obsolete or defective inventory
 Many frauds involve the inventory account
 Easily transportable making it subject to double counting
 May be stored at multiple locations, some may be remote
 May be returned by customers

2. FLOW OF INVENTORY
 Receiving raw materials
 Put raw materials in to storage
 Put raw materials in to production
 Put finished goods in to storage
 Ship finished goods to customers

3. BUSINESS FUNCTIONS IN THE CYCLE

The sequence of functions in the inventory and warehousing cycle are the following:
a. An employee recognizes a need for purchase; completes a requisition and sends it to
purchasing (Requisitioning)
b. Purchasing shops for the appropriate quality at the best price, then prepares a
purchase order
c. When goods arrive from the vendor, the receiving department inspects, counts, and
prepares a receiving report (Receiving)
d. Goods are moved from receiving to a warehouse; raw materials perpetual inventory
master file is updated.
e. When needed, goods are moved from the warehouse to production; raw materials
perpetual inventory master file and cost accounting records are updated.
f. When finished, goods are moved from production to the warehouse; finished goods
perpetual inventory master file and cost accounting records are updated.
g. When sold, goods are shipped and perpetual inventory records are updated.

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4. ACCOUNTS AFFECTED

 Raw materials
 Direct labor
 Manufacturing overhead
 Work-in-process
 Finished goods
 Cost of goods sold etc

5. AUDIT OF INVENTORY

Part of audit Cycle in which tested

Acquire and record raw materials, labor, and Acquisition and payment
overhead plus payroll and personnel
Internally transfer assets and costs Inventory and warehousing
Ship goods and record revenue and costs Sales and collection
Physically observe inventory Inventory and warehousing
Price and compile inventory Inventory and warehousing

6. AUDIT OF COST ACCOUNTING

a. Cost Accounting Controls

 Physical controls over raw materials, work in process, and finished goods
 Purpose: to prevent loss of inventory due to theft or misuse
 Control Measures:
 Physically segregate storage areas for raw materials, work in process, and
finished goods
 Restrict access to storage
 Assign responsible custodian
 Use of prenumbered documents
 Segregation of duties (e.g. separate responsibility for perpetual inventory
master file from custodian of inventories)

 Controls over related costs

o Integrate production and accounting records for the purpose of pricing finished
goods, controlling costs, and costing inventory.

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b. Tests of cost accounting

 Auditor‟s primary concerns:

i. Physical controls over inventory
 Suggested procedures: Observation and inquiry

ii. Documents and records for transferring inventory

 Test for existence of recorded transfers
 Test whether all actual transfers were recorded
 Test for the accuracy of the quantity, description, and date of all recorded
transfers

Specific procedures:
 Understand internal controls for recording transfers
 Account for a numerical sequence of raw materials requisition
 Examine raw materials requisition for proper approval
 Compare raw materials requisitions with raw materials perpetual inventory
master file (for quantity, description, and date of all recorded transfers)
 Compare completed production records with perpetual inventory master file

iii. Perpetual inventory master file

 Test for the reliability of master file. The reliability of perpetual inventory
master file affects the timing and nature physical examination. How?

Degree of reliability Timing Nature of tests required

Accurate Interim physical inventory Few tests
Less Accurate End of year physical More (detailed) tests of
inventory inventory physical counts

 Procedure: Examine documents supporting additions and reductions of

inventory amounts in master file

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 iv. Unit Cost Records

 Procedures:
 Understand internal controls in costing accounting systems
 Trace the units and unit costs of raw materials to additions recorded in
Perpetual inventory master file
 Trace the total costs to cost accounting records
 Trace the payroll summary directly to production cost records
 Determine the reasonableness of manufacturing overhead allocation
methods and their consistency

7. ANALYTICAL PROCEDURES

 There are two types of analytical procedures:

a. Analytical procedures based on financial information
e.g. inventory turnover, unit costs, inventory value, manufacturing costs etc.
b. Analytical procedures based on nonfinancial information
e.g. size of inventory products, weight of inventory products, methods of storage, the
capacity of storage facilities

