Inventories and Cost of Goods SoldChapter 12

The Special Significance of Audit of InventoriesThe valuation of goods on hand and in process often presents complex and difficult issuesDetermining the quantities of inventories may require specialized techniquesInventories often represent the largest current asset of a companyMisstatements of inventories directly affect cost of goods sold and, therefore, net incomeManagement fraud has often involved the fraudulent overstatement of inventories

Controls Over the Conversion CycleSegregation of duties over purchases and custody of inventoryUse of pre-numbered requisitions, purchase orders, and receiving reportsProcedures for authorizing purchase transactions and verifying them for paymentGeneral ledger control of inventories and reconciliation to production recordsCost accounting controlsAnalysis of variances from standard costsUse of perpetual records for inventoriesUse of appropriate procedures for taking inventoryAppropriate physical controls over inventories

Objectives for the Audit of Inventories and Cost of Goods SoldUse the understanding of the client and its environment to consider inherent risk, including fraud risks, related to inventories and cost of goods sold.Obtain an understanding of internal control over inventories and cost of goods sold. Assess the risks of material misstatement and design tests of controls and substantive procedures that:Substantiate the existence of inventories and the occurrence of cost of goods soldEstablish the completeness of recorded inventoriesVerify the cutoff of transactions affecting cost of goods soldDetermine that the client has rights to recorded inventoriesEstablish the proper valuation of inventories and the accuracy of transactions affecting cost of goods soldDetermine that the presentation and disclosure of inventories and cost of goods sold are appropriate

Figure 12.1 Objectives of Major Substantive Procedures for Inventories and Cost of Goods Sold

Relating Controls to Assertions

Considerations in Planning a Physical InventorySelecting of the appropriate dateSuspending productionSegregating obsolete and defective goodsEstablishing control over the counting processAchieving proper cutoff of sales and purchases Arranging for the services of specialists

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