UNIVERSITY OF CALOOCAN CITY AP005: Audit of INVENTORY,

Camarin Campus ACCOUNTS PAYABLE & COST OF SALES

TRANSACTION CYCLE: PURCHASING & PAYABLES

Business Two major business functions are
Functions  Resources are required from vendors in exchange for
obligations to pay
 Entity pays cash to vendors and employees
Accounts Accounts affected include the following:
Affected  Purchases (e.g. inventory and supplies)
 Purchase returns, allowances & discounts
 Accounts and/or Notes Payable
 Cash
Departments Significant departments affecting the P2P process are:
Involve EXPENDITURE
 User (any department within the entity)
 Purchasing or Procurement
 Receiving Department
 Accounting (accounts or vouchers payable)
 Accounting (Inventory and general)
DISBURSEMENT
 Treasury
 Accounting (receivable and general)

Forms Description Initiated by: Distributed to:

Requisition Contains the details of the user User  Purchasing
Slip department’s request Department  Accounts
Payable
Purchase Order Describes the goods to be Purchasing  Vendor
acquired (quantity and Department  User
description)
 Receiving
 Accounts
Payable
Receiving Describes the goods received Receiving  Purchasing
Report (quantity, description and Department  Accounts
condition) payable
Shipping Describes the goods to be Vendor (thru  Receiving
Documents shipped and serves as contract the carrier) department
between the vendor and carrier
Vendor’s Describes the goods sold, amount Vendor  Accounts
Invoice due and terms of payment Payable
Remittance A document sent by the entity to Treasury  Vendor
advice the seller, informing the seller
that their invoice has been paid
Daily Summarizes transactions recorded Account  General
Summaries during the day by the different Payable (for Accounting
department purchases)

Treasury (for
payment)

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 AP0005: Audit of Purchasing & Payable Process (Inventory, AP & COGS)

Summary of Functions of Departments in P2P Process Cycle

A. User Department
Prepares requisition slip to be forwarded to purchasing and accounts payable
departments.
B. Purchasing or Procurement Department
Primary Objective: to meet the specific needs of the user department at the least
possible cost.
Activities Possible Controls
1. Receives and approved requisition slip Common controls adopted by different
from the user department entities in this department include:
2. Locates vendor and negotiates with  Purchasing department has an exclusive
terms function to communicate with the
3. Prepares purchase orders and vendor
distributes copies to vendor, user,  The entity maintains list of
receiving and accounts payable authorized and legal vendors
4. Monitors the status of the order
 Entity compares purchase price to
5. Updates the user department as to the
market prices
status of the order
C. Receiving Department
Primary Objective: to provide reasonable assurance that received goods are based on
the approved purchase order.
Activities Possible Controls
1. Files the purchase orders until goods Common controls adopted by different
are received entities in this department include:
2. Upon receipt, counts and checks the  To ensure that the receiving
goods for appropriate quantity and department will count and check the
condition goods received, the purchasing
3. Reviews and compares purchase orders department sends a blank purchase
and shipping document from the carrier order
4. Prepares receiving reports to be
forwarded to purchasing and accounts
payable accompanied by purchase order
from purchasing and shipping document
from the carrier
D. Accounts Payable Department
Primary Objective: to provide reasonable assurance that payment will only be made to
shipments received.
Activities Possible Controls
1. Reviews and compares purchase order, Common controls adopted by different
receiving report and vendors invoice entities in this department include:
(i.e 3-way matching)  Vouchers should be supported by
2. Prepares voucher purchase order, receiving report and
3. Prepares voucher package (requisition vendor’s invoice or any other
slip, purchase order, receiving supporting documents
report, vendor’s invoice and voucher)  Accounts payable department files
and daily summary to be forwarded to voucher package by due date so as to
the treasury and general accounting, pay liability on time and take
respectively. advantage of discounts, if any.
E. Treasury Department
Primary Objective: to provide reasonable assurance that payment will only be made to
shipments received.
Activities Possible Controls
1. Reviews voucher package received Common controls adopted by different
2. Prepares check and have it signed by entities in this department include:
authorized signatories  The person last signing the check
3. Forwards check remittance advice to cancels the voucher package by placing
vendors a mark such as “paid”, ”cancelled” or
4. Prepares daily summaries which is to writing the check number.
be forwarded to general accounting  Entity may adopt any of the following