Analytical procedure Possible misstatement

Compare gross margin percentage Overstatement or understatement of

with that of previous years inventory and cost of goods sold
Compare inventory turnover (cost of Obsolete inventory overstatement or
goods sold divided by average understatement of inventory
inventory) with that of previous year
Compare unit costs of inventory with Overstatement or understatement of unit
those of previous years costs, which affect inventory and cost of
goods sold
Compare extended inventory value Misstatements in compilation, unit costs, or
with that of previous years extensions, which affect inventory and cost
of goods sold
Compare current year manufacturing Misstatements of unit costs of inventory,
costs with those of previous years especially direct labor and manufacturing
(variable costs should be adjusted for overhead, which affect inventory and cost
changes in volume) of goods sold

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8. PHYSICAL OBSERVATION OF INVENTORY

Many organizations rely on a physical inventory count at the end of their financial year in
order to arrive at a figure for inventory in their financial statements. Even if an entity
maintains „sophisticated‟ inventory records, with continuous accounting records for
inventory, the accuracy of these records should be checked by means of regular physical
counts of inventory.
It is important to appreciate the relative responsibilities of management and auditors with
respect to inventory counts.
 It is the responsibility of management to arrange for physical counts to be made and
to establish appropriate procedures for counting, to ensure that a complete and
accurate count is taken. (It is the responsibility of the company‟s directors to ensure
that the valuation of inventory in the financial statements is reliable.)
 It is the responsibility of the auditor to gather evidence from which he can reach a
conclusion on the figure for inventory in the financial statements. Observation and
other audit procedures performed by the auditor at the inventory count will provide
some of this audit evidence.

8.1 Auditing Standards: Inventory Observation Requirements

The auditor‟s attendance at the physical inventory count is covered by ISA 501 Audit
evidence – Additional considerations for specific items. The requirements of ISA 501 in
respect of inventory state that if inventory is material to the financial statements, the auditor
should obtain sufficient appropriate audit evidence regarding the existence and condition of
inventory by attendance at physical inventory counting unless impracticable. The purpose of
such attendance is given as being to:
 Evaluate management‟s instructions and procedures for recording and controlling the
results of the count.
 Observe the performance of management‟s count procedures.
 Inspect the inventory.
 Perform tests counts.
 Perform audit procedures over the final inventory records to determine whether they
accurately reflect the results of the count.

Each of these areas, along with other issues, are considered below.

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8.2 Counting Procedures-Inventory Count Instruction
It is the responsibility of management to arrange the inventory count and to establish
effective procedures to ensure that a complete and accurate count is taken. The auditor
attends the count as a means of obtaining audit evidence.
This evidence will be used, together with other appropriate evidence, to reach a conclusion
on the value of inventory in the financial statements.
It is important that the auditor should be confident that the inventory counting procedures
organized by the client‟s management will ensure a complete and accurate count.
The following procedures should therefore be in place:
 The directors of the client entity should issue written instructions for the inventory
count, well in advance of the count.
 The instructions should be reviewed by the auditor before the count takes place.
 The auditor needs to be satisfied that the instructions for the count are such that a
complete and accurate count will be taken.
 If the auditor is not confident in the instructions, the matter should be brought to the
attention of management, and suitable amendments to the counting procedures should
be requested.

