Auditing Chapter 21 Solution Manual

Chapter 21

Chapter 21

Audit of the Inventory and

Audit of the Inventory and War

Warehousing Cycle

ehousing Cycle



 Review QuestionsReview Questions

21-1

21-1 Inventory is often the most difficult and time consuming part of many auditInventory is often the most difficult and time consuming part of many audit engagements because:

engagements because: 1.

1. InInveventntorory is gey is geneneralrally a maly a majojor iter item on thm on the bale balancance shee sheet anet and oftd oftenen the largest item making up the accounts included in working capital. the largest item making up the accounts included in working capital. 2.

2. The nThe need feed for oror organganizaizatitions tons to havo have the the inve invententory iory in divn diverserse loe locatcationionss makes the physical control and counting of the inventory difficult. makes the physical control and counting of the inventory difficult. .

. InvInvententory tory takes akes manmany dify differferent fent formorms thas that are dt are dififficficult ult for tfor the auhe auditditor or  to fully understand.

to fully understand. !.

!. The coThe consinsiststent apent appliplicacatiotion of difn of diffeferenrent valt valuatuation mion methethods caods can be fain be fairlyrly complicated.

complicated. ".

". ThThe vale valuauatition of inon of inveventntorory is dify is diffificucult dult due to suce to such fach factotors as thrs as thee large number of

large number of diffdifferent items involved# the need erent items involved# the need to allocate theto allocate the manufacturing costs to inventory# and obsolescence.

manufacturing costs to inventory# and obsolescence.

21-2

21-2 The ac$uisition and payment cycle includes the system for purchasing allThe ac$uisition and payment cycle includes the system for purchasing all goods and services# including raw materials and purchased parts for producing goods and services# including raw materials and purchased parts for producing finished goods. %urchase re$uisitions are used to notify the purchasing depart& finished goods. %urchase re$uisitions are used to notify the purchasing depart& ment to place orders for inventory items. 'hen inventory reaches a predetermined ment to place orders for inventory items. 'hen inventory reaches a predetermined level or automatic reorder point# re$uisitions may be initiated by stockroom level or automatic reorder point# re$uisitions may be initiated by stockroom personnel or by computer. In other systems# orders may be placed for the materials personnel or by computer. In other systems# orders may be placed for the materials re$uired to produce a customer order# or orders may be initiated upon periodic re$uired to produce a customer order# or orders may be initiated upon periodic evaluation of the situation in light of the prior e(perience of inventory activity. evaluation of the situation in light of the prior e(perience of inventory activity.  )fter

 )fter recereceiving iving the the matematerials rials ordeorderedred# # as as part part of of the the ac$uac$uisitioisition n and and paymepaymentnt cycle# the materials are inspected with a copy of the receiving document used to cycle# the materials are inspected with a copy of the receiving document used to book perpetual inventory

book perpetual inventory. In . In a standard cost a standard cost inventory system# the ac$uisition andinventory system# the ac$uisition and payment cycle computes any inventory purchase variances# which then enter the payment cycle computes any inventory purchase variances# which then enter the inventory system.

inventory system.

The following audit procedures in the ac$uisition and payment cycle The following audit procedures in the ac$uisition and payment cycle illust

illustrate the rate the relatirelationship between that cycle onship between that cycle and the and the inventinventory and ory and warehowarehousingusing cycle.

cycle. 1.

1. *om*omparpare the ie the invenventontory cory cost enst entetered ired intnto the io the invenventntory sory systystem tem too the supporting invoice to determine that it was properly recorded the supporting invoice to determine that it was properly recorded and the purchase variance +standard cost system,# if any# was properly and the purchase variance +standard cost system,# if any# was properly reflected.

reflected. 2.

2. TTest test the puhe purchrchase cuase cutotoff at tff at the phyhe physisical ical invnvenentotory datry date and yeae and year&r& end to determine whether or not the physical inventory and year& end to determine whether or not the physical inventory and year& end inventory cutoffs are proper from a purchase standpoint.

end inventory cutoffs are proper from a purchase standpoint.

21&1 21&1

21-3

21-3 *ost accounting records are those which are concerned with the processing*ost accounting records are those which are concerned with the processing and storage of raw materials# work in process# and finished goods# insofar as and storage of raw materials# work in process# and finished goods# insofar as these activities constitute internal transfers within the inventory and warehousing these activities constitute internal transfers within the inventory and warehousing cycle. These records include computerized files# ledgers# worksheets and reports cycle. These records include computerized files# ledgers# worksheets and reports which accumulate material# labor# and overhead costs by job or process as the which accumulate material# labor# and overhead costs by job or process as the costs are incurred.

costs are incurred.

*ost accounting records are important in conducting an audit because *ost accounting records are important in conducting an audit because they indicate the relative profitability of the various products for management they indicate the relative profitability of the various products for management planning and control# and determine the valuation of inventories for financial planning and control# and determine the valuation of inventories for financial statement purposes.

statement purposes.

21-4

21-4 The most important tests of the perpetual records the auditor must makeThe most important tests of the perpetual records the auditor must make before assessed control risk can be reduced# which may permit a reduction in before assessed control risk can be reduced# which may permit a reduction in other audit tests are:

other audit tests are: 1.

