Lesson 9: Audit of the Inventory and Payroll Cycles

Perpetual Inventory Master File

Keeps track of the quantities of inventory in the perpetual system. Keeps information such as item number, description, unit cost, quantity on hand, and quantity on order. Updated automatically when acquisitions occur and also when sales occur.

Inventory Cycle Process

1. Processing the purchase order

2. Receive raw materials

3. Store raw materials

4. Processing the goods

5. Store the finished goods

6. Count Inventory

7. Ship finished goods

Source for Inherent Risk in Inventory

• Different locations make physical control and counting difficult

• Inventory is easily transportable and easy to steal

• The auditor may need specialist assistance

• Potential obsolescence (Overstated inventory)

• Returns causes problems: accuracy, timing, and cutoff

• Several acceptable inventory valuation methods under ASPE and IFRS

High Significant Risk Circumstances Examples

• the company has or is attempting to obtain financing secured by inventory.

• the inventory is difficult to count or value.

• the company is a manufacturer or has a complex system to determine the value of inventory.

• the company is involved in technology or another volatile or rapidly changing industry.

Additional Procedures Performed in Audit

• Examine the entity's inventory records to identify locations or items that require specific attention.

• Observe inventory counts at certain location on an unannounced basis or conduct inventory counts at all locations on the same date.

• Perform additional procedures during the observation of the count–use the work of an expert as needed.

• Compare the quantities for the current period with prior periods.

• Use computer-assisted audit techniques to further test the compilation of the physical inventory counts (e.g., sorting by tag number to test tag controls or by item serial number to test the possibility of time omission or duplication).

Primary Concerns of Auditor

• Internal storage, production, and transfer of inventory costs

• Physically Counting Inventory

• Pricing and compiling inventory

Internal Storage, Production, and Transfer of Inventory Costs

• Physical controls-over assets to prevent loss from misuse and theft (i.e., segregated and limited access storage areas)

• Perpetual records-data files maintained by people who do not have custody of or access to assets (i.e., segregation of duties)

Physically Counting Inventory

• The company must make a periodic count of inventory to ensure accuracy in the perpetual inventory master files.

Pricing and Compiling Inventory

• The company must use reasonable costs for valuing ending inventory.

Tests of Controls for the Inventory Cycles

• Physical controls over inventory

• Documents and records for transferring inventory

• Perpetual Inventory Master and Transaction Files

• Unit Cost records

Key Areas Considered by Auditor

• Accounting for Customer Returns

• Quality Control Process

• Cost Accounting System

• Existence of an Accurate Perpetual Inventory System

• Systematic Review for Obsolescence

Accounting for Customer Returns

Returned goods should be accounted for at net realizable value. The auditor will need to determine the procedures utilized by the client to segregate and separately identify the return of merchandise from the receipt of purchased merchandise. Major frauds have occurred where companies sold returned goods as if they were new product.

Quality Control Process

The quality control system should identify defective units and categorize them as scrap. Because penalty provisions are built into supplier contracts, the auditor should review quality control reports and consider the implications for unrecorded liabilities.

Cost Accounting System

Valuation of ending inventory is directly affected by the quality of the client's cost system. The auditor should make inquiries about the method for developing standards, overhead component identification and overhead allocation, and the methods used for variance identification and accounting.

Existence of an Accurate Perpetual Inventory System

The auditor will normally test perpetual inventory records to ensure that all receipts and sales of products are properly recorded. Another major control procedure is cycle counts of the perpetual records by internal audit or other personnel to determine their accuracy. The auditor should determine that such counts are taken and that corrections are made to the records.

Systematic Review for Obsolescence

Computerized inventory systems provide a wealth of information for a company to systematically review its inventory for potential obsolescence. If management does a thorough analysis for obsolescence, the auditor's year-end work can be reduced to corroborating management's analysis with independent tests.

Analytical Procedures

Key substantive tests and usually consist of comparing the gross margin percentage, inventory turnover ratio, and inventory unit costs for the current year with those of the prior year. In addition, the reasons for change in the total cost of inventory over the year should be assessed. The relationships between the components of inventory costs should be reviewed and compared to prior periods as well

Substantive Tests of Details

Comprise two features: physical inventory, and price and compilation.

Physical Observation of Inventory

The auditor’s attendance during inventory count procedures is encouraged as close to the balance sheet date as possible to ensure cutoff and completeness. Note, however, that management is responsible for conducting a proper inventory count; the auditor is there only to observe that the inventory actually exists, assesses its condition, and perform test counts of inventory items, which provides some evidence for the valuation objective. Attendance is not necessary if the auditor has valid reasons, such as inventory being immaterial.