The instructions issued by management for the inventory count should cover the following
areas:

Area Comments
(1) Adequate planning of the Planning must be sufficient to ensure that the work will be
count. carried out precisely and systematically. The planning
should provide for the following:
 The early issue of counting instructions to the staff
who will do the counting. There should be
arrangements for the staff to comment on the
instructions and discuss them with management, and
for suitable amendments to be made to the
instructions if appropriate.
 Deciding the date of the count.
 Identifying the locations at which inventory is held.
 Ensuring that sufficient staff are available to conduct
the count.
 There should be procedures for identifying high-
value items (for which accurate counting is

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 essential).
 There should be procedures to control or stop
production and the movement of inventory during the
count, in order to make sure that all inventory is
counted.
 There should be procedures for ensuring a clean
inventory cut-off (see discussion in section below).
(2) The inventory should be
divided into manageable
sections for the purpose of
controlling the count.
(3) There should be proper The instructions should give clear guidance about the units
instructions for counting, of measurement that should be used for the count; for
weighing, measuring, and example, single units, units of 100, units of 1,000 etc.,
checking. measurement by weight, and so on.

Counting should be carried out by teams of two (one person

to act as counter and the other person to act as a checker).
(4) There should be This inventory should be excluded from the inventory
procedures for identifying valuation for the statement of financial position.
inventory on the entity‟s
premises that is owned by For example, inventory may be supplied to the entity on a
third parties. sale or return basis; this is legally owned by the supplier.
(5) There should be These procedures are necessary in order to identify
procedures for identification inventory whose NRV may be below cost.
of defective, damaged,
obsolete and slow-moving
inventory.
(6) There must be Pre-numbered documents should be used.
appropriate documentation
for recording the count. Typically, these are tags for attaching to counted inventory
items (containing details of the counted items) and
sequentially-numbered sheets on which details from the
tags are summarized, with the tags listed in numerical
order.
Controls over documentation should include keeping
records of the tags and sheets that have been used, and
accounting for all these documents at the end of the count.
Records should be kept of the documentation issued.
(7) There should be For example, the entity may supply goods to customers on
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procedures for identifying a sale or return basis.
and quantifying inventory
belonging to the client but The auditor will probably seek to verify the quantity and
value of these items of inventory by writing to the other
held by other entities.
entities concerned and asking them for written confirmation
of the amount of the client‟s inventory that they are
holding.

8.3 Audit Work Relating to the Inventory Count

The main financial statement assertion addressed by the auditor‟s attendance at the
inventory count is existence. However, the audit work at the count (and after the count) will
also generate evidence relating to:
 valuation, and
 ownership (rights and obligations).

It is convenient to deal with the auditor‟s work on the inventory count under three headings:
 Before the Count: Planning
 During the Count: Observing and Recording
 After the Count: ‘Follow-up’.

8.3.1 Audit Work Before the Count: Planning

The auditor should carry out the following planning tasks before the inventory count:
 Review the audit files for previous years, to find out whether problems were
encountered with the inventory count on previous audits. If so, the auditor should
plan to make sure that similar problems do not occur again this year.
 Review (for adequacy) the instructions for the count that have been prepared by the
client entity‟s management: suggest appropriate changes if necessary.
 Establish the date, time and location of the count.
 Decide which counts at which locations will be observed by members of the audit
team.
 Establish whether any inventory is held by third parties. If so, decide whether written
confirmation is needed in respect of inventory held by third parties.
 Make arrangements with a local firm of auditors to attend a physical count location if
the audit firm‟s own auditors are unable to do so.
 Consider the possible use of the client‟s internal audit department, which may be
involved in checking inventory counts.

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  The auditor in charge should make a requisition for the appropriate number and grade
of audit staff to observe the inventory counts.
 He may also circulate these instructions to members of the audit team and invite their
comments.
The auditor in charge should also plan the audit for the inventory count.
 He should become familiar with the client‟s inventory. He should give particular
attention to high value or complex inventory items.
 He should decide the scope of the audit testing to be performed during the count,
based on materiality and risk considerations.
 He should consider whether there is a need to use an expert to assist with the count of
complex items.

8.3.2 Audit Work During the Count: Observing and Recording

What is the purpose of attending an inventory count?

