Auditing Inventory and Warehousing Cycle

Inventory and Warehousing Cycle.

My video lectures about auditing the inventory cycle and warehousing cycle including substantive testing, test of internal control and analytical procedures are covered in my auditing course and CPA lessons.  Or browse from menu above.

Auditing and attestation course

Auditing and Attestation course


The  inventory cycle interacts with other cycles of a business. In a retail or wholesale business, finished goods inventory is purchased as a function of the acquisitions and payments cycle and sold as a function of the revenue and collections cycle. In a manufacturing entity, the products purchased as a function of the acquisitions and payments cycle are raw mate- rials or inputs to the manufacturing process.

When inputs to production are needed, they are physically moved from storage and into the manufacturing process. Labor and manufacturing overhead are added to the input materials until the manufacturing process is complete. At that point the work-in-process inventory becomes finished goods, is available for sale, and is ultimately sold as a function of the revenue and collections cycle. Documentation at each of these steps is required both to add to physical control and to trace and allocate the appropriate costs to the various items of finished goods inventory. The types of transaction activities affecting the inventory cycle follow.

The cost accounting records of the business accumulate the addition of inputs into work-in-process inventory. The source and form of information that goes into the cost accounting system varies widely among companies. The cost accounting system may account for the work-in-process based only on the quantity of units of inputs used or may have cost dollars included. The journal entry shown above is an example of a tracking system that includes dollar amount information. If just the quantity of inputs is tracked at this stage, then cost dollars are attached later. The movement of goods may be tracked using technol- ogy such as bar codes, weight measures, or even inventory locations. Alternatively, the tracking system may be as simple as recording the quantity of the inventory item removed from stores.

After entering the manufacturing function, input materials are processed. Typically, human labor is involved in the production process, along with machine time and supplies. Each company determines which costs to track individually, sometimes called direct tracing, and which to allocate. The costs that are tracked individually are called direct costs and those that are allocated are called indirect costs or overhead. Direct costs are traced and added to work-in-process in the cost accounting records. For example, those human resources costs that are traced to inventory production are generally called direct labor and increase the work-in-process balance. The specific journal entry used to account for this transaction depends on the integration of the cost records with payroll records in the human resources cycle.

One way to handle the transaction is to post a journal entry, increasing direct labor and decreasing compensation expense after the payroll cash disbursement. In some situations all of an employee’s payroll costs are captured as direct labor at the time of the cash disbursement. Overhead costs are usually posted to work-in-process when the manufacturing activities are completed. Overhead costs are also calculated and posted at the end of the fiscal period for any goods that are still in process at that time. A common method of accounting for overhead is to capture actual overhead expenses as they are incurred in a Manufacturing Overhead Control account. The entry that allocates overhead posts the allocated amount contra to the actual overhead expense. At the end of the year, the net difference between actual and allocated overhead expense is a variance called over- or underallocated overhead.

Inventory is often the most difficult and time consuming part of many audit engagements because:

  1. Inventory is generally a major item on the balance sheet and often the largest item making up the accounts included in working capital.
  2. The need for organizations to have the inventory in diverse locations makes the physical control and counting of the inventory difficult.
  3. Inventory takes many different forms that are difficult for the auditor to fully understand.
  4. The consistent application of different valuation methods can be fairly complicated.
  5. The valuation of inventory is difficult due to such factors as the large number of different items involved, the need to allocate the manufacturing costs to inventory, and obsolescence.
    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.
    1. Compare the inventory cost entered into the inventory system to the supporting invoice to determine that it was properly recorded and the purchase variance (standard cost system), if any, was properly reflected.
    2. Test the purchase cutoff at the physical inventory date and year-end to determine whether or not the physical inventory and year-end inventory cutoffs are proper from a purchase standpoint.