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AUDITINGBAC2664 (New), BAC2287(Old)

Topic 11, Lecture 11

Audit of Inventory and Cost of Sales Cycle

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Inventory and Cost of Sales Cycle

• The importance of inventory• Internal control and objectives of the audit• Periodic and perpetual inventory accounting system• Costing system auditing for merchandising and manufacturing• Cut-off test procedures: relationship with sales and creditors• Test on distribution: relationship between sales and accounts

receivable• Confirmation of the existence and valuation of inventories• Physical examination of inventories (‘stock-take’) • Test of pricing and summary• Lower of cost or net realizable (market) value

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Importance of Verification of Inventory

• Stock being the single largest item in the balance sheet• Audit of inventory would help to identify whether it has been stated

properly• Whether it has been understated or overstated by the client• Valuation of inventory is quite subjective• Stock figure is derived from physical count, as such it is susceptible

to manipulation• Requires consideration on obsolescence and pilferages• Any misstatement would affect gross profit and eventually the net

profit• Stocks are held at diverse locations• Valuation of stock poses measurement and identification problems• Presence of third parties stock in the stock count

Note: cases on stock manipulation (1) Kingston Cotton Mill Co. Ltd., 1896, (2) McKesson and Robbins Inc., USA 1939, (3) Allied Crude Vegetable Oil Refining Corporation of New Jersey 1963, (4) Thomas Gerrard & Sons Ltd., 1967.

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Categories of Stock

Primary division:• Goods purchased for sale• Consumables stores (oils, fuels, spare-parts)• Raw materials and components purchased for incorporation into

product for sale• Products and services in intermediate stages of completion (work-

in-progress)• Finished goods• Returnable containers

Secondary division:• Stocks assessed by physical count at year end only• Stocks assessed near the year end and the year end total obtained

by adjustment by sales and purchases• Stocks recorded on a continuous inventory system

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Stocktaking Procedures

Where stock is based on records:

(a) adequate stock record must be kept to date

(b) All categories of stock are checked physically at least once during the year and the amount found compared with the book record

(c) Checking is organized and systematic

(d) Differences found lead to correction of the records and a proper investigation of the cause of the difference

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Stocktaking ProceduresWhen stock is based on a year end count:(a) Good planning so that work carried out carefully and

systematically – early issue of stocktaking instructions with consideration of feedback from staff

(b) Division of the stock-take into manageable areas for control purposes

(c) Proper instructions for counting, weighing, measuring, checking(d) Proper cut-off arrangements(e) Identification of defective, damaged, obsolete, slow moving stock(f) Identification of stock on premises owned by third parties and of

client’s stock held by outside parties(g) Proper control over issue of blank stock sheets and the return of

completed and unused stock sheets(h) Identification of stock held subject to reservation of title(i) Identification of stocks and especially of high value items

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Stocktaking Procedures

(j) Controls of stock movement during the stock count

(k) Controls to ensure all stock is counted, and, at that, once only

(l) Nomination of people responsible for each aspect of the count

(m) Appropriate treatment for sealed containers, dangerous goods, goods with special problems

Note: items (d), (e), (h), are also important for stock based on records

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Stocktaking – Auditor’s Duties

• Auditor must satisfy himself as to the validity of the amount attributed to stock and work in progress in the balance sheet

• Does this by first considering the client’s system of internal control (examine the system by finding out what the system is, evaluating its effectiveness, and testing it)

• Auditor’s duties usually divided into three parts – (1) before observation, (2) during observation, (3) after observation, the stock-take

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Stocktaking – Auditor’s Duties

(1) Before the stock-take:(a) Review previous year’s working papers and discuss with

management any significant changes from previous year(b) Discuss stock-taking arrangements with management(c) Familiarize himself with the nature and volume of stocks and

especially with high value items(d) Consider the location of stock (e.g. branches) and the problems

thus caused for the client and the auditor(e) Consider likely points of difficulty, e.g. cut-off(f) Consider internal audit involvement and if reliance can be placed

upon them(g) Arranging to obtain from third parties confirmation of stock held by

them

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Stocktaking – Auditor’s Duties

(h) Establishing whether expert help may be needed, e.g. precious stones, antiques

(i) Evaluate the effectiveness of the instructions, especially that they cover all items, meet potential difficulties, are discussed with, and adequately communicated to stock-taking staff

(j) Review surrounding systems of internal control to identify areas of potential difficulty

(k) Plan usage of audit staff as to availability to cover all required locations

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Stocktaking – Auditor’s Duties

(2) During the stock-take (in practice, auditor attends the stock-take, to observe the client’s internal control system in action):

(a) Observe the stock-take to ascertain that the client’s staff are carrying out their instructions

(b) Check the count of a selected number of lines (found to be present with items recorded on the stock sheets)

(c) Note for follow-up: details of items selected by the auditor to compare with final stock sheets

(i) list of items counted in the auditor’s presence; (ii) details of defective, damaged, obsolete, slow moving items; (iii) instances of stock-taking instructions not being followed; (iv) details of items for cut-off purposes

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Stocktaking – Auditor’s Duties(d) Enquiry into, observe and discuss with store keeping staff the

procedures for identifying damaged, obsolete, slow moving stock(e) Enquire into and test the cut-off procedures(f) Form an impression of the magnitude of stock held for

comparison with the Accounts(g) Record fully the work done and his impressions of the stock-take

in the working papers(h) If any aspects prove unsatisfactory, inform the management and

request a recount(i) High value items should be given special attention(j) Photocopies of rough stock sheets should be taken(k) Details of the sequence of stock sheets should be verified

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Stocktaking – Auditor’s Duties

(3) After the stock-take:(a) Check the cut-off with details of the last numbers of

stock movement forms and goods inwards and goods outwards note during the year and after the year end

(b) Test that the final stock sheets have been properly prepared from the count records, in particular the record of stock-take forms issued and returned must be checked

(c) Follow-up notes made at the attendance(d) Check final stock sheets for pricing, extensions,

casting, summarizing, official’s signature(e) Inform management of any problems encountered in

the stock-take for action in subsequent counts

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Non-attendance at the stock-take

This may occur through the auditor having numerous clients all with the same accounting date or the client may have stock at remote or overseas locations.

