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Chapter 21 Solutions Manual
Chapter 21 Solutions Manual
Review Questions
21-1 Inventory is often the most difficult and time consuming part of many audit
engagements because:
21-2 The acquisition and payment cycle includes the system for purchasing all
goods and services, including raw materials and purchased parts for producing
finished goods. Purchase requisitions are used to notify the purchasing
department to place orders for inventory items. When inventory reaches a
predetermined level or automatic reorder point, requisitions may be initiated by
stockroom personnel or by computer. In other systems, orders may be placed for
the materials required to produce a customer order, or orders may be initiated
upon periodic evaluation of the situation in light of the prior experience of
inventory activity. After receiving the materials ordered, as part of the acquisition
and payment cycle, the materials are inspected with a copy of the receiving
document used to book perpetual inventory. In a standard cost inventory system,
the acquisition and payment cycle computes any inventory purchase variances,
which then enter the inventory system.
The following audit procedures in the acquisition and payment cycle
illustrate the relationship between that cycle and the inventory and warehousing
cycle.
21-1
21-3 Companies provide online access to descriptions of inventory products
and on-hand quantity levels to key inventory suppliers because this information
helps the suppliers work with management to monitor the flow of inventory items.
There are risks associated with providing this information, however. First, there is
a risk that sensitive proprietary information may be made available to
unauthorized users. The use of the Internet and other e-commerce applications
may also lead to financial reporting risks if access to inventory databases and
systems is not adequately controlled. The risks of providing online access to
inventory information can be reduced by the use of security access password
restrictions, firewalls, and other IT management controls.
21-4 Cost accounting records are those which are concerned with the
processing and storage of raw materials, work in process, and finished goods,
insofar as these activities constitute internal transfers within the inventory and
warehousing cycle. These records include computerized files, ledgers,
worksheets and reports which accumulate material, labor, and overhead costs by
job or process as the costs are incurred.
Cost accounting records are important in conducting an audit because
they indicate the relative profitability of the various products for management
planning and control, and determine the valuation of inventories for financial
statement purposes.
21-5 The most important tests of the perpetual records the auditor must make
before assessed control risk can be reduced, which may permit a reduction in
other audit tests are:
21-6 The continuation of shipping operations during the physical inventory will
require the auditor to perform additional procedures to insure that a proper cutoff
is achieved. The auditor must conclude that merchandise shipped is either
included in the physical count or recorded as a sale, but not both.
Since no second count is taken, the auditor must increase the number of
test counts to determine that the counts recorded are accurate.
21-2
21-7 The auditor must not give the controller a copy of his or her test counts.
The 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 will be able to adjust other uncounted items without detection by the
auditor.
21-8 The most important audit procedures to test for the ownership of inventory
during the observation of the physical counts and as a part of subsequent
valuation tests are:
1. Discuss with the client.
2. Obtain an understanding of the client's operations.
3. Be alert for inventory set aside or specially marked.
4. Review 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.
5. Examine vendor invoices indicating that merchandise on hand was
sold to the company.
6. 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.
21-3
21-10 The auditor could have uncovered the misstatement if there were
adequate controls over the use of inventory tags. More specifically, the auditor
should have assured himself or herself that the client had accounted for all used
and unused tag numbers by examining 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
subsequent follow-up. As part of substantive procedures, the auditor could have
performed analytical tests on the inventory and cost of sales. A comparison of
ratios such as gross margin percentage and inventory turnover could have
indicated that a problem was present.
21-12 Compilation tests are the tests of the summarization of physical counts,
the extension of price times quantity, footing the inventory summary, and tracing
the totals to the general ledger.
Several examples 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.
21-4
21-12 (continued)
2. Trace the test counts recorded in the working papers to the final
inventory summary to make sure they are correctly included.
3. Trace inventory items on the final inventory list to the tags as a test
of the existence of recorded inventory.
4. Test the extensions and footings of the physical inventory
summary.
21-13
21-14
PURCHASE TO BE INCLUDED IN
DATE QUANTITY PRICE 12-31-07 INVENTORY EXTENSION
11-26-07 2,400 $2.07 700 @ $2.07 $1,449.00
12-06-07 1,900 $2.28 1,900 @ $2.28 4,332.00
$5,781.00
21-5
21-15 The direct labor hours for an individual inventory item would be verified by
examining engineering specifications or similar information to determine whether
the number of hours to complete a unit of finished goods was correctly
computed. Ordinarily 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 acquisition and payment
cycles.
Once 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.
21-16 With 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.