1. TTestests of s of the the purcpurchasehases of s of raw raw matmateriaerials als and pnd pricricing ing thethereoreof.f. 2.

2. TTestests of the cos of the cost acst accocountuntining docg documumenents ants and recod records by verds by verifrifyiyingng the reduction of the raw material inventory for use in production and the reduction of the raw material inventory for use in production and the increase in the $uantity of finished goods inventory when goods the increase in the $uantity of finished goods inventory when goods have been manufactured.

have been manufactured. .

. TTestests of the reds of the reductuctioion in the fin in the fininishshed gooed goods inds invenventotory thry throurough thgh thee sale of goods to customers.

sale of goods to customers.  )ssuming

 )ssuming the perpetuals the perpetuals are determined are determined to be to be effective# physical effective# physical inventory testsinventory tests may be reduced# as well as tests of inventory cutoff. In addition# an effective may be reduced# as well as tests of inventory cutoff. In addition# an effective perpetu

perpetual inventory will allow the al inventory will allow the compancompany y to test to test the physical inventorthe physical inventory y prior toprior to the balance sheet date.

the balance sheet date.

21-

21- The continuation of shipping operations during the physical inventory willThe continuation of shipping operations during the physical inventory will re$uire the auditor to perform additional procedures to insure that a proper cutoff  re$uire the auditor to perform additional procedures to insure that a proper cutoff  is achieved. The auditor must conclude that merchandise shipped is either  is achieved. The auditor must conclude that merchandise shipped is either  included in the physical count or recorded as a sale# but not both.

included in the physical count or recorded as a sale# but not both.

-ince no second count is taken# the auditor must increase the number of  -ince no second count is taken# the auditor must increase the number of  test counts to determine that the counts recorded are accurate.

test counts to determine that the counts recorded are accurate.

21-!

21-! The auditor must not give the controller a copy of his or The auditor must not give the controller a copy of his or her test counts. Theher test counts. The auditors test counts are the only means of controlling the original counts recorded auditors test counts are the only means of controlling the original counts recorded by the company. If the controller knows which items were test counted# he or she by the company. If the controller knows which items were test counted# he or she will be able to adjust

will be able to adjust other uncounted items without detection other uncounted items without detection by the auditor.by the auditor.

21-"

21-" The most important audit procedures to test for the ownership of inventoryThe most important audit procedures to test for the ownership of inventory during the observation of the physical counts and as a part of subse$uent valuation during the observation of the physical counts and as a part of subse$uent valuation tests are:

tests are: 1

1.. //iissccuusss ws wiitth th thhe ce clliieenntt.. 2.

21-" #continued$

!. eview contracts with suppliers and customers to test for the possibility of consigned inventory or inventory owned by others that is in the clients shop for repair or some other purpose.

". 3(amine vendor invoices indicating that merchandise on hand was sold to the company.

4. Test recorded sales just before and just after the physical inventory to determine that the items were or were not on hand at the physical inventory date and that a proper cutoff was achieved.

21-%  )uditing procedures to determine whether slow&moving or obsolete items have been included in inventory are:

1. 0btain a sufficient understanding of the clients business to aid in recognizing inventory that is no longer useful in the clients business. 2. eview the perpetual records for slow&moving items.

. /iscuss the $uality of the inventory with management.

!. )sk $uestions of production personnel during physical inventory observation about the e(tent of the use or nonuse of inventory items. ". 5ake observations during the physical inventory for rust# damaged

inventory# inventory in unusual locations# and unusual amounts of  dust on the inventory.

4. e aware of inventory that is tagged obsolete# spoiled# or damaged# or is set aside because it is obsolete or damaged.

6. 3(amine obsolescence reports# scrap sales# and other records in subse$uent periods that may indicate the e(istence of inventory that should have been e(cluded from the physical inventory or included at a reduced cost.

7. *alculate inventory ratios# by type of inventory if possible# and compare them to previous years or industry standards.

21-& The auditor could have uncovered the misstatement if there were ade$uate

controls over the use of inventory tags. 5ore specifically# the auditor should have assured himself or herself that the client had accounted for all used and unused tag numbers by e(amining all tags# if necessary. In addition# the auditor should have selected certain tags +especially larger items, and had the client show him or her where the goods were stored. The tag numbers used and unused should have been recorded in the auditors working papers for subse$uent follow&up. )s part of substantive procedures# the auditor could have performed analytical tests on the inventory and cost of sales. ) comparison of ratios such as gross margin percentage and inventory turnover could have indicated that a problem was present.

21-1'  ) proper cutoff of purchases and sales is heavily dependent on the physical inventory observation because a proper cutoff of sales re$uires that finished goods inventory included in the physical count be e(cluded from sales and all inventory received be included in purchases.

To make sure the cutoff for sales is accurate# the following information should be obtained during the taking of the physical inventory:

1. The last shipping document number should be recorded in the working papers for subse$uent follow&up to sales records.

2. ) review should be made of shipping to test for the possibility of  shipments set aside for shipping and not counted or other potential cutoff problems.

. 'hen prenumbered shipping documents are not used# a careful review of the clients method of getting a proper sales cutoff is the first step in testing the cutoff.

!. ) list of the most recent shipments should be included in the working papers for subse$uent follow&up to sales records.

