Page 196 - DCOM204_AUDITING_THEORY

Auditing Theory

Notes and shipping transactions prior to the physical count, as well as transactions immediately
following it, to see if properly accounting for them.
2. Observe the physical inventory count: The auditors want to be comfortable with the
procedures company use to count the inventory. This means that they will discuss the
counting procedure, observe counts as they are being done, test count some of the inventory
themselves and trace their counts to the amounts recorded by the company’s counters, and
verify that all inventory count tags were accounted for. If company has multiple inventory
storage locations, they may test the inventory in those locations where there are significant
amounts of inventory. They may also ask for confirmations of inventory from the custodian
of any public warehouse where the company is storing inventory.
3. Reconcile the inventory count to the general ledger: They will trace the valuation compiled
from the physical inventory count to the company’s general ledger, to verify that the
counted balance was carried forward into the company’s accounting records.
4. Test high-value items: If there are items in the inventory that are of unusually high value,
the auditors will likely spend extra time counting them in inventory, ensuring that they
are valued correctly, and tracing them into the valuation report that carries forward into
the inventory balance in the general ledger.
5. Test error-prone items: If the auditors have noticed an error trend in prior years for
specific inventory items, they will be more likely to test these items again.
6. Test inventory in transit: There is a risk that company has inventory in transit from one
storage location to another at the time of the physical count. Auditors test for this by
reviewing transfer documentation.

7. Test item costs: The auditors need to know where purchased costs in accounting records
come from, so they will compare the amounts in recent supplier invoices to the costs listed
in inventory valuation.

8. Review freight costs: Company can either include freight costs in inventory or charge it to
expense in the period incurred, but it need to be consistent in its treatment - so the auditors
will trace a selection of freight invoices through accounting system to see how they are
handled.
9. Test for lower of cost or market: The auditors must follow the lower of cost or market rule,
and will do so by comparing a selection of market prices to their recorded costs.
10. Finished goods cost analysis: If a significant proportion of the inventory valuation is
comprised of finished goods, then the auditors will want to review the bill of materials for
a selection of finished goods items, and test them to see if they show an accurate compilation
of the components in the finished goods items, as well as correct costs.

11. Direct labor analysis: If direct labor is included in the cost of inventory, then the auditors
will want to trace the labor charged during production on time cards or labor routings to
the cost of the inventory. They will also investigate whether the labor costs listed in the
valuation are supported by payroll records.
12. Overhead analysis: If company apply overhead costs to the inventory valuation, then the
auditors will verify that it is consistently using the same general ledger accounts as the
source for its overhead costs, whether overhead includes any abnormal costs (which should
be charged to expense as incurred), and test the validity and consistency of the method use
to apply overhead costs to inventory.
13. Work-in-process testing: If company has a significant amount of work-in-process (WIP)
inventory, the auditors will test how it determines a percentage of completion for WIP
items.

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