21-6
21-21
21-7
21-21 (continued)
POTENTIAL SUBSTANTIVE
PURPOSE OF TEST OF FINANCIAL AUDIT
INTERNAL CONTROL CONTROL MISSTATEMENT PROCEDURE
3. To minimize theft Discuss with Overstatement of Compare
or unrecorded client and inventory. physical count
shipments of observe whether to perpetual
inventory. personnel records.
(Existence) prepare shipping
documents.
4. To ensure Account for a Understatement of Trace quantity
inventory numerical sales. and description
shipments are sequence of on bills of
recorded as sales. shipping orders. lading to
(Completeness) recorded sales.
5. To make sure Observe Misstatement of Compare
physical inventory counting inventory. physical count
counts are personnel and to perpetual
accurate. discuss with inventory
(Accuracy, client. record.
existence and
completeness)
6. To assure Review Misstatement of Trace costs
reasonable costs procedures for inventory. from supporting
are used for determining documents to
inventory and cost standard costs. development of
of goods sold. standards.
(Accuracy)
7. To make sure Read policy and Misstatement of Analytical
obsolete goods are discuss inventory. procedures for
classified as such. procedures with inventory.
(Accuracy) client.
8. To make sure Observe who Misstatement of Reperform
inventory compiles the inventory. clerical tests of
compilation is inventory and inventory
accurate. discuss with compilation.
(Accuracy) client.
21-8
21-22 (continued)
a. TRANSACTION-
RELATED AUDIT
OBJECTIVE b. RELATED RISK c. TEST OF CONTROL
1. Recorded transactions If purchasing agents can Enter non-valid vendor
represent valid, approved make purchases from any numbers into the
purchases (Occurrence) vendor, there is a risk that purchasing system to see if
purchasing agents may the related transaction is
make unauthorized rejected.
purchases of items not
approved (for personal
use).
2. Recorded inventory may Without information about Select a sample of
not be recorded at the amount of time inventory items from the
appropriate amounts, due inventory is in the perpetual inventory system
to obsolescence warehouse, management is and recalculate the number
(Accuracy). less likely to identify slow of days each item has been
moving items that should present in the warehouse.
be recorded at the lower of
cost or market.
3. Actual shipments of Shipments of inventory may Select a sample of items in
inventory are recorded in occur but not be recorded. the warehouse and
the perpetual inventory physically move them to the
records (Completeness). shipping areas to see if the
microchip correctly removes
those items from the
perpetual inventory records.
4. Inventory recorded in Non-inventory warehouse Observe client personnel in
the perpetual records individuals may remove the inventory warehouse
physically exists inventory without and determine if each
(Occurrence). authorization. person is authorized to be
in the warehouse.
5. Inventory transactions Equipment or supplies may Observe whether
are properly classified be inaccurately classified equipment or supplies are
(Classification). as inventory if they are not stored in the same physical
physically separated from space as inventory.
the inventory.
6. Recorded inventory If periodic reconciliations of Inspect the clients test
items are physically present inventory records to samples for accuracy and
(Occurrence) and recorded physical counts are not reasonableness. Inquire
at correct amounts performed, there is a risk about the nature of
(Accuracy). that items may be removed discrepancies identified.
from the warehouse without
knowledge, which would
result in overstated
inventory amounts.
21-9
7. Actual inventory on hand There is a risk that Inspect the clients test
may not be recorded in the inventory on hand is not samples for accuracy and
perpetual inventory listing included in the inventory reasonableness. Inquire
(Completeness). records. about the nature of
discrepancies identified.
a. TRANSACTION-
RELATED AUDIT
OBJECTIVE b. RELATED RISK c. TEST OF CONTROL
8. The perpetual inventory There could be errors in the Recalculate the inventory
records are accurately mathematical formulas of amounts and determine that
summarized and posted to the inventory records. the totals agree to the
the general ledger accounts general ledger balances.
(Posting and
Summarization)
9. Recording inventory Inventory could be added to Enter an addition to the
transactions represent the inventory account perpetual inventory system
actual receipts of inventory balance before actual without a valid receiving
items (Occurrence). goods are received. report number to determine
if the system rejects the
transaction.
10. Recording of inventory Inventory held on Observe whether inventory
in the clients records is consignment may be held on consignment is
valid (Occurrence) recorded as the clients stored in the same physical
inventory. space as inventory.