8or the purchase cutoff# the following information should be noted:

1. The last receiving report number should be noted in the working papers for subse$uent follow&up to purchase records.

2. ) review should be made of the receiving department to make sure all inventory has been properly included in the physical inventory.

21-11 *ompilation tests are the tests of the summarization of physical counts#

the e(tension of price times $uantity# footing the inventory summary# and tracing the totals to the general ledger.

-everal e(amples of audit procedures to verify compilation are:

1. Trace the tag numbers used to the final inventory summary to make sure they were properly included and the numbers not used to the final inventory summary to make sure no tag numbers have been added.

2. Trace the test counts recorded in the working papers to the final inventory summary to make sure they are correctly included.

. Trace inventory items on the final inventory list to the tags as a test of the e(istence of recorded inventory.

21-12

A(A)*+ICA) ,RC./0R.

+*,. 

,+.(+IA) I+A+..(+

1. *ompare gross margin percentage with previous years.

0verstatement or understatement of inventory amounts +prices and9or $uantities,.

2. *ompare inventory turnover with previous years.

0bsolete inventory. . *ompare unit costs with previous

years.

0verstatement or understatement of unit costs.

!. *ompare e(tended inventory value with previous years.

3rrors in compilation# unit costs# or e(tensions.

". *ompare current year manufacturing costs with previous years.

5isstatement of unit costs of inventory# especially direct labor and manufacturing overhead. 21-13 /A+. ,0RCA. Q0A(+I+* ,RIC. + 5. I(C)0/./ I(

12-31-'& I(6.(+R* .7+.(I(

11&24&11 12&4&11 2#! 1#; <2.6 <2.27 6 = <2.6 1#; = <2.27 <1#!!;. !#2 . <"#671 .

 )ssuming 8I80 inventory valuation# the 12&1&11 inventory should be valued at <"#671# and is thus currently overstated by <121.

If the 1&24&12 purchase was for 2# binders at <2.12 each# the 12&1& 11 inventory should be valued at <"#!66. +1#; = <2.12 > 6 = <2.6, and is thus currently overstated by <!2". The reason is the lower of cost or market rule# with the <2.12 being the replacement cost.

21-14 The direct labor hours for an individual inventory item would be verified by

e(amining engineering specifications or similar information to determine whether the number of hours to complete a unit of finished goods was correctly computed. 0rdinarily it is difficult to test the number of hours to an independent source.

The manufacturing overhead rate is calculated by dividing the total annual number of labor hours into total manufacturing overhead. These two totals are verified as a part of the payroll and personnel and ac$uisition and payment cycles.

0nce these two numbers are verified +overhead rate per direct labor hour  and the number of direct labor hours per unit of each type of inventory,# it is not difficult to verify the overhead cost in inventory.

21-1 'ith a job cost system# labor charged to a specific job is accumulated on a job cost sheet. The direct labor dollars included on the job cost sheet can be traced to the employee ?job time sheet? to make sure the hours are correctly included on the job cost sheet. The labor rate can be verified by comparing it to the amount on the employees earnings record.

21-1!  )ssuming the auditor properly documents receiving report numbers as a

part of the physical inventory observation procedures# the auditor should verify the proper cutoff of purchases as a part of subse$uent tests by e(amining each invoice to see if a receiving report is attached. If the receiving report is dated on or before the inventory date and the last recorded number# the received inventory must have been included in the physical inventory@ therefore the invoice should be included in accounts payable. Those invoices that are received after the balance sheet date but shipped 8.0.. shipping point on or before the close of the year  would indicate merchandise in transit.

 ultiple Choice Questions ro8 C,A .9a8inations

21-1" a. +, b. +2, c. +1,

21-1% a. +1, b. +2, c. +2,

21-1& a. +!, b. +, c. +2,

 /iscussion Questions and ,ro:le8s

21-2' ,0R,.  I(+.R(A) C(+R) +.+  C(+R) ,+.(+IA) I(A(CIA) I+A+..(+ 05+A(+I6. A0/I+ ,RC./0R.

1. 8or a proper valuation of inventory. +)ccuracy, 3(amine receiving and re$uisition documents# trace to perpetual records. 5isstatement of inventory. *ompare physical count to perpetual inventory record. 2. To make sure physical

inventory counts are accurate. +)ccuracy# e(istence and completeness, 0bserve counting personnel and discuss with client. 5isstatement of inventory. *ompare physical count to perpetual inventory record. . To make sure inventory

compilation is accurate. +)ccuracy, 0bserve who compiles the inventory and discuss with client. 5isstatement of inventory. eperform clerical tests of inventory compilation.

21-2' #continued$ ,0R,.  I(+.R(A) C(+R) +.+  C(+R) ,+.(+IA) I(A(CIA) I+A+..(+ 05+A(+I6. A0/I+ ,RC./0R. !. To ensure inventory is recorded when received# payments made are for goods received# and $uantities and descriptions are accurate. +*ompleteness# e(istence and accuracy,  )ccount for a numerical se$uence of receiving reports and observe matching invoices received from vendors. Anderstatement of inventory or payment for goods not received. Trace $uantity and description on vendors invoice to receiving report. ". To minimize theft or unrecorded shipments of inventory. +3(istence, /iscuss with client and observe whether personnel prepare shipping documents. 0verstatement of inventory. *ompare physical count to perpetual records. 4. To ensure inventory shipments are recorded as sales. +*ompleteness,  )ccount for a numerical se$uence of shipping orders. Anderstatement of sales. Trace $uantity and descrip& tion on bills of lading to recorded sales. 6. To assure reasonable

costs are used for inventory and cost of goods sold. +)ccuracy, eview procedures for determining standard costs. 5isstatement of inventory. Trace costs from supporting documents to development of standards. 7. To make sure obsolete

goods are classified as such. +)ccuracy, ead policy and discuss procedures with client. 5isstatement of inventory.  )nalytical procedures for inventory. 21&6

21-21 a; +RA(AC+I(-R.)A+./ A0/I+ 5<.C+I6. :; R.)A+./ RI= c; +.+  C(+R) 1. ecorded transactions represent valid# approved purchases +0ccurrence,.