The auditor should attend inventory counts by the client for the following reasons.
 Tests of control. To ensure that the inventory count is carried out by the client
entity‟s employees in accordance with their instructions. Also, to look for any control
weaknesses in the inventory counting system.
 Substantive tests. To ensure that there is no material misstatement at the assertion
level in the client‟s financial statements. This means not just checking that the
inventory does exist, but also that the method of valuation is appropriate. For
example, if some inventory appears to the auditor to be in deteriorating condition, or
if there is evidence of slow-moving items (from dates on the inventory containers) the
auditor should consider whether inventory should be valued at Net Realizable Value
(NRV) rather than cost.

Procedures at the count

The inventory count should be a fairly straightforward procedure. The client will appoint
employees to carry out the count and will give instructions about how the count should be
performed. The counters are given count sheets to record the quantities for each inventory
item. These count sheets are handed out at the beginning of the counting process (although
additional sheets may be handed out later).

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 When inventory has been counted, it should be marked or tagged. This is to prevent the
same inventory from being counted twice. It also helps with identifying inventory items that
have not yet been counted.
On completion of the count, each count sheet should be signed by the counter responsible
for filling it in. All the sheets are handed in for recording and summarizing.

What will be the work of the auditor during the inventory count?
During the physical inventory count, the auditor should observe the count and make
his own records.

i) Observe
During the count, the auditor should:
 Observe whether or not the count is being conducted in accordance with the written
instructions of the client‟s management
 Observe the condition of the inventory, in order to identify items where NRV might
be below cost (and in particular, inventory that seems to have deteriorated in
condition)
 Observe whether or not inventory not owned by the client entity is properly
identified and labelled (for example, inventory owned by customers but held on the
entity‟s premises)
 Observe whether or not, during the count, production of new inventory and the
movement of inventory are controlled and properly documented, in accordance with
management‟s instructions for the count
 At the end of the count, observe whether or not all inventory items have been
counted and tagged accordingly.

 It is normal practice for the auditor to prepare an inventory count memorandum

recording his observations in the audit files. The memorandum should include a
conclusion on the effectiveness of the count procedures.
ii) Record
The auditor should also prepare some records relating to the inventory count:
 The auditor should carry out a sample of test counts.
o Audit staff will count items of inventory selected for the sample and compare
the quantity they have counted with the quantity recorded by the client‟s staff.
This will test that recorded inventory is complete.
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 o They should also select a sample of items from the client‟s count records and
count those items themselves. This will test that recorded inventory exists.

Any differences should be discussed with the client and resolved. The results of the
test counts should be recorded.
 The auditor should make a record of the sequence numbers of the last tags and
summary sheets used during the count. This record will be used after the count to
confirm that all inventory items are included in the client‟s inventory list.
 The auditor should also record cut-off information. Typically, he will record details
of the last few Goods Received Notes (GRN) issued before the count and then first
few Goods Received Notes issued after the count. Similar information should be
recorded relating to Dispatch Notes. This helps to establish the financial year in
which inventory items were physically received or physically dispatched so that the
auditor can subsequently check the cutoff assertion for sales and purchases.
 The auditor should record details of slow-moving or obsolete inventory, or inventory
in poor condition, observed during the count. This will provide evidence to
subsequently support the valuation assertion.

8.3.3 Audit Work After the Count: Follow up

The final audit work on inventory may take place several weeks after the inventory count
itself. In the intervening period the client should have calculated a final inventory figure for
the financial statements.
One of the main objectives of the audit work on inventory quantity at this stage is to ensure
that the inventory quantities that existed at the count date are properly reflected in the final
inventory figure in the financial statements (the completeness and presentation and
disclosure assertions). (Note: At this stage, the auditor should also carry out his checks on
the valuation of inventory items, described in the next section.)
The audit work involved in verifying inventory quantities will include the following:
 Obtaining the final inventory sheets that were prepared by the client‟s staff during
their inventory count.
 Check the numerical sequence of the sheets and the auditor‟s record of the last sheet
number, to confirm that no sheets are missing.
 Check the numerical sequence of tag numbers listed on the sheets and the auditor‟s
record of the final tag number, to confirm that no inventory items are missing from
the sheets.

