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UNIT 4 AUDIT OF INVENTORIES Estimated Time: 4.

5 HOURS
*Use Louwers 4th edition

Discussion questions 4-1

1. Many auditors consider the substantiation of the figure for inventory to be a more difficult and challenging task than the verification of most other items on the balance sheet. List several specific factors that support this view. 2. What should be considered in classifying inventory items? What are those items that should be accounted for as part of inventory? What role does passage of title play in the recognition of inventories? How should an auditor account for items not classified as inventory?

Discussion questions 4-2

Refer to Louwers 9-10, 9-12, 9-14 and 9-17. In an annual audit at December 31, 2012, you find the following transactions near the closing date: 1) Merchandise costing P18,220 was received on January 3, 2013, and the related acquisition invoice recorded January 5. The invoice showed the shipment was made on December 29, 2012, FOB destination. 2) Merchandise costing P6,250 was received on December 28, 2012, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was marked ON CONSIGNMENT. 3) A package case containing products costing P8,160 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked HOLD FOR SHIPPING INSTRUCTIONS. Your investigation revealed that the customers order was dated December 18, 2012, but that the case was shipped and the customer billed on January 10, 2013. The product was a stock item of your client. 4) Merchandise received on January 6, 2013, costing P7,200 was entered in the acquisitions journal on January 7, 2013. The invoice showed shipment was made FOB suppliers warehouse on December 31, 2012. Because it was not on hand December 31, it was not included in inventory. 5) A special machine, fabricated to order for a customer, was finished and in the shipping room on December 31, 2012. The customer was billed on that date and the machine excluded from inventory, although it was shipped on January 4, 2013.

Problem 4-1 Items to be reported as inventory

Assuming that each of the amounts is material, state whether the merchandise should be included in the clients inventory or not and give your reason for your decision on each item.
Refer to Louwers 9.46. Refer to Louwers 9.47.
Auditing Practice I Workbook

Problem 4-2 Sales/inventory cutoff

Problem 4-3 Purchasing cutoff

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Problem 4-4 Sales and purchases cut-off

WWW Enterprises engaged you to examine its books and records for the fiscal year ended June 30, 2012. The companys accountant has furnished you not only the copy of trial balance as of June 30, 2012 but also the copy of companys balance sheet and income statement as of the said date. The following data appears in the cost of goods sold section of the income statement: Inventory, July 1, 2011 Add: Purchases Goods available for sale Less: Inventory, June 30, 2012 Cost of goods sold P500,000 3,600,000 4,100,000 700,000 P3,400,000

The beginning and ending inventories of the year were ascertained through physical count except that no reconciling items were considered. Even though the books have been closed, your working paper trial balance shows all accounts with activity during the year. All purchases are FOB shipping point. The company is employing a periodic inventory system. In your examination of inventory cutoffs at the beginning and end of the year, you took note of the following: July 1, 2011: a) June invoices totaling to P130,000 were entered in the voucher register in June. The corresponding goods not received until July. b) Invoices totaling P54,000 were entered in the voucher register in July but the goods received during June. June 30, 2012: c) Invoices with an aggregate value of P186,000 were entered in the voucher register in July, and the goods were received in July. The invoices, however, were dated June. d) June invoices totaling P74,000 were entered in the voucher register in June but the goods were not received until July. e) Invoices totaling P108,000 (the corresponding goods for which were received in June) were entered in the voucher register in July. f) Sales on account in the total amount of P176,000 were made on June 30 and the goods delivered at that time. Book entries relating to the sales were made in June.

Prepare an audit working paper to answer the following questions: 1) How much is the adjusted Inventory as of July 1, 2011? 2) How much is the adjusted Purchases for the fiscal year ended June 30, 2012? 3) How much is the adjusted Inventory as of June 30, 2012? 4) How much is the adjusted Cost of Goods Sold for the fiscal year ended June 30, 2012? 5) What are the necessary adjusting entries to be made as of June 30, 2012?