If purchasing agents can make purchases from any vendor# there is a risk that purchasing agents may make unauthorized purchases of items not approved +for personal use,.

3nter non&valid vendor numbers into the

purchasing system to see if the related

transaction is rejected.

2. ecorded inventory may not be recorded at appropriate amounts# due to obsolescence +)ccuracy,.

'ithout information about the amount of time

inventory is in the ware& house# management is less likely to identify slow moving items that should be recorded at the lower of cost or market.

-elect a sample of inventory items from the perpetual inventory system and recalculate the number of days each item has been present in the warehouse.

. )ctual shipments of inventory are recorded in the perpetual

inventory records +*ompleteness,.

-hipments of inventory may occur but not be recorded.

-elect a sample of items in the warehouse and physically move them to the shipping areas to see if the microchip correctly removes those items from the perpetual inventory records.

!. Inventory recorded in the perpetual records physically e(ists +0ccurrence,.

Bon&inventory warehouse individuals may remove inventory without

authorization.

0bserve client personnel in the inventory ware& house and determine if each person is authorized to be in the warehouse. ". Inventory transactions

are properly classified +*lassification,.

3$uipment or supplies may be inaccurately classified as inventory if they are not physically separated from the inventory.

0bserve whether e$uipment or supplies are stored in the same physical space as inventory.

21-21 #continued$ a; +RA(AC+I(-R.)A+./ A0/I+ 5<.C+I6. :; R.)A+./ RI= c; +.+  C(+R) 4. ecorded inventory items are physically present +0ccurrence, and recorded at correct amounts +)ccuracy,. If periodic reconciliations of inventory records to physical counts are not performed# there is a risk that items may be

removed from the warehouse without knowledge# which would result in overstated inventory amounts.

Inspect the clientCs test samples for accuracy and reasonableness. In$uire about the nature of discrepancies identified.

6. )ctual inventory on hand may not be recorded in the perpetual inventory listing +*ompleteness,.

There is a risk that inventory on hand is not included in the inventory records.

Inspect the clientCs test samples for accuracy and reasonableness. In$uire about the nature of discrepancies identified. 7. The perpetual

inventory records are accurately summarized and posted to the

general ledger

accounts +%osting and -ummarization,

There could be errors in the mathematical

formulas of the inventory records.

ecalculate the inventory amounts and determine that the totals agree to the general ledger balances.

;. ecording inventory transactions represent actual receipts of inventory items +0ccurrence,.

Inventory could be added to the inventory account balance before actual goods are received.

3nter an addition to the perpetual inventory system without a valid receiving report number to determine if the system rejects the transaction. 1. ecording of inventory

in the clientCs records is valid +0ccurrence,

Inventory held on consignment may be recorded as the clientCs inventory.

0bserve whether inventory held on

consignment is stored in the same physical space as inventory.

21-22 a. It is important to review the cost accounting records and test their  accuracy for the following reasons:

1. The cost accounting records determine unit costs that are applied to derive inventory values. -ince inventory is usually material# unit costs must be verified.

2. In many companies# there are many types of inventory items with comple( cost structures. The potential for misstatement is great in determining costs. The auditor would need to go to an e(treme effort to verify such costs without being able to rely on the cost accounting records which provides the costs# +i.e.# it is far more efficient to test the cost accounting records than the costs themselves,.

. The cost accounting records also deal with transferring inventories through the production cycle and then from finished goods for sales. These transfers must be handled accurately for inventory to be properly stated.

b. 1. 3(amine engineering specifications for e(pected +standard, labor hours. 3(amine time records for hours worked on part during measured period. /ivide by units produced to test reasonableness of standard.

2. eview specifications for types of labor re$uired to produce parts# or observe production. eview union contracts or  earnings records to develop reasonable rate for this labor mi(. . Identify appropriate overhead accounts# paying careful

attention to consistent application. /etermine amounts for  these accounts for a measured period. /etermine direct labor  hours from payroll records from the same period. *ompute the overhead rate per direct labor hour.

!. eview engineering specifications. eview material usage variance.

". Trace to vendors invoices. eview material price variance. 4. -um individual components.

21-23

A0/I+

,RC./0R. +*,.  +.+ ,0R,.

1 Test of *ontrol To make sure that proper

controls e(ist and are being followed in the taking of the physical inventory.

+3(istence# completeness# accuracy and classification,

2 -ubstantive Test To ensure that all inventory

represented by an inventory tag actually e(ists.

+3(istence,

 -ubstantive Test To test the accuracy of the

clients perpetual inventory records.