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  Check the arithmetical accuracy of the calculations on the sheets.
 Confirm that inventory records have been amended as appropriate. For some
inventory items, there is likely to be a difference between the physical count numbers
and the quantity of stock shown in the client‟s inventory records (where a continuous
recording system is used). In these situations, the client‟s inventory records will be
incorrect. The auditor should therefore check that the inventory records were
amended.
 Confirm that inventory belonging to the client, but held by third parties, is included
on the inventory sheets.
 Confirm that inventory belonging to third parties, but on the client‟s premises at the
date of the count, is not included on the inventory sheets.
 Check that cut-off is correct. This is done by reference to the cut-off information
recorded at the time of the count.

Having done all this work, the auditor should be able to reach a final conclusion on the
quantity of inventory held at the end of the reporting period.

8.4 Possible Control Weaknesses in an Inventory Count

Control weaknesses in the client‟s inventory counting procedures may be observed by the
auditor. These might include:
 Failure to pre-number the count sheets. All count sheets should be prenumbered, so
that they can all be accounted for at the end of the count and none are „lost‟ (and none
are counted twice).
 Including on the count sheet for each inventory item the quantity of the inventory
as recorded in the entity’s inventory records. The counters should not be told what
quantity of inventory to „expect‟ for each item, because this may influence them to
expect in advance how much inventory to „look for‟.
 Entering the quantities counted on the count sheets in pencil. Entries in pencil can
be erased and altered later, fraudulently, without leaving trace of the alteration.
 Stores staff are commonly used to do the counting. However, if all the counters are
from the stores staff, there is a risk that they may collaborate to hide errors or missing
inventory. The client should therefore use some other non-stores staff to assist in the
count, such as some employees from the accounts department.
 Inventory may not be marked when it is counted. This gives rise to a risk that items
of inventory will be counted twice, and possibly that some items will not be counted
at all.

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  Count sheets may not be signed by the individual counter who prepared them. If
there is no signature on the count sheet, it may be difficult to refer queries back to the
counter if a problem arises.
 Lack of precise instructions to the counting team. The counting team must be given
precise and specific instructions about how to perform the count. If the counting team
is left to decide itself how the count should be conducted, this will increase the risk of
mistakes in counting – such as missing out some items and double counting others.

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 Common tests of details of balances audit procedures for physical inventory
observation are summarized in the table that follows:
Audit Common inventory observation procedures
Objective
Existence  Select a random sample of tag numbers and identify the tag with that
number attached to the actual inventory
 Observe whether movement of inventory takes place during the count
Completeness  Examine inventory to make sure that it is tagged
 Inquire as to inventory in other locations
 Account for all used and unused tags to make sure none are lost or
intentionally omitted
 Record the tag numbers for those used and unused for sequential
follow-up
Accuracy  Recount client‟s counts to make sure the recorded counts are
accurate on the tags
 Compare physical counts with perpetual inventory master file
 Record client‟s counts for subsequent testing
Classification  Examine inventory descriptions on the tags & compare with the
actual inventory for raw materials, WIP, & finished goods
 Evaluate whether the percent of completion recorded on the tag for
WIP is reasonable
Cutoff  Record in the audit files for subsequent follow up the last shipping
(timing) document number used at year-end
 Make sure the inventory for the above item was excluded from the
physical count
 Review shipping area for inventory set aside for shipment but not
counted
 Record in the audit files for subsequent follow up the last receiving
report number used at year-end
 Make sure the inventory for the above item was included in the
physical count
 Review receiving area for inventory set aside for shipment but not
counted
Valuation  Test for obsolete inventory by:
(realizable  inquiry of factory employees & management
value)  being alert for items that are damaged, rust or dust covered, or
located in an inappropriate place
Rights  Inquire about consignment or customer inventory included on
client‟s premises
 Be alert for inventory that is set aside or specially marked as
indications of non-ownership
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9. CUTOFF
Cutoff is a test used to ensure that all of the company‟s transactions have been included in
the correct period.
9.1 Purchases cutoff
All purchases for which goods have been received before the year end must be included in
the financial statements as a liability, expense and closing (ending) inventories.
Goods received after the year end should not be included in the financial statements.
For purchases cut-off, if goods are received in the year ended 31 December Year 4 and
included in closing inventory, the following entries should also be recorded in that period:
 an inventory purchases
 a payable balance.