Need to satisfy these objectives:

• Existence

• Completeness

• Valuation

• Cutoff

Note that inventory count observation procedures cannot satisfy the disclosure objective.

In addition to performing substantive tests on inventory observation procedures that allow the auditor to have assurance about the quantity of items in inventory, the auditor must also substantively test the value of these items.

Existence (Physical Observation)

This test is done by selecting tags returned to the count custodian and tracing them back to items on the floor. Inventory movement during the count is also observed to ensure that items sold but awaiting shipment are not counted.

Completeness (Physical Observation)

To satisfy this objective, the auditor observes inventory to ensure that it has all been tagged and traces selected items off the floor to the count sheets. The auditor also observes inventory movement during the count to ensure that items just received are included in the count. Inquiries are also made about the existence of any inventory not on the premises.

Valuation (Physical Observation)

To satisfy this objective, the auditor performs test counts of items by counting items on the floor and tracing quantities to completed count tags. Physical count results are also compared with perpetual inventory records. Lastly, the auditor must inquire about, and attempt to ascertain by observing, any inventory that is obsolete or damaged. If inventories are considered obsolete or damaged, the market value, if any, of the items is determined and compared to the cost to calculate any write-downs required.

Cutoff (Physical Observation)

The auditor obtains copies of the last several shipping reports for the period and ensures that the items shipped were not included in the items counted. Also, the last several receiving reports are examined to ensure that these items were included in the items counted. The shipping and receiving areas are also observed to determine whether items in these areas should be included in the year-end inventory.

Substantive Tests for Inventory Pricing and Compilation

1. The method must be in accordance with an acceptable financial accounting framework.

2. The application of the method must be consistent from year to year.

3. Cost versus market value must be considered. 

When conducting testing procedures, the auditor attempts to satisfy the audit objectives as follows.

• Existence

• Completeness

• Ownership

• Valuation

• Classification

• Presentation
  

Existence (Substantive Testing)

The auditor selects items from the listing and agrees quantities to count tags and to the auditor’s test count amounts if applicable. The auditor must ensure that the count list of the count date is complete. This can be achieved by observing how this list was controlled on count day (i.e., numbered pages) and by checking to see that all pages are there. Also, some items from each page on the list are selected as the sample that will be checked. When feasible, a copy of the listing should be obtained on count day and then compared to the list on which the pricing is performed at year end.

Completeness (Substantive Testing)

This test is done by tracing quantities from a selection of count tags to the listing. Unused count tags should be examined to ensure that they were actually unused.

Ownership (Substantive Testing)

The auditor attempts to ensure that the inventory that is not owned has not been tagged and, if tagged, that quantities thereon do not appear on the listing. The existence of any inventory on hand that is not owned is discussed with management. The auditor inquiries about any inventory on consignment in or consignment out.

Valuation (Substantive Testing)

For inventory on the listing that was tested and counted by the auditor, the quantities on the listing are agreed to amounts counted by the auditor. Price tests on inventory are completed by agreeing to the prices used by the client to calculate inventory values to recent purchase invoices for retail items. This list can also be checked for lower of cost or market valuation. For manufactured items, the auditor tests the value of inventory by examining the accumulation of costs in work-in-progress and finished goods inventory. The costing method is reviewed to ensure that it has been applied properly.

Classification (Substantive Testing)

The auditor examines completed tags to assess the nature of inventory and to trace details to count summaries on which the calculation of ending inventory is performed. If some of the items pertain to work-in-process, an attempt is made to calculate the percentage of completion for these items.

The auditor also needs to ensure that the inventory category balances calculated on the listing are properly reflected in the correct category in the accounting records.

Presentation (Substantive Testing)

The auditor examines financial statements for proper segregation and disclosure of major inventory components, costing methods, existence of any pledged inventory, and disclosure of any sale or purchase commitments.

Payroll Cycle

Starts with hiring employees and ends with issuance of a payment. Is concerned with recording payroll expenses and accrued payroll liabilities.

Phases of Payroll Cycle

1. Hiring

2. Recording of Payroll

3. Payment of Payroll

Hiring

Segregation of duties is achieved by ensuring that the hiring function is not performed by those responsible for the accounting of payroll transactions. This procedure reduces the possibility of people who are not employees receiving pay. Personnel files should exist for each employee and be kept by the person or department responsible for these duties. When employees are hired, their backgrounds and references are checked and there is a formal process for notifying the accounting department about new employees and their rate of pay. Similar written notices about properly authorized pay-rate changes, terminations, and vacation requests are also used. All information pertaining to an employee is kept in the personnel file.

