1. Internal Controls Related to the Inventory Cycle

Internal control over inventory purchases and sales was covered in the sections on the revenue cycle and the expenditure cycle. For inventory held by the entity, proper internal control includes adequate safeguarding of inventory and proper segregation of duties.

The following duties should be segregated:

1. Purchasing

2. Receiving

3. Warehouse

4. Shipping

2. Performing Specific Procedures to Obtain Evidence: The Inventory Cycle

2.1. Auditing the Inventory Balance

The observation of the beginning and ending physical inventory counts is a required generally accepted auditing procedure. Attendance by the auditor at the physical inventory count involves the following dual-purpose tests:

1. evaluating management's instructions and procedures for the inventory count;

2. observing the performance of management's count procedures;

3. inspecting the inventory to ascertain its existence and condition; and

4. performing test counts.

An auditor who is not present to observe the physical inventory must use alternative procedures to justify any opinion expressed. This is acceptable when it is impractical or impossible to observe physical inventory, or when inventories are not material.

2.2. Auditing Inventory Transactions

Inventory sales and purchases should be audited as part of the audits of the revenue cycle and the expenditure cycle.

2.3. Auditing Presentation and Disclosure

Completeness: The auditor should ensure that all required disclosures related to inventory have been included in the notes to the financial statements. Inventory disclosures include:

• Cost method (LIFO, FIFO, weighted average) and valuation method (net realizable value or lower of cost or market).

• Raw materials, work-in-process, and finished goods inventory balances.

• Consigned inventory.

• Pledged or assigned inventory.

• Significant losses from inventory write-downs or purchase commitments.

• Warranty obligations.

Valuation, Allocation, and Accuracy: The auditor should read the footnotes and other information related to inventory to determine whether the information is accurate and presented at the appropriate amounts.

Rights and Obligations, and Occurrence: The auditor should determine that inventory-related obligations have been properly disclosed by inquiring of management and reviewing loan agreements and minutes for evidence that inventory has been pledged or assigned. The auditor should also inquire about warranty obligations. The auditor should compare disclosures to other audit evidence to ensure that all disclosed information related to inventory has occurred.

Understandability of Presentation and Classification: The auditor should read all inventory-related disclosures to ensure that they are understandable. The auditor should review inventory records for proper classification between raw materials, work in process, and finished goods.