It is important to ensure that if an asset (inventory) is recorded, a corresponding liability (a

trade payable) must also be recorded.
9.2 Sales cutoff
Sales for which the goods have left the warehouse should be included within the sales and
trade receivables at the year end, but not in closing inventories.
Sales made after the year end must not be included in the financial statements but should be
included in closing inventories.
For example, if a sale is recorded in the year to 31 December Year 4, the following should
also be recorded in that period:
 a receivable balance
 the goods must be removed from inventory
 a cost of sales entry.

This is an example of sales cut-off. In particular, it is important to ensure that the same item
is not reflected as both a receivable balance and an inventory item.
 Cutoff is usually tested by obtaining a sample of Goods Receiving Note (GRN) and
GDN (Goods Dispatch Note) either side of the year end and then matching them to
purchase/ sales invoices to ensure they have been included in the correct account
balance(s).

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10. AUDIT OF PRICING AND COMPILATION OF INVENTORY

A. Pricing and compilation controls

i. Inventory Pricing internal controls
 Purpose: To provide assurance that the client uses reasonable costs for valuing
ending inventory
 Control procedures:
 The use of standard cost records (provided that standards are updated for changes
in production processes & costs)
 Assign person responsible for review of costs independently
 Having formal review and reporting of obsolete, slow-moving, damaged, and
overstated inventory items (by a knowledgeable person)

ii. Inventory compilation internal controls

 Purposes: To ensure that inventory counts are:
 Correctly summarized
 Priced at the same amount as the unit records
 Correctly extended and totaled
 Included in the perpetual inventory master file & related GL accounts at the
proper amount

 Control procedures
 Internal verification of unit costs, extensions, & footings by competent &
independent person
 Record inventory count on prenumbered tags
 Carefully review the inventory tags before the counting personnel are released
from the physical examination of inventory

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B. Pricing and Compilation Procedures

Audit Inventory pricing & compilation procedures

Objective
Existence  Trace inventory listed in the schedule to inventory tags and
auditor‟s recorded counts for existence and description
 Account for unused tag numbers shown in the auditor‟s
documentation to make sure no tags have been added
Completeness  Trace from inventory tags to the inventory listing schedules &
make sure inventory on tags is included
 Account for tag numbers to make sure none have been deleted
Accuracy  Trace inventory listed in the schedule to inventory tags and
auditor‟s recorded counts for quantity & description
 Perform price tests of inventory
 Perform compilation tests
 Foot the inventory listing schedules for Raw Materials, WIP, &
Finished Goods
 Trace the totals to the general ledger
 Extend the quantity times the price on selected items
Classification  Verify the classification in to raw materials, WIP, & finished
goods by comparing the descriptions on the inventory tags &
auditor‟s recorded test counts with the inventory listing schedule
Valuation  Perform tests of lower of cost or market, selling price, and
(realizable obsolescence
value)
Rights  Trace inventory tags identified as nonowned during the physical
observation to the inventory listing schedule to make sure these
have not been included
 Review contracts with suppliers & customers and inquire of
management for the possibility of the inclusion of consigned or
other nonowned inventory, or the exclusion of owned inventory

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C. Test for Valuation of Inventories (Price Tests)

 Auditor‟s primary concerns:

o The use of accepted method of inventory valuation
o Consistency in the use of inventory valuation method
o Bases for inventory valuation (inventory cost vs market values such as
replacement cost, net realizable value)

 IAS 2 requires that inventory should be valued at the lower of cost or net realizable
value, on an item-by-item basis.