21-23 a. It is important to review the cost accounting records and test their
accuracy for the following reasons:
21-10
21-23 (continued)
21-24
21-11
7 Test of Control or To ensure that additions
Substantive Test recorded on the finished goods
perpetual records were recorded
on the books as completed
production. (Accuracy and
classification)
21-25
21-12
21-26 (continued)
21-14
21-26 (continued)
21-15
Inadequate Accounting System Interface. If the online sales or
inventory purchasing system interface with the main
accounting system is inadequate, online transactions may
(1) not be processed, (2) be processed more than once, or
(3) be processed inaccurately. Any of these risks could lead
to material misstatements in the financial statements.
Inaccurate Information. If inaccurate information posted online is
used to process inventory transactions, the transactions may
be inaccurately processed and recorded in the accounting
records, resulting in material misstatements.
Consumer Privacy. If consumer privacy is breached, existing
sales may be cancelled or returns beyond the normal period
may be requested. Such activity would need to be properly
reflected in the financial statements. Additionally, legal
exposures may increase, which may require additional
financial statement disclosures.
Security. Unauthorized access to the Technology Parts
inventory database or other IT system records may introduce
unintentional and intentional misstatements into the
accounting records. If unauthorized access is not restricted,
material misstatements in financial statements may result.
21-27 a. When the inventory is a material item in the financial statements
that the CPA is auditing, his or her observation of the taking of the
physical inventory is in compliance with the auditing standard
pertaining to field work that requires obtaining sufficient available
evidential matter to afford a reasonable basis for an opinion
regarding the financial statements. Observation is a generally
accepted auditing procedure applied in the audit of the physical
inventory.
By observing the taking of the physical inventory, the CPA is
seeking to satisfy himself or herself as to the effectiveness and
application of the methods of inventory taking and as to the
measure of reliance which may be placed upon the client's
inventory records and its representations as to inventory quantities.
He or she must ascertain that the physical inventory actually exists,
that the inventory quantities are being determined by reasonably
accurate methods, that the inventory is in a salable or usable
condition, and that consigned goods are not commingled with
owned goods.
b. The CPA makes test counts of inventory quantities during
observation of the taking of the physical inventory to satisfy himself
or herself that an accurate count is being made by the individuals
taking the inventory. The extent of test counting will be determined
by the inventory taking procedures; for example, the number of test
counts would be reduced if there were two teams, one checking the
other, taking the inventory. On the other hand, the test counts would
be expanded if misstatements were found in the inventory counts.
21-16
Some test counts are recorded by the CPA for the purpose of subsequent
comparison with the client's compilation of the inventory. The
comparison procedure goes beyond the mere determination that
quantities have been accurately transcribed. The CPA also seeks
assurance that the description and condition of the inventory items
is accurate for pricing purposes and that the quantity information,
such as dozen, gross, cartons, etc., is proper.
Another reason for recording test counts in the working papers is to provide
evidence of the extent of tests in the event that audit procedures are questioned
at some future date.
c.
21-17
21-28 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.
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 subsequent evaluation. The auditor should
also be aware that this could be an indication of widespread
obsolescence problems in other parts of the inventory.
d. One 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 request that the practice be stopped, and that control of
tags be established under the auditors direct observation.
1. All 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.
3. If possible, the day's shipments of finished appliances should be
taken to the shipping area before the count. (Unshipped items
remaining in the shipping area should be inventoried at the end of
the day.)
4. Great care must be exercised over goods removed from the
warehouse itself. These may be unassembled parts and supplies
requisitioned on an emergency basis or unscheduled shipments of
finished appliances. Alternative methods for recording these
removals are:
21-18
21-29 (continued)
21-30
a.
2007 2006 2005 2004
Gross margin % 26.3% 22.6% 22.4% 22.4%
21-19
21-30 (continued)
d. The auditor should discuss the two changes with the client and
obtain a reasonable explanation for them. He or she should then
perform appropriate procedures to verify the validity of the
explanation. Ultimately, the auditor must be confident the change
does not result from a misstatement in the financial statements.
21-31 a.
1. Exclude
2. Exclude
3. Include
4. Include
5. Exclude
21-20
21-31 (continued)
b.
1. This merchandise would be excluded because title does not
pass to buyer on an F.O.B. destination shipment until
delivery to the buyer. Since it was not received until January
2008, there is no basis for including it in inventory.
2. Goods held "on consignment" do not belong to the
consignee, and should not be included in inventory.
3. Normally 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.
4. Title to goods shipped F.O.B. shipping point normally passes
to the buyer on delivery to the transportation agency, and in
this instance the goods belong to your client at December
31, 2007. There is an error in recording the acquisition.
5. Since 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. When the job
is completed and ready for shipment as in this case, it may
be considered as a completed sale.
21-32 a.