The auditor must still satisfy on the stock-take.This can be done by:(a) Arranging for the stock-take to be at an earlier date(b) Appointing agents, e.g., for overseas locations(c) Examining continuous stock-take records more thoroughly(d) Intensifying other stock-taking verification methods(e) Using rotational methods

Note: None of the above possible reasons for non-attendance is wholly satisfactory, and the auditor must make very extensive enquiries before he gives a clean report.

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Continuous Stock RecordsSome clients which keep continuous stock records may wish to

determine the quantity of stock at the year end by extracting the balances from the stock records without physically counting the stock on the year end date.

This may be acceptable to the auditor if:(a) The auditor is satisfied that the records are very reliable, accurate,

and up to date, and either(b) (i) the whole stock is physically compared with the records on at

least one day in the year and reasonable correspondence is found, or

(ii) every item of stock is checked to the records at least once in the year in a systematic and orderly manner. The records of such checking should demonstrate reasonable concurrence between the actual stock and the records.

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Stock-takes other than at the year end

Auditing guidelines states that stock-taking carried out before or after the year end may be acceptable for audit purposes provided the records of stock movements in the intervening period are such that the movements can be examined and substantiated.

The greater the interval, the more difficult this will be.

Acceptability depends also on there being a good system of internal controls and satisfactory stock records.

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Work In Progress (WIP)All that has been said about stock applies equally to WIP, but this item presents

even greater problems of ascertainment and valuation to the directors and to the auditor.

The auditor’s investigations will include:(a) Inquiry into the costing system from which WIP is ascertained(b) Inquiry into the reliability of the costing system (is costing system integrated

with the financial accounting system)(c) Inquiry into the checks made as part of the system on statistical data

concerning inputs of materials and outputs of products and expectations(d) Inquiry into the system of inspection and reporting thereon to enable due

allowance to be made for scrapping and rectification work(e) Inquiry into the basis on which overheads are included in costs (based on

FRS)(f) Inquiry into the basis on which any element of profit is dealt with. Profit

should be eliminated from WIP. However, it is legitimate to include an element of profit in long term contract WIP in accordance with FRS.

(g) Where items such as buildings and plant are constructed internally, it is important for the auditor to make sure that if such items are under construction at the year end, they are not included twice, i.e., in fixed assets and WIP.

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Overall TestsWhile detail work on the stocks and WIP is imperative in an audit, there

are a number of overall tests which are important. These include:(a) Reconciliation of changes in stocks at successive year ends with

records of movements, e.g., purchases and sales(b) Comparison of quantities of each kind of stock held at year end

with those held at previous year ends and with purchases and sales

(c) Consideration of gross profit ratio with that of previous years, other companies, and budgeted expectations

(d) Consideration of rate of stock-turn with previous years(e) Comparison of stock figures with budgets for stock, sales,

purchases(f) Consideration of standard costing records and the application of

variances in the valuation of stock and WIP

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Valuation of Stock-in Trade, and WIP

Two problems in relation to stock which are really very fundamental to reporting profits have existed for many years. They are:

1 Valuation methods are many and various2 Disclosure of the methods of valuation used is not made

The first problem has been partly solved by FRS. This standard has met with much opposition and is in parts imprecise but it has certainly gone a long way towards solving the problem of variety of methods.

The second problem is still with us and companies have a tendency to be vague on valuation methods (e.g., what we do not know is how direct costs, production overheads and appropriate proportion of production overheads, are dealt with).

The auditor’s duty is to:

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Valuation of Stock-in Trade, and WIP

The auditor’s duty is to:• Ascertain accounting policies adopted for valuing stock• Consider the acceptability of the policies selected• Test the stock sheets or continuous stock records with relevant

documents such as invoices and costing records to determine if ‘cost’ has been correctly arrived at

• Examine and test the treatment of overheads• Test the treatment and examine evidence for items valued at net

realizable value• Test the arithmetical accuracy of all calculations• Test the consistency with which the amounts have been

computed• Consider the adequacy of the description used in the accounts

and disclosure of the accounting policies adopted

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Cut-off

Suppose, goods valued at RM50 were:(a) Dispatched and invoiced by the supplier before the

balance sheet date, and(b) Received after balance sheet date owing to delays in

transit by rail,Then, they would be included in purchases as a

consequence of (a) and they would be excluded from closing stock as a consequence of (b).

This would mean an incorrect computation of the profit.Avoiding this possibility is a vital part of the system of

internal control as applied to stock and consequently of prime concern to the auditor.

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Independent Stock-takers

In some trades, the stock is counted and valued by an independent firm of stock-takers. Examples include the jewellery, licensed and retail pharmacy trades.

The question arises as to whether this influences the extent of the auditor’s examination.

The answer is that the auditor has a duty to form an opinion on the amount at which stock is stated. He cannot simply accept an outside stock-taker’s valuation, but it is usual to do so if:

(a) He is satisfied of the stock-taker’s independence and standing (integrity and competence)

(b) He has made enquiries and is satisfied: (i) on the bases of valuation used, (ii) proper cut-off procedures were employed.

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References

• Lecture notes

• Tutorial questions

• Text – Margaret Boh, Chapter

• Past examination questions

• ACCA, MIA, MICPA, professional journals and magazines articles