+3(istence# completeness# and accuracy,

! -ubstantive Test To test clients final inventory

compilation.

+3(istence# completeness# accuracy and classification,

" -ubstantive Test To test that the final inventory

was valued at its proper cost. +)ccuracy,

4 Test of *ontrol To ensure that no raw material

was issued without proper approval.

+3(istence,

6 Test of *ontrol or  

-ubstantive Test

To ensure that additions

recorded on the finished goods perpetual records were

recorded on the books as completed production.

+)ccuracy and classification,

21-24 I+A+..(+ a; C(+R) +A+ 0)/ A6. ,R.6.(+./ +. I+A+..(+ R CC0RRI(> :; 05+A(+I6. A0/I+ ,RC./0R. +A+ C0)/ 5. 0./ + 0(C6.R +. I+A+..(+ 1 Internal verification by another person.

3(amine vendors invoices in support of prices used.

2 Deep a record of the last

shipping report number shipped before the inventory count.

3(amine bills of lading for first shipments recorded after the physical inventory to determine that they were shipped after year&end.

 %erform independent

second counts on all merchandise. )ll persons responsible for inventory tags and compilation of physical inventory should be independent of custody of perpetual inventory records.

ecord test counts and trace to compiled inventory.

! Ase of prenumbered tags

and accounting for numerical se$uence.

 )ccount for all prenumbered tags during the physical e(amination and during compilation tests.

" Internal verification of

perpetual inventory prices.

*ompare vendor invoice prices to perpetual inventory prices.

4 -egregation of obsolete

inventory.

%erform net realizable value and lower of cost or market tests of inventory# including tests of the perpetual inventory.

6 %eriodic review of

reasonableness of

manufacturing overhead rate.

Test reasonableness of

21-2 a.

Internal Controls +ests of Controls

1. Inventory purchases are used to update the

perpetual )tlanta inventory records.

Trace inventory $uantities for a sample of purchase transactions to the perpetual inventory records as a part of tests of controls and substantive tests of ac$uisition transactions.

2. Transfers of inventory are used to update the )tlanta and local distribution center perpetual inventory records.

Trace inventory $uantities for a sample of shipments from )tlanta to local

distribution centers to the perpetual inventory records.

. Inventory sales are used to update the local distribution center perpetual inventory records.

Trace inventory $uantities for a sample of sales transactions to the perpetual inventory records as a part of tests of controls and substantive tests of sales transactions.

!. Eocal distribution centers access to perpetual records is restricted to processing sales transactions.

Test the effectiveness of the perpetual records access restrictions using the *%) firmCs computer audit specialists.

". Fuarterly physical inventory is taken for comparison to and adjustment of perpetual records.

3(amine local distribution center physical inventory count records and adjustments to the perpetual records.

4. Internal auditors test the perpetual records

continuously.

3(amine internal auditor audit programs and working papers for their tests of the perpetual records and the findings. 6. Internal auditors sample

inventory counts and test inventory adjustments.

3(amine internal auditor audit programs and working papers for their tests of the physical observation of inventory and the findings.

b. There are four ways to reduce physical observation of inventory.  )uditors will use their judgment to decide which combination of these

to use.

1. educe the number of local warehouses to observe inventory counting and do test counts of inventory.

2. educe the number of auditors who observe the inventory counting at each location.

. educe the sample sizes for test counts inventory.

!. %erform the physical observation of inventory at an interim date.

21-2! a. Inventory /escription 0nits on and /ollars (u8:er of  0nits Re?uiring loor pace ,er 0nit Re?uired ?; ootage +otal ?uare ootage Re?uired to tore Inventory #0nits 9 ? ft$  )* Anit G 5odel 4" 12! <74# !1.a _{14 441.}  )* Anit G 5odel 66 16 <1#;!#;4 "66.444446a _{14 ;2!2.44446} 8urnace G 5odel 22 1;;2 <2#"7;#4 ;;4b _{14 1";4} 8urnace G 5odel 22" 27 <2#641# 1!b _{14 144!}

 )ir Handling /ucts 1177 <1#!7"#! 2;6.6"c _{2" 6!#247.6"}

<;#"72#;4 122#12!.6"

a _{2 pallets of )* units sit on top of 1 pallet that rests on the floor +12!9  !1.@}

169  "66.44446.

b _{1 furnace can sit on top of the unit that rests on the floor +1;;292  ;;4@ 2792}

 1!,

c _{ bo(es can be stored on top of the bo( that rests on the floor +11779!  2;61,}

.

b. .The above analytical procedure suggests that inventory may be significantly overstated. The amount of s$uare footage that would be needed +122#12!.6" s$uare feet, to store the stated amount of  inventory is 22.1J greater than the amount of s$uare footage +1# s$uare feet, available in the warehouse facility. The auditor would need to design further substantive tests to e(amine the e(istence of inventory at year end.