1. Extension errors are as follows:
EXTENSION OVER
AS ACTUAL (UNDER)
DESCRIPTION RECORDED EXTENSION STATEMENT
Wood $ 5.58 $ 55.80 $ ( 50.22)
Metal cutting tool 670.00 870.00 (200.00)
Cutting fluid 529.00 640.00 (111.00)
Sandpaper 258.00 2.85 255.15
$ (106.07)
21-21
21-32 (continued)
OVER-
PAGE CLIENT CORRECT (UNDER-)
NO. TOTAL TOTAL STATEMENT
14 $1,375.12 $1,375.08 $ 0.04
82 8,721.18 8,521.18 200.00
$200.04
b. First, the auditor should keep in mind that only 20% of the inventory
was tested. If sampling were random, a direct extrapolation 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 $93.97, a small amount (see items 1 and 4). However,
the exceptions 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 extensions and other computations for
reasonableness and obvious misstatements.
For the items for which the amount of the misstatement
could not be determined, the auditor should follow up as described
in 2 and 3 above. From the results of the follow-up, the effect of the
misstatements noted should be assessed and determination made
as to the need for expansion of scope for the tests considered.
c. Prior to compiling the inventory next year, Martin Manufacturing
should implement the following internal controls:
21-22
21-32 (continued)
1. Purchases $ 2,183
Accounts Payable $ 2,183
21-23
21-33 (continued)
4. Sales 19,270
Accounts receivable 19,270
5. No adjustment required.
8. Sales 15,773
Accounts receivable 15,773
Case
21-34
21-24
21-34 (continued)
$200
= $0.1875 per ft
(12,800 inches / 12 inches per foot)
Total inventory cost should be ($1.20 + 0.1875 per foot) times 833
feet (10,000/12) = $1,155.79 or an overstatement of inventory by
$10,844.21.
21-25
21-34 (continued)
SEA GULL AIRFRAMES, INC.
SUMMARY OF INVENTORY MISSTATEMENTS
Quantity Price
Per Per Recorded Correct Amount of
Item No. and Inventory Correct Difference Inventory Correct Differenc Amount Amount Misstatement
Description e
A. L37 Spars 3,000 3,000 0 8.00 8.00 0.00 24,000.00 24,000.00 0.00
B. B68 Metal Formers 10,000 833 9,167 1.20 1.3875 -0.1875 12,000.00 1,155.79 -10,844.21
C. R01 Metal Ribs 1,500 1,500 0 10.00 10/9.50 .50 15,000.00 14,750.00 -250.00
D. St26 Struts 1,000 1,000 0 8.00 8/8.20 -.20 8,000.00 8,040.00 40.00
E. Industrial hand 45 45 0 20.00 20.00 0.00 900.00 900.00 0.00
drills
21-25
F. L803 Steel Leaf 40 80 -40 69.00 69.00 0.00 276.00 5,520.00 5,244.00
Springs
G. V16 Fasteners 5.50 5.50 0 10.00 10.00 0.00 55.00 55.00 0.00
Total misstatement -5,810.21
Items over $5,000 -11,054.21
Items under $5,000 5,244.00
-5,810.21
21-26
21-34 (continued)
PROJECTED MISSTATEMENTS
Dollars tested
4,150,000
More than $5,000 X 11,054.21 = - $109,486
419,000
4,125,000
Less than $5,000 X 5,244 = $5,646,436
3,831
21-1 Since 1938 when auditors failed to uncover fictitious inventory recorded by
the McKesson & Robbins Company, auditors have been ordinarily required to
physically observe the counting of inventory. It is important to recognize that
auditors are not required to actually count the inventory for inclusion on the
balance sheet, but they are required to observe the inventory being counted.
Occasionally, companies employ inventory specialists to perform their inventory
counts. One very large inventory counting specialist is Retail Grocery Inventory
Service, now known as RGIS. Visit RGISs [www.rgisinv.com] Web site and
answer the following questions.
21-27
21-1 (continued)
Answer: Student responses will likely vary based upon their experience with
companies such as RGIS and whether they have participated in a physical
inventory. This question is meant to encourage students to consider whether
the hiring of an outside company such as RGIS affects how the auditor
executes his/her responsibilities during a physical inventory. Most students
have very likely never considered who actually counts a companys inventory
let alone the significance of hiring another company to do the work. For
example, the instructor might ask the students to explain the difference
between hiring temporary employees to help with the counting of inventory
and hiring a company such as RGIS to count the inventory.
(Note: Internet problems address current issues using Internet sources. Because
Internet sites are subject to change, Internet problems and solutions are subject to
change. Current information on Internet problems is available at
www.prenhall.com/arens).
21-28