 Testing the pricing of purchased inventories (such as raw materials, parties and
supplies)
Step 1: The auditor must determine:
 Whether the client uses LIFO, FIFO, or other valuation method
 Which costs should be included in the valuation of inventory (freight, storage,
discount etc.)?
Step 2: Select specific inventory items for pricing
 Focus on larger Birr amounts & on products that are known to have wide
fluctuations in price
 Test a representative sample of all types of inventories & departments (using
monetary unit sampling)
 List the inventory items to be verified for pricing
 Request the client to locate the appropriate vendors‟ invoices
 Examine invoices to account for quantity & costs
 Trace unit costs to perpetual records and then to invoices

 Testing the pricing of manufactured inventories (work-in-process and finished goods)

o Audit of work-in-process and finished goods are more complex than purchased
inventories because the auditor must consider the cost of raw materials, direct
labor, and manufacturing overhead.

o Pricing raw materials in manufactured goods:

 Examine vendors‟ invoices or perpetual inventory master file to test the
unit cost of raw materials in manufactured goods
 Examine engineering specifications or inspect the finished goods to
determine the number of units required to manufacture a unit of output

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 o Testing Direct labor
 Verify the hourly costs of direct labor by examining labor payroll or
union contracts
 Verify the number of hours it takes to manufacture a unit of output by
examining engineering specifications or other sources

o Testing manufacturing overhead

 Evaluate the method being used for consistency & reasonableness
 Recompute the overhead costs to determine whether the overhead is
correct.
 Ensure only production overheads included
 Ensure based on normal levels of activity
 Use analytical procedures (e.g. compute actual overhead rate and
compare with the predetermined overhead rate)

NB. When the client has standard costs records, an efficient and useful method of
determining valuation is to review and analyze variances. Small variances in
materials, labor, and manufacturing overhead are evidence of reliable cost
records.

o Cost or market in testing inventory valuation

 Auditors must consider whether replacement or net realizable value is
lower than historical cost.
 To test for replacement cost, examine vendor invoices of the subsequent
period (or recent invoices if no purchases of an inventory were made
after year-end)
 In order to determine the Net Realizable Value, consider the sales value
of inventory items and the possible effect of rapid fluctuations of prices.

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 SUMMARY

Common tests of details of balances audit procedures for physical inventory

observation
Audit Common inventory observation procedures
Objective
Existence  Select a random sample of tag numbers and identify the tag with that
number attached to the actual inventory
 Observe whether movement of inventory takes place during the count
Completeness  Examine inventory to make sure that it is tagged
 Inquire as to inventory in other locations
 Account for all used and unused tags to make sure none are lost or
intentionally omitted
 Record the tag numbers for those used and unused for sequential
follow-up
Accuracy  Recount client’s counts to make sure the recorded counts are accurate
on the tags
 Compare physical counts with perpetual inventory master file
 Record client’s counts for subsequent testing
Classification  Examine inventory descriptions on the tags & compare with the actual
inventory for raw materials, WIP, & finished goods
 evaluate whether the percent of completion recorded on the tag for WIP
is reasonable
Cutoff (timing)  Record in the audit files for subsequent follow up the last shipping
document number used at year-end
 Make sure the inventory for the above item was excluded from the
physical count
 Review shipping area for inventory set aside for shipment but not
counted
 Record in the audit files for subsequent follow up the last receiving
report number used at year-end
 Make sure the inventory for the above item was included in the physical
count
 Review receiving area for inventory set aside for shipment but not
counted
Valuation  Test for obsolete inventory by:
(realizable  inquiry of factory employees & management
value)  being alert for items that are damaged, rust or dust covered, or
located in an inappropriate place
Rights  Inquire about consignment or customer inventory included on client’s
premises
 Be alert for inventory that is set aside or specially marked as indications
of non-ownership