21-2" a. The auditor in this situation should observe the recording of the

shipments on the day of occurrence and record these details in the working papers so a determination can be made as to whether the shipments affected the physical inventory count.

b. 1. There is no clear&cut answer to sample size for inventory counts. The answer to the $uestion depends on additional factors# such as the randomness of your test counts and whether the values of the merchandise are relatively stratified. It also depends on inherent risk for inventory physical counts and the materiality of inventory compared to total assets. 2. e$uest a recount by the client or greatly e(pand your tests

21-2" #continued$

c. The auditor should determine how this inventory is valued and after  discussion with the client it may be well to classify it as obsolete. In all cases# the auditor must specifically identify the merchandise in the working papers for subse$uent evaluation. The auditor should also be aware that this could be an indication of widespread obsolescence problems in other parts of the inventory.

d. 0ne of the important tasks the auditor undertakes during the observation is to determine that inventory tags are physically controlled. This assures that the inventory is not understated because tags are lost# or overstated because falsified tags are added. In this situation# the auditor should recover the discarded tags and re$uest that the practice be stopped# and that control of tags be established under the auditorCs direct observation.

21-2% The following procedures should be established to insure that the

inventory count includes all items that should be included and that nothing is counted twice:

1. )ll materials should be cleared from the receiving area and stored in the appropriate space before the count.

2. Incoming shipments of unassembled parts and supplies should be held in the receiving area until the end of the day and then inventoried. . If possible# the days shipments of finished appliances should be taken to the shipping area before the count. +Anshipped items remaining in the shipping area should be inventoried at the end of  the day.,

!. Kreat care must be e(ercised over goods removed from the warehouse itself. These may be unassembled parts and supplies re$uisitioned on an emergency basis or unscheduled shipments of  finished appliances. )lternative methods for recording these removals are:

a, Deep a list of all items removed and indicate on the list whether  the item had been counted.

b, ecord the removal on the inventory tag if the item has been inventoried.

c, Indicate on the material re$uisition or the shipping order that the item had been inventoried. 8or any of these alternatives# a warehouse employee or the perpetual inventory clerk must adjust the recorded counts.

". The finished appliances remaining in the warehouse should be inventoried at the end of the day.

21-2% #continued$

4. The warehouse should be instructed to date all documents as of  the day the materials are received# issued# or shipped.

6. The inventory clerk should post the 5ay 1 production and shipment of finished goods to the inventory record based upon the dates shown on the plant production report and the shipping report. This will provide a proper cutoff because provisions have been made to adjust all counts for goods manufactured and shipped on 5ay 1. 7. The listing of inventory differences should be reviewed by the controller 

and warehouse supervisor prior to booking the adjustment. )bnormal differences should be investigated# and recounts +with appropriate reconciliation, should be made where appropriate.

21-2&

*omputer Solution. *omputer solutions in 3(cel are contained on the companion

'ebsite +8ilename is %212;.(ls,. a.

2'11 2'1' 2''& 2''%

Kross margin J 24.J 22.4J 22.!J 22.!J Inventory turnover 4.4 6.4 6.4 6.;

b. Eogical causes of the changes in the gross margin as a percent of  sales include:

1. -elling prices were raised without a corresponding increase in cost of sales.

2. The method of accounting for inventory was changed# causing a higher ending inventory +more e(penses absorbed into inventory, and lower cost of sales.

. Inventory cutoff was improper# causing sales to be recorded without the corresponding entry to cost of sales.

!. The product mi( of the company changed. 5ore high markup items were sold than in previous years.

". )n improper journal entry was recorded which adjusted the gross margin upward.

21-2& #continued$

Eogical causes of the changes in the inventory turnover include: 1. The increased selling prices# which caused the gross margin

percent to increase# reduced demand for the product# and decreased the inventory turnover.

2. The company is building its inventory supply in anticipation of  increased sales in the future.

. The companys inventory contains obsolete or unsalable merchandise# which is affecting the turnover rate.

c. 24.J & 22.4J  .6J increase in gross margin J .6J ( sales of <;2.7 million 

<#!#4 potential misstatement

<47.! million +2; *0K-, 9 6.4 inventory turnover  <;. million

<11.4 million & ;. million 

<2#4# potential misstatement

oth calculations indicate a potential misstatement e(ceeding <2##.

d. The auditor should discuss the two changes with the client and obtain a reasonable e(planation for them. He or she should then perform appropriate procedures to verify the validity of the e(planation. Altimately# the auditor must be confident the change does not result from a misstatement in the financial statements.

21-3' a. 1. 3(clude 2. 3(clude . Include !. Include ". 3(clude

b. 1. This merchandise would be e(cluded because title does not pass to buyer on an 8.0.. destination shipment until delivery to the buyer. -ince it was not received until Lanuary 212# there is no basis for including it in inventory.

2. Koods held ?on consignment? do not belong to the consignee# and should not be included in inventory.

. Bormally title to a stock item does not pass to the customer  until shipment# even though it has been set aside. Therefore it should be included in inventory.

21-3' #continued$

!. Title to goods shipped 8.0.. shipping point normally passes to the buyer on delivery to the transportation agency# and in this instance the goods belong to your client at /ecember  1# 211. There is an error in recording the ac$uisition.

". -ince this machine is fabricated to the customers order# title to customer made&merchandise passes to the buyer as materials and labor are appropriated to the job. 'hen the job is completed and ready for shipment as in this case# it may be considered as a completed sale.