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 AP0005: Audit of Purchasing & Payable Process (Inventory, AP & COGS)

in relation to issuance of checks:

 Check over a certain amount should
have an identified payee
 No checks shall be issued without
an identified payee
 Checks should be signed by at least
two authorized signatories

Other Internal Control Procedures

1. There should be careful selection of inventory personnel and intensive training of
such personnel in policies, objectives, and system of inventory control.
2. Adequate physical facilities for handling and storage of inventory should be
provided.
3. Quantitative controls through perpetual inventory records; book quantities verified
with physical counts at least once a year and differences being investigated,
promptly adjusted, and reported to higher authority should be implemented.
4. Slow-moving, obsolete, and damaged stock should be identified and reported following
periodic reviews of physical and book records by qualified employees. Valuation
based on approved cost-mark-down methods should be reviewed.

Audit Objectives
Assertion Audit Objective
Existence or All inventories included in SFP are held by the entity or by
Occurrence (EO) others for the entity and purchases (cost of sales) have really
occurred and pertain to the entity.
Completeness All inventories owned by the entity at the reporting date are
(C) included on the SFP and all cost of sales is included in the SCI.
Cut-off Purchases (cost of sales) have been recorded in the proper
accounting period.
Valuation (V) Inventories and carried at the Lower of Cost and Net Realizable
Value (LCNRV)
Rights and The entity owns or has a legal right to all the inventories in
Obligations the financial statements at the reporting date.
(R&O)
Presentation Inventories are properly classified, described and disclosed in
and Disclosure the financial statements, including notes, in accordance with
(PD) applicable PFRS.

Pledged inventories are properly disclosed.

Audit Procedures
At the minimum, the substantive testing performed over the inventory and cost of sales are
as follows:
1. Observing inventory count and performing test counts (EO, C, A, R&O, V, CO)
 Matters relevant in planning attendance at physical inventory counting:
o The risks of material misstatement (ROMM) related to inventory.
o The nature of the internal control related to inventory.
o Whether adequate procedures are expected to be established and proper
instructions issued for physical inventory counting.
o The timing of physical inventory counting.
o Whether the entity maintains a perpetual inventory system.
o The locations at which inventory is held, including the materiality of the
inventory and the ROMM at different locations, in deciding at which locations
attendance is appropriate.
o Whether the assistance of an auditor’s expert is needed.
 As required by PSA 501(R) – Audit Evidence – Specific Considerations for Selected
Items, if inventory is material to the financial statements, the auditor shall

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 AP0005: Audit of Purchasing & Payable Process (Inventory, AP & COGS)