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Problem 4-5 Valuation and accuracy of reported inventory

An audit is being made of the accounts of XXX Company for the year ended December 31, 2012. You were asked to verify the following merchandise inventory items as to correctness of quantity, pricing, and extension. Item A B C D E F G H I J K L Quantity 31,700 9,500 3,500 11,500 pcs 81,000 3,700 gross 21,500 2,100 25,500 4,100 doz 7,000 8,800 Price per unit P 5.00 45.20 112.00 8.50 (per doz) 1.80 17.20 per gross 20.00 63.90 5.50 19.00 per piece 36.00 95.10 Amount P 158,500.00 423,400.00 392,000.00 97,750.00 1,458,000.00 63,640.00 430,000.00 134,190.00 140,250.00 77,900.00 252,000.00 836,880.00 P 4,464,510.00

A comparison of the quantities in the inventory with those on the original tags used in making the count disclosed that item C should be 5,300 units instead of 3,500 and item F should be 7,300 gross instead of 3,700 gross. Quantities of the other items in the inventory were in agreement with quantities on the inventory tags. Net realizable values as of the closing date were as follows: Item Item Item A P 5.10 E P 1.50 I B 45.50 F 17.20 per J gross C 112.00 G 19.00 K D 8.30 per doz H 64.00 L

P 4.50 19.00 per piece 30.00 94.70

1. Prepare a schedule or schedules showing the corrected inventory values. 2. Using direct write-off, what adjustments should be made to correct the accounts, assuming inventory per books agrees with the inventory total shown above (use one compound entry only)?

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Problem 4-6 Inventory estimation - gross profit

On March 31, 2012, DDD Company had a fire which completely destroyed the factory building and inventory of goods in process; some pieces of equipment were saved. After the fire, a physical inventory was taken. The material was valued at P750,000 and the finished goods at P620,000. The inventories on January 1, 2012 consisted of: Materials Goods in process Finished goods Total 335,000 1,215,000 1,700,000 P 3,250,000 P

A review of the accounting records disclosed that the sales and gross profit on sales for the last three years were: 2009 2010 2011 Sales P 8,000,000 7,600,000 5,000,000 Gross profit P 2,400,000 2,250,000 1,775,000

The sales for the first three months of 2012 were P3,000,000. Material purchases were P1,250,000, transportation on purchases was P90,000 and direct labor cost for the three months was P1,000,000. For the past two years, factory overhead cost has been 70% of direct labor cost.

1. Determine the most likely gross profit rate to be used in estimating the inventory of goods in process destroyed by fire. 2. Compute for the total cost of goods placed in process. 3. Compute for the total cost of goods manufactured. 4. Determine the goods in process that were destroyed by fire. Problem 4-7 Physical observation audit tests for inventory periodic
You have been engaged for the audit of ZZZ Chemicals, Inc. for the year ended December 31, 2012. ZZZ is engaged in the wholesale chemical business and makes all sales at 25% over cost. Following are portions of the clients sales and purchases accounts for the calendar year 2012.

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EXHIBIT Sales Date 12/31 Reference Closing entry Amount P699,860 12/27 12/28 12/28 12/31 12/31 12/31 P699,860 SI# 965 SI# 966 SI# 967 SI# 969 SI# 970 SI# 971 Date Balance Forward Reference Amount P658,320 5,195 19,270 1,302 5,841 7,922 2,010 P699,860

Purchases Date 12/28 12/30 12/31 12/31 Balance Forward Reference RR# 1059 RR# 1061 RR# 1062 RR# 1063 Amount P360,300 3,100 8,965 4,861 8,120 P385,346 Date 12/31 Reference Closing entry Amount P385,346