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 Pricing and Compilation Procedures
Audit Inventory pricing & compilation procedures
Objective
Existence  Trace inventory listed in the schedule to inventory tags and auditor’s
recorded counts for existence and description
 Account for unused tag numbers shown in the auditor’s
documentation to make sure no tags have been added
Completeness  Trace from inventory tags to the inventory listing schedules & make
sure inventory on tags is included
 Account for tag numbers to make sure none have been deleted
Accuracy  Trace inventory listed in the schedule to inventory tags and auditor’s
recorded counts for quantity & description
 Perform price tests of inventory
 Perform compilation tests
 Foot the inventory listing schedules for raw materials, WIP, & finished
goods
 Trace the totals to the general ledger
 Extend the quantity times the price on selected items
Classification  Verify the classification in to raw materials, WIP, & finished goods by
comparing the descriptions on the inventory tags & auditor’s
recorded test counts with the inventory listing schedule

Valuation  Perform tests of lower of cost or market, selling price, and

(realizable obsolescence
value)
Rights  Trace inventory tags identified as nonowned during the physical
observation to the inventory listing schedule to make sure these have
not been included
 Review contracts with suppliers & customers and inquire of
management for the possibility of the inclusion of consigned or other
nonowned inventory, or the exclusion of owned inventory

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 ADDIS ABABA UNIVERSITY
COLLEGE OF BUSINESS & ECONOMICS
DEPARTMENT OF ACCOUNTING & FINANCE
COURSE NAME: AUDITING PRINCIPLES & PRACTICES II
INSTRUCTOR: - TEWODROS HAILU

Nationwide Company Limited

Date: 15 December 2021
From: General Manger
To: Shop Managers and Head Storekeepers
Subject: Stock take Instructions – 31 December 2021
-------------------------------------------------------------------------------
All stocks will be physically counted and recorded on Friday 31 December 2021 and shops will close at
12:00 midday to allow sufficient time for counting.

At shops, it is the manager‟s responsibility to accurately count and record stock. At stores, it is the
responsibility of the head storekeeper.

In order that the management can be certain that the count is undertaken properly, a committee member
will be in attendance at each shop. I will be present at the head office store and my deputy will attend the
area store count.

Stock sheets must clearly record the item description and number of items.

All stock sheet must be returned to head office by Saturday 8 January 2022 without fail.
------------------------------------------------------------------------------------------------------------
Note for the Auditor

STOCK AT 30 NOVEMBER 2021

Goods for Vehicles
Shops and stores Fuel $ Stationary Total $
resale Spares
Head Office store 54,500 6,000 $2,000 3,200 65,700
Head office shop 33,300 33,300
Anguna Shop 21,600 21,600
Branga Shop 19,500 19,500
Carja Shop 17,800 17,800
Kidia Shop 22,100 22,100
Edrund Shop 15,600 15,600
Fragia Shop 17,300 17,300
Carja Area Store 41,300 3,000 1,200 1,200 46,700
Total $243,000 9,000 $3,200 $4,400 259,600

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Assignment:
1) Review the stock take instruction & suggest improvements.

2) What work is required by the auditor:

a. Before the stock count;
b. During the stock count; and
c. After the stock count.

Addition Information on stock

a) Head office store has 6,000 lion brand “U2” size torch batteries. The area store and shops have a
further 5,000. These have been purchased in three lots at a cost price of $ 0.40, $ 042 and $0.45
respectively but the stock records cannot identify which lots are in which store area.
b) The acc-punts departments have calculated that the transport cost of getting the batteries from the
head office store to the area store is $0.05 per battery.
c) Cheapo supermarket (1km from Nationwide‟s head office) is selling the same batteries for $ 0.35
each.

Required: Discuss the implication of the additional information on the value of the stock items.

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