obtain sufficient appropriate audit evidence regarding the existence and condition
of inventory by:
a. Attendance at physical inventory counting, unless impracticable, to:
o Evaluate management’s instructions and procedures for recording and
controlling the results of the entity’s physical inventory counting
 The application of appropriate control activities, for example,
collection of used physical inventory count records, accounting for
unused physical inventory count records, and count and re-count
procedures.
 The accurate identification of the stage of completion of work in
progress, of slow moving, obsolete or damaged items and of inventory
owned by a third party, for example, on consignment.
 The procedures used to estimate physical quantities, where applicable,
such as may be needed in estimating the physical quantity of a coal
pile.
 Control over the movement of inventory between areas and the shipping
and receipt of inventory before and after the cutoff date.
o Observe the performance of management’s count procedures
 Observance of controls over the movement of inventory before, during and
after the count to assist the auditor in obtaining audit evidence that
management’s instructions and count procedures are adequately designed
and implemented.
 Obtaining copies of cutoff information, such as details of the movement
of inventory, to assist the auditor in performing audit procedures over
the accounting for such movements at a later date.
o Inspect the inventory
 Inspecting inventory when attending physical inventory counting assists
the auditor in ascertaining the existence of the inventory (though not
necessarily its ownership), and in identifying, for example, obsolete,
damaged or aging inventory.
o Perform test counts
 Tracing items selected from management’s count records to the physical
inventory and tracing items selected from the physical inventory to
management’s count records, provides audit evidence about the
completeness and the accuracy of those records.
 Obtaining copies of management’s completed physical inventory count
records assists the auditor in performing subsequent audit procedures to
determine whether the entity’s final inventory records accurately
reflect actual inventory count results.
b. Performing audit procedures over the entity’s final inventory records to determine
whether they accurately reflect actual inventory count results.
NOTE:
 If the count is conducted at a date other than the reporting date, the auditor shall,
in addition to the procedures above, perform audit procedures to obtain audit
evidence about whether changes in inventory between the count date and the date of
the financial statements (A.K.A. intervening period) are properly recorded.
 If the auditor is unable to attend physical inventory counting due to unforeseen
circumstances, the auditor shall make or observe some physical counts on an
alternative date and perform audit procedures on intervening transactions.
 If attendance at physical inventory counting is impracticable, the auditor shall
perform alternative audit procedures to obtain sufficient appropriate audit evidence
regarding the existence and condition of inventory.

The matter of general inconvenience to the auditor, however, is not sufficient to

support a decision by the auditor that attendance is impracticable. Further, the
matter of difficulty, time, or cost involved is not in itself a valid basis for the

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 AP0005: Audit of Purchasing & Payable Process (Inventory, AP & COGS)

auditor to omit an audit procedure for which there is no alternative or to be

satisfied with audit evidence that is less than persuasive.

If it is not possible to do so, the auditor shall modify the opinion in the auditor’s
report in accordance with PSA 705(R).

2. Reconciling inventory summary sheets with general ledger (C, A)

 The review of the reconciliation of the inventory summary sheet with general ledger
generally consists of:
o Footing the reconciliation
o Reconciling the book and physical inventory figures to the compilation and
unadjusted and uncorrected general ledger, respectively.
o Investigation significant variances between book and physical inventories.
o Reviewing the reconciling items
o Agreeing reconciling items to the supporting working papers, adjusting the
journal entries and the general ledger
o Verifying that the accrual for inventory received prior to the count date, but
not billed, was included in the books.
NOTE: Differences and adjustments are closed to Cost of Sales/Cost of Goods Sold.

3. Confirming inventories held by others (i.e. consignment) (EO, C, R&O)

 When inventory under the custody and control of a third party is material to the
financial statements, the auditor shall obtain sufficient appropriate audit evidence
regarding the existence and condition of that inventory by performing one or both of
the following:
a. Request confirmation from the third party as to the quantities and condition of
inventory held on behalf of the entity.
b. Perform inspection or other audit procedures appropriate in the circumstances.
Depending on the circumstances, for example where information is obtained that
raises doubt about the integrity and objectivity of the third party, the auditor
may consider it appropriate to perform other audit procedures instead of, or in
addition to, confirmation with the third party. Examples of other audit
procedures include:
o Attending, or arranging for another auditor to attend, the third party’s
physical counting of inventory, if practicable.
o Obtaining another auditor’s report, or a service auditor’s report, on the
adequacy of the third party’s internal control for ensuring that inventory is
properly counted and adequately safeguarded.
o Inspecting documentation regarding inventory held by third parties, for
example, warehouse receipts.
o Requesting confirmation from other parties when inventory has been pledged as
collateral.