P385,346

You observed the physical inventory of goods in the warehouse on December 31, 2012, and were satisfied that it was properly taken. When performing a sales and purchases cutoff test, you found that at December 31, 2012, the last receiving report used was no. 1063 and that no shipments have been made on any sales invoices with numbers larger than no. 968. You also obtained the following additional information: 1. Included in the warehouse physical inventory at December 31, 2012, were chemicals that had been acquired and received on receiving report no. 1060 but for which an invoice was not received until 2013. Cost was P2,183. 2. In the warehouse at December 31, 2012, were goods that had been sold and paid for by the customer but which were not shipped out until the year 2013. They were all sold on sales invoice no. 965 and were not inventoried. 3. On the evening of December 31, 2012, two cars were on ZZZ Chemicals siding: a. Car AR38162 was unloaded on January 2, 2013, and received on receiving report no. 1063. The freight was paid by the vendor. b. Car BAE74123 was loaded and sealed on December 31, 2012, and was switched off the companys siding on January 2, 2013. The sales price was P12,700 and the freight was paid by the customer. This order was sold on sale invoice no. 968.
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4. Temporarily stranded at December 31, 2012 on a railroad siding were two cars of chemical en route to the Papyrus Paper Company. They were sold on sales invoice no. 966, and the terms were FOB destination. 5. En route to ZZZ Chemicals on December 31, 2012, was a truckload of material that was received on receiving report no. 1064. The material was shipped FOB destination, and freight of P75 was paid by ZZZ Chemicals. However, the freight was deducted from the purchase price of P975. 6. Included in the physical inventory were chemicals exposed to rain in transit and deemed unsalable. Their invoice cost was P1,250, and freight charges of P350 had been paid on the chemicals. ZZZ Chemicals filed a claim against the shipper in January 2013. 1) 2)

Prepare a schedule or schedules showing the corrected inventory values and draft proposed adjusting entries as of December 31, 2012. Calculate the corrected physical inventory at December 31, 2012. Problem 4-8 Physical observation audit tests for inventory perpetual
You have been engaged for the audit of AAA Tires, Inc. for the year ended December 31, 2012. AAA Tires is engaged in the wholesale auto parts business. All sales are made at cost plus 30 percent of cost. AAA Tires maintains perpetual inventory records and adjusts the records annually after taking a physical inventory. Shown in Exhibit are portions of AAA Tires sales and inventory accounts for tires, the single most important (40 percent of total sales) product handled by the firm. EXHIBIT Tire Sales Amount Date P11,460,200 12/27 12/28 12/28 12/31 12/31 12/31 12/31 P11,460,200 Date 12/28 12/30 12/31 Reference Balance Forward RR# 2060 RR# 2062 RR# 2063 Tire Inventory Amount Date P780,680 6,400 22,600 10,800 12/31 Reference Adjustment to physical

Date 12/31

Reference Closing entry

Reference Balance Forward SO# 1278 SO# 1279 SO# 1280 SO# 1281 SO# 1282 SO# 1283 SO# 1284

Amount P11,250,000 16,400 48,600 20,100 56,800 17,600 42,700 8,000 P11,460,200 Amount P120,480

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You observed the physical inventory and are satisfied that it was taken properly. The tire inventory is located in two adjacent bays in the companys central warehouse. When performing a sales and purchases cutoff test, you found that at December 31, 2012, the last receiving report used was #2063. Moreover, you determined that no shipments had been made on any shipping orders with numbers larger than 1281. You also obtained the following information: 1. Included in the physical inventory at December 31, 2012, were tires that had been purchased and received on receiving report #2061 but for which an invoice was not received until 2013. The cost was P14,200. 2. In the warehouse at December 31, 2012, were tires that had been sold and paid for by the customer but that were not shipped until 2013. They were all sold on sales invoice/shipping order #1278. The tires were included in the physical inventory. 3. On the evening of December 31, 2012, two cars were on the AAA Tires railroad track. Both cars contained tires that were included in the 12/31/12 physical inventory. Car #SA877560 was unloaded on January 2, 2013, and received on receiving report #2064 (cost of tires, P16,800). The freight was paid by the vendor. Car #EE455621 was loaded and sealed on December 31, 2012, and because the freight was paid by the customer, title passed when the car was switched off the Hedley track on January 2, 2013. The sales price was P56,800. This order was sold on sales invoice/shipping order #1281. 4. Temporarily stranded on a railroad track at December 31, 2012, were two cars of tires in transit to St. Luke Tires of San Felipe. They were sold on sales invoice/shipping order #1279 and the terms were FOB shipping point. 5. En route to AAA Tires on December 31, 2012, was a truckload of tires that was received on receiving report #2065. The tires were shipped FOB shipping point and freight of P1,600 was paid by AAA Tires. However, the freight was deducted from the purchase price of P32,100. 6. Included in the physical inventory were tires damaged by excessive heat in transit and deemed unsalable. Their invoice cost was P16,300; freight charges of P960 had been paid on the tires. AAA Tires filed a claim against the shipper in January 2013.