Recording of Payroll

more complex if employees are paid hourly. Time clocks and timecards that must be approved by a supervisor are used to ensure that the proper amount of time is recorded. In larger organizations, the punching of timecards by employees is observed by supervisors to ensure that employees are, in fact, punching their own cards.

These timecards are forwarded to the accounting department and are used to calculate gross pay and deductions, which are displayed on the payroll register. These calculations should be checked through computer edit checks, batch control totals of timecards, or manager review of payroll registers. Approval for overtime worked should be reviewed before the time is input into the computer. Wage rates in use in the employee master file should be periodically reviewed and compared to authorized rates in the personnel file by independent personnel.

Payment of Payroll

The payroll cheque signer should be someone other than the person who calculates and records the payroll or distributes the signed cheques. If a cheque–signing machine is used, access to it should be strictly controlled. Payroll cheques should be prenumbered to ensure completeness of recording.

Payroll cheques should be prepared and distributed by people who do not have access to the timecards or any payroll records. In larger companies, this is done by the treasurer’s department, which is responsible for the control of cash in the organization.

An imprest payroll bank account minimizes the exposure to payroll fraud. This type of account is used to hold exactly the amount of cash required to pay the employees listed on the current period’s payroll register. If the account has an overdraft balance at the end of the period, unauthorized and unrecorded payments occur. Cost savings can be obtained through the use of electronic funds transfers.

Low Risk of Material Misstatement in Payroll Cycle Because

• Employees tend to complain if they are underpaid.

• Payroll transactions may be straightened or standard (repetitive)

• Payroll transactions may be audited by regulatory agencies such as Canada Revenue Agency.

Significant Risks of Payroll Cycle

1. Errors in payroll withholdings and remittances

2. The potential for misstatement of inventory of payroll including fraud

3. The potential for nonexistent (fictitious) employees

Key Controls for Payroll Cycle

• Proper Authorization

• Adequate Segregation of Duties

• Master File Change

• Access Rights Management

• Timekeeping and Payroll Preparation Controls

• Payroll Payment Controls

• Employee Withholdings and Benefit Remittance Controls

Tests of Controls for Payroll Cycle

Used more than substantive tests, and the auditor often focuses on the audit of payroll transactions rather than payroll balance because payroll transactions are far more significant than related balance sheet accounts, and most organizations have good internal controls over payroll transactions. Therefore, most auditors do not spend an excessive amount of time performing tests of controls for payroll unless significant risks are identified.

Analytical Procedures (Payroll Cycle)

• Payroll Expense Accounts

• Direct Labour

• Commission Expense

• Payroll benefits expense and payroll benefits liability

• Accrued payroll benefits and payroll benefits expense

Payroll Expense Accounts

Compare payroll expense account balance with previous years (adjusted for payrate increases and increases in volume).

Direct Labour

Compare direct labour as a percentage of sales with that of previous years.

Commission Expense

Compare commission expense as a percentage of sales with that of previous years.

Payroll Benefits Expense and Payroll Benefits Liability

Compare payroll benefits expense as a percentage of salaries and wages with that of previous years (adjusted for changes in the benefits rates).

Accrued Payroll Benefits and Payroll Benefits Expense

Compare accrued payroll benefits accounts with that of previous years.

Substantive Tests of Details

• Accuracy

• Completeness

• Cutoff

Accuracy (Payroll Cycle)

The auditor compares balance of accrued liability account with subsequent period cash disbursement to ensure that accruals are stated at the correct amount

Completeness (Payroll Cycle)

The auditor can recalculate the accruals liability account with subsequent period payroll accounts.

Cutoff (Payroll Cycle)

The auditor can confirm accrued commissions with employees and compare balance with subsequent cash disbursements to ensure that the transactions in the payroll cycle are recorded in the proper period.

Fraud Procedures

Two most common types

1. Nonexistent employees

2. Fraudulent hours

ADAs are the useful approach to identify them, such as following:

• Summarize/stratify salaries by department or employee group.

• Analyze costs for special pay, overtime, premiums, etc.

• Sort employees by name and store to identify conflicts of interest where managers have relatives working for them.

• Extract all payroll cheques where the gross amount exceeds the set amount.