4. Performing purchases and inventory cut-off (EO, C)

 Objective of this procedure are as follows:
a. To check that inventory transactions are properly recorded in the proper period.
b. To determine that inventories are not double-counted or missed due to movements
within plant/warehouses or move between entity branches and other parties.
 Common concerns:
a. Shipments received but invoice received in the next period
b. Invoice received but merchandise received in the subsequent period
 Cutoff Procedures:
a. Examining a sample receiving report for inventory receipts immediately before and
after the inventory count to check whether it is recorded in the correct
accounting period.

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 AP0005: Audit of Purchasing & Payable Process (Inventory, AP & COGS)

b. Examining a sample of shipping documents for shipments immediately prior to and

subsequent to the count to check whether it is recorded after the reporting
period.

5. Checking appropriate valuation in accordance with accounting policies and performing

lower of cost and net realizable value (LCNRV) test (i.e. slow-moving, obsolete and
damaged stock) (A, V, PD)
 Considerations:
a. valuation and costing method
b. consistency of the use and changes in the costing method if any
c. consistent application of the accounting policy in practice
 LCNRV Test: The net realizable value of the following inventories follow:
a. Finished Goods & Work-in-Process – generally based on the selling price evidenced by
the sales subsequent to the reporting date, by entity’s catalogue or price lists or
by customer’s contract LESS any estimated costs to dispose them.
b. Raw Materials and Factory Supplies– generally based on the replacement costs (by
purchase or reproduction) less any estimated cost to complete and dispose them.
- To be written down only if the finished goods to which they are related to
are also to be written down.

NOTE: The auditor should verify whether any write-down to NRV and/or any reversal is
charged to expense (COGS) in accordance to PAS 2.

6. Determining whether any inventories have been pledged and reviewing purchase
commitments (V, PD)
 Pledged inventories or inventories subject to a lien to secure a bank loan can be
obtained when the auditor performs a Bank Confirmation.
 Any existing purchase commitment should be checked and reviewed by the auditor.
Further, the commitment price should be checked against the market value or NRV at
year-end.

7. Performing test of details on cost of goods sold (EO, A, CO)

 Obtain the COGS Detailed Listing (Subsidiary Ledger)
 Perform SL-GL reconciliation to ensure completeness of the population
 After reconciliation, the auditor will select from the population to test.
 Obtain supporting documentation from the client to ensure the correctness of the
samples selected (i.e. PO, Shipping Documents, Receiving Report, Invoice & Proof of
Payment)
 Vouch and document the supporting documents obtained.
 Material variance should be further investigated, if there are any.

8. Performing analytical procedures

 Material misstatements of inventory may be disclosed by analytical procedures
designed to establish the reasonableness of the figures.
Analytical Procedures Possible Misstatement
Compare the current gross margin rate  Overstatement or understatement of
with that of previous years inventory and cost of good sold
Compare the current inventory turnover  Obsolete inventory.
with that of previous years  Overstatement or understatement of
inventory
Compare of unit costs of inventory with  Overstatement or understatement of unit
that of previous years costs

SAMPLE THEORIES:

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 AP0005: Audit of Purchasing & Payable Process (Inventory, AP & COGS)

