In selecting specific inventory items for pricing, emphasis should be put on the larger dollar amounts and on products that are known to have wide fluctuations in price but a representative sample of all types of inventory and departments should be included as well. Stratified variables or monetary unit sampling is commonly used in these tests.
The auditor should list the inventory items that he or she intends to verify for pricing and request the client to locate the appropriate vendor’s invoices. It is important that sufficient invoices be examined to account for the entire quantity of inventory for the item being tested,especially for the FIFO valuation method. Examining sufficient invoices is useful to uncover situations in which clients value their inventory on the basis of the most recent invoice only and, in some cases, to discver obsolete inventory. As an illustration, assume that the client’s valuation of an inventory item is ฿12.00 per unit for 1,000 units, using FIFO. The auditor should examine the most recent invoices for acquisitions of that in ventory item made in the year under audit until the valuation of all of the 1,000 units is accounted for. If the most recent acquisition of the inventory item was for 700 units at ฿12.00 per unit and the immediately preceding acquisition was for 600 units at ฿11.30 per unit, the inventory item in question is overstated by ฿210.00 (300x฿70).
When the client has perpetual inventory master files that include unit costs of acquisitions. It is usually desirable to test the pricing by tracing the unit costs to the perpetuals rather than to vendors’ invoices. In most cases, the effect is to reduce the cost of verifying inventory valuation significantly. Naturally, when the perpetuals are used to verify unit costs, it is essential to test the unit costs on the perpetuals to vendors’ invoices as a part of the tests of the acquisition and payment cycle
Pricing Manufactured InventoryThe auditor must consider the cost of raw materials direct labor, and manufacturing overhead in pricing work-in-process and finished goods. The need to verify each of these has the effect of making the audit of work-in-process and finished goods inventory more complex than the audit of purchased inventory. Nevertheiess. Such considerations as selecting the items to be tested,testing for whether cost or market value is lower,and evaluating the possibility of obsolescence also apply.
In pricing raw materials in manufactured products,it is necessary to consider both the unit cost of the raw materials and the number of units required to manufacture a unit of output. The unit cost can be verified in the same manner as that used for other purchased inventory-by examining vendors’ invoices or perpetual inventory master files. Then it is necessary to examine engineering specifications, inspect the finished product, or find a similar method to determine the number of units it takes to manufacture a product.
Similarly, the hourly costs of direct labor and the number of hours it takes to manufacture a unit of output must be verified while testing direct labor. Hourly labor costs can be verified by comparison with labor payroll or union contracts. The number of hours needed to manufacture the product can be determined from engineering specifications or similar sources.
The proper manufacturing overhead in work-in-process and finished goods is dependent on the approach being used by the client. It is necessary to evaluate the method being used for consistency and reasonableness and to recomputed the costs to determine whether the overhead is correct. For example,if the rate is based on direct labor dollars, the auditor can divide the total manufacturing overhead by the total direct labor dollars to determine the actual overhead rate. This rate can then be compared with the overhead rate used by the client to determine unit costs.
When the client has standard costs records, an efficient and useful method of determining valuation is by the review an analysis of variances. If the variances in material, labor, and manufacturing overhead are small, it is evidence of reliable cost records.
Cost or Market In pricing inventory. It is necessary to consider whether replacement cost or net realizable value is lower than historical cost. For purchased finished goods and raw materials, the most recent cost of an inventory item as indicated on a vendor’s invoice of the subsequent period is a useful way to test for replacement cost. All manufacturing costs must be considered for work-in-process and finished goods for manufactured inventory. It is also necessary to consider the sales of inventory items and the possible effect of rapid fluctuation of prices to determine net realizable value. Finally, it is necessary to consider the possiblility of obsolescence in the valuation process.
INTEGRATION OF THE TESTS
The most difficult part of understanding the audit of the inventory and warehousing cycle is grasping the interrelationships of the many different tests the auditor makes to evaluate whether inventory and cost of goods sold are fairly stated. Figure 20-6 and the discussions that follow are designed to aid the reader in perceiving the audit of the inventory and warehousing cycle as a series of integrated test.