1. Prepare a schedule or schedules showing the corrected inventory values and draft proposed adjusting entries as of December 31, 2012. 2. Calculate the corrected physical inventory at December 31, 2012.

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Problem 4-9 Comprehensive problem

You are observing inventory as a part of the August 31 year-end audit of BBB Warehouse Supply Company, a wholesale and retail engine parts company. Inventory included a large number of diverse parts varying from small bolts to large engines for earth-moving equipment. The company has ceased operation during the physical count except for receiving goods from suppliers and making shipments to essential wholesale customers. On the morning of the physical count, which is Saturday, September 2, you record in your working papers the last shipping document and receiving report number issued the previous day. They are 109313 and 41682, respectively. You observe the clients counting procedures and test count selected inventory yourself. You conclude the counts and descriptions are accurate. Before you leave the warehouse at the end of the day, after all counting is completed, you do several things: 1) Examine the receiving report book. The last number used was 41685. The receiving clerk informs you that all goods received on September 2 were kept in the receiving department with other goods received during the past two or three days. 2) Examine the shipping document book. The last number used was 109317. The shipping department informs you that two shipments were made in the morning, one was made after noon, and one was still in the shipping department. 3) Ask the receiving department to identify all goods received September 1. He identifies receiving reports 41680 through 41682 as having been received September 1. 4) Ask the shipping department to identify all goods shipped or sold over the counter September 1. He informs you goods on shipping document 109311 to 109313 were shipped September 1. He shows you approximately 300 duplicate sales slips for September 1 over-the-counter sales. September 1 retail sales totaled P12,690, but they were not included in August sales. 5) Examine the clients inventory counts in the receiving department. Inventory had been counted only for receiving reports 41674 to 41684. 6) Examine the clients inventory counts in the shipping department. Inventory had been counted only for shipping documents 109316 and 109317. Further examination shows that the inventory for all shipments made September 2 were included in the counts in the department from which the inventory was taken.

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During the year-end audit work you obtain selling prices, costs, terms, and recording data for each receipt and shipment. They are as shown as follow: Receiving Report Date Shipped ACQUISITON OF INVENTORY Date Amount of Received Acquisition Included In Or Excluded From August Acquisitions Journal FOB Origin or Destination

41679 41680 41681 41682 41683 41684 41685 41686 Shipping Document No. 109310 109311 109312 109313 109314 109315 109316 109317 109318

8-29 8-27 8-20 8-27 8-30 8-30 9-02 8-30

8-31 9-01 9-01 9-01 9-02 9-02 9-02 9-02

P 860 1,211 193 4,674 450 106 2,800 686

I I I I E E E E

Destination Origin Origin Destination Destination Origin Origin Destination Included in or Excluded from August Sales Journal I I I I I E E E E

SHIPMENTS OF INVENTORY Date Shipped Amount of Sale

8-31 9-01 9-01 9-01 9-02 9-02 9-02 9-02 9-02

P 780 56 3,194 635 193 1,621 945 78 3,611

Assume the information you have obtained from the receiving and shipping departments about the September 1 receipts and shipments is accurate.

1. Prepare all adjustments for cutoff errors in accounts payable, assuming no acquisitions are made for cash. 2. Prepare all adjustments for errors in sales. 3. What is the amount of the clients error in inventory assuming a periodic inventory method, and no adjustments in part (a) or (b) affected inventory? For retail sales, assume the gross margin percentage is approximately 30 percent.

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