Chapter 13

Final work: specific problems,
related to stocks, long-term

contracts and trade creditors
Chapter 13
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Stuart Manson ISBN 1-86152-946-5
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LEARNING OBJECTIVES
After studying this chapter you should be

able to:
Apply the general principles for determining
the validity of the amount attributed to stocks,
long-term contracts and trade creditors.
Describe the inherent risks affecting stocks,
long-term contracts and trade creditors.
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LEARNING OBJECTIVES CONT'D
Explain the controls introduced by management

and the detection procedures carried out by the
auditor to keep audit risk to acceptable low
levels.
Evaluate a companys system for the
determination of physical existence, condition
and ownership of stocks and long-term
contracts.
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LEARNING OBJECTIVES CONT'D
Explain how identification by the auditor of

judgements by management in relation to
stocks, long-term contracts and creditors
helps to direct audit effort to critical areas.
Draft audit programmes to test the amounts
attributed to stocks, long-term contracts and
trade creditors.
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KEY POINTS p.484
Stocks are normally a significant asset of

manufacturing companies with direct effect on
profit. They vary in character and pose a variety
of problems for auditors.
The examples used here are taken from the

mineral oil industry and the manufacture of
television sets.
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KEY POINTS p.485
The costing system is important in determining cost

of stocks and long-term contracts and auditors pay
particular attention to ensuring costs are genuine,
accurate and complete.
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KEY POINTS pp.485486
Some costs are easily allocated to products, but

overheads may be allocated on some arbitrary but
reasonable basis, and on the basis of production
levels, which are normal, taking one year with
another.
Some products may be main products, whereas
others may be by-products, with income on disposal
being treated as reduction in cost of main products.
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KEY POINTS p.486
Net realizable value may not be easy to determine

because stocks may not be used or sold or
completed until after audit field work is complete.
Inherent risks affecting stocks include:

(a) changes in demand for the companys products;
(b) changes in production levels;
(c) defects in product lines;
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KEY POINTS p.486 CONT'D
(d) stocks can be attractive and easily transportable;

(e) complex production process;
(f) joint products;
(g) significant variances from standard costs;
(h) competitors providing more risky environment;
(i) complex calculation of overheads.
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ACTIVITY 13.1
Explain why significant variances from standard

costs are an inherent risk factor.
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Acquisitions: it is important to determine the point

at which title passes, particularly in e-commerce
relationships.
Safeguarding stocks: this includes physical
safeguards and restriction of access via
documentation.
Disposals of stocks: normal sales are more likely
to be controlled than abnormal disposals.
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KEY POINTS p.489
Determining existence, condition and ownership

at period-ends: physical stock counts, timely
reconciliation to stock records and investigation of
significant differences.
Valuation of stocks: the basic principle is the lower
of cost and net realizable value, with controls to
ensure costing and other records are reliable and
prepared consistently.
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ACTIVITY 13.2
Look at the figures in the case study and give

your initial impressions.
Remember that your review is intended to set the
scene for your substantive testing procedures of
stocks.
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ACTIVITY 13.3
Analyse the information in Case study 13.1 (Part

2) and ask yourself if it has changed your
perceptions. What areas, in your view, require
special audit emphasis? Do not spend too much
time in very detailed analysis, just pinpoint areas
of concern in relation to stock quantities and
values. We suggest also that you look at
allocation of overheads.
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KEY POINTS p.492
Substantive testing of stocks and related production
costs address:
existence;
condition;
ownership;
cut-off;
production costs (genuine accurate and complete);
production costs (properly allocated to stocks on
hand, and amount attributed to stocks is genuine,
accurate and complete)
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KEY POINTS p.493
Discussion under two headings:

(1) Do stocks exist, in good condition and are they
owned by the company? Is cut-off accurate?
(2) Have all production costs and stock values
been properly determined?
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KEY POINTS p.494
Normal audit practice to attend stock counts to

ensure the stocktaking system is operating
satisfactorily and to perform compliance and
substantive tests.
Cut-off procedures are performed at external and
internal cut-off points.
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ACTIVITY 13.4
Calculate the effect on profits of the following

matters:
(a)Goods with a cost value of 10,000 were
transferred from raw materials store to
production on 31 December 2007. They were
not included in stock in the raw materials
store, but erroneously were not counted in the
factory either. The goods were used in
production on 2 January 2008.
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ACTIVITY 13.4 CONT'D
(b) Finished goods costing 15,000 were

transferred to the finished goods store at
12.30 p.m. on 31 December 2007. The stock
count team had completed the count in the
finished goods store at 12 noon and did not
commence counting stock in the factory until
2.00 p.m.
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(c) Goods with a sales value of 30,000 were

despatched to customers on 2 January 2008
but were invoiced at 31 December 2007. The
goods had been included in stock in the
finished goods store and valued for
accounting purposes at 20,000.
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KEY POINTS p.496
Company procedures to ensure accurate cut-off

are as follows:
(a) individual responsible for cut-off;
(b) restrict movement of goods during count;
(c) if movements are unavoidable then a decision
on treatment to be made by a responsible
official;
(d) note the number of the last movement
document.
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ACTIVITY 13.5
Review the stocktaking instructions and list