1. Which of the following functions is not common to the Purchasing to Payable (P2P)
Cycle?
a. Obligations to vendors are paid.
b. Resources are held, used and transformed.
c. Resources are acquired from vendors in exchange for the obligation to pay.
d. Resources are acquired from employees in exchange for obligations to pay.
2. If internal control is well-designed, employees of the same department most likely
would approve purchase orders and also
a. Inspect goods upon receipt.
b. Negotiate terms with the vendors.
c. Authorize requisition of goods.
d. Reconcile the open invoice file.
3. When the goods are received, the receiving clerk should match the goods with the
a. Purchase order and requisition
b. Vendor’s invoice and the receiving report
c. Vendor’s shipping document and the purchase order
d. Receiving report and the vendor’s shipping documents
4. Which of the following controls is not usually performed in the vouchers payable
department?
a. Approving vouchers for payment by having an authorized employee signed the vouchers.
b. Accounting for unused prenumbered purchase orders and receiving reports.
c. Matching the vendor’s invoice with the related receiving report.
d. Indicating the asset and expense accounts to be debited.
5. When inventory is material to the financial statements, the auditor shall obtain
sufficient appropriate audit evidence regarding the existence and condition of
inventory by:
a. Attendance at physical inventory counting, unless impracticable.
b. Performing audit procedures over the entity’s final inventory records to determine
whether they accurately reflect actual inventory count results.
c. Both a & b.
d. Neither a & b.
6. Attendance at physical counting involves:
a. Inspecting the inventory to ascertain its existence and evaluate its condition and
performing test counts.
b. Observing compliance with management’s instructions and the performance of
procedures for recording and controlling the results of the physical inventory
count.
c. Obtaining audit evidence as to the reliability of management’s count procedures.
d. All of these.
7. The auditor tests the quantity of materials charged to work-in-process by tracing these
quantities to
a. Cost ledgers
b. Perpetual inventory records
c. Receiving reports
d. Material requisition
8. In which of the following cases is attendance at physical inventory counting
impracticable?
a. Where inventory is held in a location that may pose threats to the safety of the
auditor.
b. Where the auditor will be inconvenienced because of the difficulty, time and cost
involved in doing the procedures.
c. Both a & b.
d. Neither a & b.
9. An auditor selected items for test counts while observing a client’s physical
inventory. The auditor then traced the test counts to the client’s inventory listing.
This procedure most likely obtained evidence concerning

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a. Existence.
b. Rights.
c. Completeness.
d. Valuation.
10. Which of the following auditing procedures most likely would provide assurance about
a manufacturing entity’s inventory valuation?
a. Tracing test counts to the entity’s inventory listing.
b. Obtaining confirmation of inventories pledged under loan agreements.
c. Reviewing shipping and receiving cutoff procedures for inventories.
d. Testing the entity’s computation of standard overhead rates.

SAMPLE PROBLEM:
You were assigned to audit the receivables of M1ss Jade So Doll Shenanigans and
Paraphernalia. As instructed by your audit manager, you have performed a cut-off test of
sales. The results of the cut-off test revealed the following:

Recorded as Sales in December 2018

Selling Cost Terms Shipment Date Received by
Price customers
P18,000 P16,500 FOB shipping point 12/26/2018 12/29/2018
20,000 14,000 Shipped to consignee 12/26/2018 12/29/2018
8,680 7,240 FOB destination 12/28/2018 01/02/2019
9,000 7,500 FOB shipping point 12/30/2018 01/02/2019
10,000 7,750 FOB destination 12/31/2018 01/03/2019
7,800 6,100 FOB shipping point 12/31/2018 01/02/2019
14,000 12,000 Shipped to consignee 12/31/2018 01/02/2019

Recorded Sales in January 2019

Selling Cost Terms Shipment Date Received by
Price customers
P21,000 P18,200 FOB shipping point 12/30/2018 01/03/2019
10,500 8,800 FOB shipping point 12/31/2018 01/03/2019
8,680 3,200 FOB destination 01/02/2019 01/03/2019
9,000 5,000 FOB shipping point 01/02/2019 01/05/2019

A count of all inventories within the premises was made on December 30, 2018. The total
cost of the count was recorded as inventories as of December 30, 2018. Half of the goods
shipped to consignee on December 26 are still unsold at December 31. The agreed commission
on consignment sales is 20% of the sales price.

The unadjusted ledger balances show the following:

Account Receivables P376,500
Inventories 525,000
Sales 1,520,000
Cost of sales 942,000
QUESTIONS:
Determine the adjusted balances of the following:
1. Account Receivables Ans: 363,320
2. Inventories Ans: 524,340
3. Sales Ans: 1,508,820
4. Cost of sales Ans: 942,660

-Nothing follows-

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