21-31 a. 1. 3(tension errors are as follows:

/.CRI,+I( .7+.(I( A R.CR/./ AC+0A) .7+.(I( 6.R #0(/.R$ +A+..(+ 'ood

5etal cutting tool *utting fluid -andpaper  < 11.! 1#6!. 2!. "6;. < 11.! 1#!6. 1#!. ".6 <+ ;;.4, 26. +7., "6 . < + "4 .4,

2. The differences in the previous years and this years cost indicate a problem. The auditor should attempt to obtain support for the current years cost if the effect of the differences noted seems significant +considering that the test only covered 2J of the dollar items,. ) review for reasonableness indicates the following:

a, %recision cutting torches are e(pensive. 5aybe <7 each is a reasonable price. 3(amine a vendors invoice or a price list.

b, )luminum scrap values may fluctuate significantly. The two prices may be reasonable. Eook at sales invoices for the two years.

c, Eubricating oil cost appears unreasonable for this year  and for the previous year. The auditor should e(amine invoices for both years. If the previous years costs were incorrect# determination of the effect of the misstatements on the prior years and this years financial statements must be completed to determine the need for disclosure of the misstatements.

21-31 #continued$

. Investigate the reasons for the omission of these tags from final inventory compilation. If it is determined that the omission of two tags is significant based on the number of tags used and tested# the auditor should account for all tags to determine the total e(tent of omissions.

!. %age total footing errors are as follows:

,A>. (; C)I.(+ ++A) CRR.C+ ++A) 6.R- #0(/.R-$ +A+..(+ 1! 72 <2#6".4 4#621.17 <2#6".   4#!21.17 < .4   . <.4

b. 8irst# the auditor should keep in mind that only 2J of the inventory was tested. If sampling were random# a direct e(trapolation would magnify projected misstatements by five. In addition# the auditor must consider sampling error.

The net effect of the misstatements for which we were able to compute the actual misstatement was an overstatement of inventory by <2!!. a small amount +see items 1 and !,. However# the e(ceptions resulted from various causes including incorrect decimal placement# mathematical errors# and unit of measure errors. The auditor should determine that the net effect of the misstatements is not significant@ in addition# to insure against other individual misstatements that might be significant# the auditor should review the e(tensions and other computations for reasonableness and obvious misstatements.

8or the items for which the amount of the misstatement could not be determined# the auditor should follow up as described in 2 and  above. 8rom the results of the follow&up# the effect of the misstatements noted should be assessed and determination made as to the need for e(pansion of scope for the tests considered.

c. %rior to compiling the inventory ne(t year# 5artin 5anufacturing should implement the following internal controls:

1. eview formulas in schedule for inventory compilation. )ccuracy of spreadsheet should be independently reviewed.

2. -omeone familiar with the inventory should review the compilation schedules for reasonableness of $uantities# prices# and e(tensions.

. )ll inventory tags should be accounted for prior to posting to the compilation schedules and a control total compared to the total on the compilation sheets after the compilation is complete.

21-32 a. Becessary adjustments to clients physical inventory: 5aterial in *ar M)7142 N received

in warehouse on Lanuary 2# 212 < 7#12 5aterials stranded en route

+-ales price <1;#26 9 12"J, 1"#!14

Total 2#"4

Eess unsalable inventory 1#2"O Total adjustment <22#274

O If freight charges have been included in the clients inventory# the amount would be <1#4 and the amount of the total adjustment would be <21#;4. Lournal entry 4 probably would have a credit to purchases of <1#4 in this case. b. )uditors worksheet adjusting entries:

1. %urchases < 2#17

 )ccounts %ayable < 2#17

To record goods in warehouse but not invoicedGreceived on  14.

2. Bo entry re$uired. Title to goods had passed.

. )ccounts receivable 12#6

-ales 12#6

To record goods as sold which were loaded on /ecember 1 and not inventories&-I ;47.

!. -ales 1;#26

 )ccounts receivable 1;#26

To reverse out of sales material

included in both sales +-I ;44, and in physical inventory +after adjustment,. ". Bo adjustment re$uired.

4. *laims receivable 1#4

%urchases 1#2"

8reight In "

To record claim against carrier for  merchandise damaged in transit.

21-32 #continued$

6. Inventory 22#274

*ost of goods sold 22#274

To adjust accounts for changes in physical inventory $uantities.

7. -ales 1"#66

 )ccounts receivable 1"#66

To reverse out of sales invoices M;4;# ;6# ;6l. The sales book was held open too long. This merchandise was in warehouse at time of physical count and so included therein.

@ Case 21-33

Computer Solution. *omputer solutions in 3(cel are contained on the *ompanion

'ebsite +8ilename %21.PE-,.

 ). ) price of <7 is proper for pricing E6 spars at 12&1&11 since the ne(t shipment of spars was not received until 1&4&12. However# the ne(t invoice shows a lower cost# which indicates a decline in the value of this product. If the net realizable value +selling price less cost to sell, is less than the <7 per meter cost# the spars should be revalued to net realizable value at 12&1&11.

. The total is 1#912 feet times <1.2 per foot  <1#. In addition# the freight of <2 should have been as follows:

  <2 QQQQQQQQQQQQ 

+12#7 inches 9 12 inches per foot,  <.176" per ft.

Total inventory cost should be +<1.2 > .176" per foot, times 7 feet +1#912,  <1#1"".6; or an overstatement of inventory by <1#7!!.21.

*. 8I80 value would be:

Roucher 12&41 1# yards at <1. per yard  <1# Roucher 11&71 " yards at < ;." per yard  !#6" Inventory is overstated by <2" <1!#6" Roucher number 12&71 is not used because the receiving date is after year&end.