those features that:
would serve to ensure that the stocks were

properly counted and recorded; and
might be regarded as weaknesses in the
system for counting and recording the stocks.
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Procedures to ensure stock is properly counted

and recorded are as follows:
(a) issue of stocktaking instructions;
(b) person with overall responsibility, independent
of stores personnel;
(c) balanced stock count teams;
(d) stores neat and tidy;
(e) arrangements for cut-off;
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KEY POINTS pp.497499 CONT'D
(f) issue of pre-numbered stock sheets and

completeness check;
(g) stock names and reference numbers on the
stock sheets;
(h) members of count teams count stock
independently until agreement reached;
(i) count sheets signed by two members of the
count team;
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(j) count teams comment on items in poor

physical condition;
(k) responsible officials to investigate significant
discrepancies between stock records and
count;
(l) count teams responsible for manageable
quantities of products;
(m) logical system for recording stock names and
reference numbers;
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(n) test counts by responsible officials;

(o) marking stock counted;
(p) identification of goods held for or by third
parties;
(q) auditors available for advice;
(r) briefing sessions with count teams to ensure
instructions properly understood.
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KEY POINTS p.499
Stock count observation, purposes and procedures.

Auditors attend the count to check if instructions are
properly followed, and to make test counts to ensure
procedures and internal controls are satisfactory.
Auditors select items from count records and
physical count and compare to gain assurance as
to completeness and accuracy of count records,
giving particular consideration to high value stocks.
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Level of substantive tests of details depends on the

auditors view of the quality of stocktaking instructions
and how they are applied. Stock counts may be
carried out during the year and stock quantities taken
from records only if:
(a) controls over stock records are adequate;
(b) stock records are accurate and complete;
(c) significant differences between stock records and
quantities counted are investigated and corrected.
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KEY POINTS p.500
Audit procedures include:

(a) stock count observations during the year;
(b) test the accuracy of stock records;
(c) test for cut-off at count date and balance sheet
date;
(d) if necessary, conduct a restricted test count at the
balance sheet date.
There are particular problems affecting work in
progress, stocks held at third parties and at branches.
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The basis of stock valuation is the lower of cost and

net realizable value. Basic rules for calculating cost
include:
(a) for different categories of stock, not for the
stocks as a whole;
(b) comprises cost of purchase and costs of
conversion;
(c) cost of purchase comprises direct costs, less
cost reductions;
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(d) cost of conversion comprises:

(i) direct costs;
(ii) production overheads based on normal level
of activity, taking one year with another;
(iii) other overheads incurred in bringing a product
or service to its present location and condition;
(e) costs may be allocated to production using an
arbitrary method, such as FIFO and AVCO.
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KEY POINTS p.502
Net realizable value is actual or estimated selling

price less all further costs of production and costs
yet to be incurred in marketing, selling and
distributing.
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ACTIVITY 13.6
Calculate the amount at which 1,000 wooden

building bricks should be stated in the financial
statements.
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KEY POINTS p.511
A long-term contract may be defined as:

A contract entered into for the design,
manufacture or construction of an asset or
provision of a service or a combination such
that the contract activity usually falls into
different accounting periods.
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The major problem is that the construction period

overlaps accounting periods, so a decision must
be made as to whether profits and losses should
be taken up before completion. This is subjective
and auditors assess the validity of management
judgements.
Case study 13.4 identifies nine judgemental
points, each assertion involving an audit evidence
search and testing:
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(1) costs incurred to date are genuine, accurate

and complete;
(2) stages of completion and related costs are
properly determined;
(3) invoices issued to customers are calculated in
accordance with contract and certified by the
surveyor;
(4) cash received from debtors is genuine,
accurate and complete and properly allocated
to contracts;
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(5) estimated total costs are genuine, accurate and

complete;
(6) contract prices are genuine, accurate and
complete;
(7) when attributable profits on contracts are taken
up, it is sufficiently complete to give adequate
assurance that the outcome of the contract is
certain; losses should be provided for when
recognized;
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(8) the profitability of different stages of the contact

has been properly determined;
(9) the method employed in taking up profits is
comparable with prior years, unless
appropriate and the effect of change is
disclosed.
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KEY POINTS p.517
Trade creditors are normally classified as amounts

payable in the short term. They come into
existence as the result of purchase of goods or
the performance of services by third parties, so
audit work on purchases and related assets
cannot be divorced from each other.
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Inherent risks affecting trade creditors include:

(a) new or material transactions or events;
(b) material variances from standard costs;
(c) suppliers experiencing difficulties;
(d) significant changes in terms of trade;
(e) a material increase in the age of trade
creditors;
(f) major changes in the nature of purchases;
(g) above-average returns of goods purchased.
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KEY POINTS p.518
Apart from a satisfactory control environment,

auditors expect to see controls over:
the creation of trade creditors;
recorded trade creditors at year-end;
payment of trade creditors.
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For creation of trade creditors, expected controls

include:
(a) preparation of integrated purchases budget
and investigation of variances;
(b) record the point at which title in goods acquired
passes and services rendered are complete;
(c) for goods accepted on sale or return, a clear
statement of company obligations to suppliers;
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(d) where title remains with the supplier there may

be special disclosure requirements;
(e) purchases not in the normal purchases system
to be kept to a minimum, and specially
authorized;
(g) investigation of reasons for significant returns;
(h) cut-off procedures.
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For recorded trade creditors at the year-end,

expected controls include:
(a) appropriate division of duties;
(b) regular review of suppliers statements;
(c) system for adhering to and renegotiating
supplier credit limits;
(d) a system for detecting unrecorded liabilities;
(e) a system for enquiry into unusual features.
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KEY POINTS p.519520
For payment of trade creditors balances, expected

controls include:
(a) independent matching operation;
(b) calculations on purchase invoices checked for
accuracy;
(c) evidence of controls performed;
(d) cheque signatories to see supporting
documentation;
(e) blank cheques never to be signed.
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Substantive approaches cover:

(a) creation of trade creditors balances, including
re-performing matching operation;
(b) recorded trade creditors at year-end;
(c) search for unrecorded liabilities:
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ACTIVITY 13.7
Situation 1.
Company A is a glass manufacturer and requires
high quality sand from Australia for its production
of special precision glass products. At the year-
end, sand is on board a ship in the middle of the
Indian Ocean. What audit steps would you take
to ensure related liabilities have been properly
recorded and reflected in the financial
statements?
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Situation 2.
The audit programme for purchases and trade
creditors of company B includes the following:
Examine the companys reconciliations between
creditors statements and purchase ledger
balances. You discover that company B has not
made such reconciliations and on selecting
creditors statements for comparison with purchase
ledger balances you find many material differences
between the two. Suggest further audit steps.
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Situation 3.
You are investigating debit balances in the
creditors balances of company C. What audit
steps would you take to ensure the debit
balances are valid?
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Situation 4.
Company D has listed unmatched GRNs and
goods returned forms (GRFs) at the year-end
date, valued them and included the amounts in
purchases accruals. What steps would you take
to satisfy yourself that the accruals are
acceptable?
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Situation 5.
As part of your audit work you have reviewed the
forecast accounts to 31 December 2007 prepared
by company E six months prior to that year-end
date. You note that trade creditors in the forecast
accounts are about 25% higher than those shown
in the draft financial statements at 31 December.
Describe the audit tests you would make to satisfy
yourself that the trade creditors in the draft
financial statements are acceptable.
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CHAPTER SUMMARY
This chapter has demonstrated:

The general principles relating to the audit of
balance sheet headings;
How these should be applied to the audit of
stocks;
Related profit and loss account headings and the
audit approaches to them;
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CHAPTER SUMMARY CONT'D
Management assertions and audit objectives

appropriate to each asset or liability;
How such matters relate to issues discussed in
other chapters, for example systems work, the
use of computers and analytical review.
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FURTHER READING
SSAP 9 (Stocks and Long-term Contracts)
ISA 500 and ISA 501 (Part A)

Practice Note 25 (Attendance at Stocktaking)
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Final work: specific problems,

related to stocks, long-term

After studying this chapter you should be

Explain the controls introduced by management

Explain how identification by the auditor of

Stocks are normally a significant asset of

The examples used here are taken from the

The costing system is important in determining cost

Some costs are easily allocated to products, but

Net realizable value may not be easy to determine

Inherent risks affecting stocks include:

(d) stocks can be attractive and easily transportable;

Explain why significant variances from standard

Acquisitions: it is important to determine the point

Determining existence, condition and ownership

Look at the figures in the case study and give

Analyse the information in Case study 13.1 (Part

Discussion under two headings:

Normal audit practice to attend stock counts to

Calculate the effect on profits of the following

(b) Finished goods costing 15,000 were

(c) Goods with a sales value of 30,000 were

Company procedures to ensure accurate cut-off

Review the stocktaking instructions and list

would serve to ensure that the stocks were

Procedures to ensure stock is properly counted

(f) issue of pre-numbered stock sheets and

(j) count teams comment on items in poor

(n) test counts by responsible officials;

Stock count observation, purposes and procedures.

Level of substantive tests of details depends on the

Audit procedures include:

The basis of stock valuation is the lower of cost and

(d) cost of conversion comprises:

Net realizable value is actual or estimated selling

Calculate the amount at which 1,000 wooden

A long-term contract may be defined as:

The major problem is that the construction period

(1) costs incurred to date are genuine, accurate

(5) estimated total costs are genuine, accurate and

(8) the profitability of different stages of the contact

Trade creditors are normally classified as amounts

Inherent risks affecting trade creditors include:

Apart from a satisfactory control environment,

For creation of trade creditors, expected controls

(d) where title remains with the supplier there may

For recorded trade creditors at the year-end,

For payment of trade creditors balances, expected

Substantive approaches cover:

This chapter has demonstrated:

Management assertions and audit objectives

SSAP 9 (Stocks and Long-term Contracts)

ISA 500 and ISA 501 (Part A)

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