21-33 #continued$

/. 8I80 value would be:

Roucher 12&41 7 feet at <7. per foot  <4#! Roucher 11&71 2 feet at <7.2 per foot  1#4! <7#! Inventory is understated by <!. However# if the reduction in cost on voucher M12&41 indicates that the net realizable value of the struts is below the cost on voucher M11&71# then the net realizable value of the struts should be used as the cost. 3. %ricing is correct if the item is for inventory. It is possible that this item

should be capitalized.

8. %roper 8I80 cost is ! pair ( 2  7 springs ( <4;. each  <"#"2. Inventory is understated by <"#2!!.

K. %ricing is correct. However# the fasteners were purchased in 2! five years ago# and only eleven or 1!J have been used. *onsideration should be given as to whether net realizable value is less than cost.

21-33 #continued$

-3) KAEE )I8)53-# IB*.

-A55)S 08 IBR3BT0S

5I--T)T353BT-Quantity Price Item No. and 

Description

Per 

Inventory Correct Difference

Per  Inventory Correct   Differenc  e Recorded   Amount  Correct   Amount   Amount of  Misstatement   ). E6 -pars . 47 5etal 8ormers *. 1 5etal ibs /. -t24 -truts 3. Industrial hand drills

8. E7 -teel Eeaf -prings K. R14 8asteners # 1# 1#" 1# !" ! "." # 7 1#" 1# !" 7 "."  ;#146     G !  7. 1.2 1. 7. 2. 4;. 1. 7. 1.76" 19;."  797.2 2. 4;. 1. .  G .176" ."  G .2 . . . 2!#. 12#. 1"#. 7#. ;. 264. "". 2!#. 1#1"".6; 1!#6". 7#!. ;. "#"2. "". .  G 1#7!!.21  G 2". !. . "#2!!.   . Totalmisstatement G"#71.21 Items over <"# Items under <"#  G 11#"!.21   "#2!!. G "#71.21

*0B*EA-I0B: +see ne(t page for calculations,

35)D-There is a material potential misstatement

due to the number and size of misstatements found relative to the sample chosen. In order to

determine a more accurate estimate of the actual misstatement# additional tests are necessary.

 ). BR assumedU e(ceeds cost.

. Fuantity based on inches# not feet@ freight not included. *. " yards overpriced.

/. 2 feet underpriced. BR assumedU 0.D. 3. )ssumedU not capitalizable.

8. Includes e(tension error in inventory. K. *onsider separately for obsolescence. 2        

1         &   2                  

21-33 #continued$

PROJC!D MISS!A!MN!S /ollars tested

a8ple ite8s 0ver "# Ander <"#

Bo e(ceptions 4# 2#4  ) 2!#  12# * 1"# / 7# 3 ; 8 264 K QQQQQQQQQ "" /ollars tested !1;# #71

PROJC!D MISS!A!MN! I"NORIN" SAMP#IN" RROR$ 

5ore than <"# !#1"#

!1;# P G11#"!.21  G <1;#!74 Eess than <"# !#12"#

#71 P "#2!!  <"#4!4#!4

O Ased ratio estimation for projected misstatement. /ifference estimation results are e$ually unacceptable.

 Internet ,ro:le8 olution 0sing Inventory Count pecialists

Internet ,ro:le8 21-1

a. KI- has assisted Hines Horticulture in the physical inventory counts of HinesC products held on consignment at Home /epot stores. Hines maintains ownership of the inventory until it is scanned and sold at a Home /epot store. KI- helps Hines maintain its perpetual inventory records by providing coverage on a wide geographic basis.

b. The business arrangement between Hines and Home /epot involves HinesC products being on consignment at numerous Home /epot stores. ecause Hines maintains ownership# it must maintain accurate counts of inventory located at numerous Home /epot stores that span a wide geographic area. Hines doesnCt have the workforce needed to verify accurate counts of items on consignment at Home /epot. KI-# as an outsourced inventory count specialist#

Internet ,ro:le8 21-1 #continued$

c. The auditor has a responsibility to obtain sufficient appropriate evidence about inventory related assertions. That responsibility would not differ for inventory counted by count specialists or client personnel. The auditor would need to obtain evidence about inventory balances counted by KI- and Hines employees.

d. The fact that some of HinesC inventory is counted by KI-# a reputable inventory count specialists company# may be viewed by the auditor  as an effective internal control to support a lower control risk assessment than when the inventory is counted by Hines personnel. The auditor may also be able to send re$uests to KI- to confirm directly to the auditor inventory counts at a sample of Home /epot stores.

e. Advantages: 3(perienced inventory specialists@ Bo or very limited

management time re$uired to train employees on inventory procedures@ )bility to continue business while the counting proceeds@ *ompany employees are free to continue with their daily tasks# etc.

/isadvantages: *ompany may lose control over the counting process@

5anagement may e(perience a disconnect from the inventory counting process which might lead to a loss of information@ Inventory specialists may not be familiar with inventory if the company is in a uni$ue industry@ etc.

+(ote: Internet problems address current issues using Internet sources. ecause

Internet sites are subject to change# Internet problems and solutions may change. *urrent information on Internet problems is available at www.pearsonhighered.com9arens.,