Question

Your firm is the auditor of Best Drink Sdn Bhd, and you have been asked to audit the valuation of the company’s inventory at 31 December 2019 in accordance with MFRS 102 Inventories. Best Drink Sdn Bhd operates from a single factory, purchases local fruits from the wholesalers, manufactures them into fruit juices and then sells them to the general public.

The inventory consists of canned carbonated fruit drinks, bottled fruit drinks and fruit cordial drinks. They are sold in house, as well distributed to other sellers who operate local shops and vending machines.

As an auditor of the company, you found the followings:

  

• A full physical inventory count was carried out at the year-end, and you are satisfied that the inventory was counted accurately and there are no cut-off errors.

• Because of the limited time available between the year end and the completion of the audit, the company has valued the inventory at cost (by recording the selling price and deducting the normal gross profit margin). Inventory which the company believes to be worth less than cost has been valued at net realisable value. The selling price used is the price used for selling the item in store when it was counted.

• The inventories have a two-year shelf life from their manufacturing dates. One of the risk of the fruit drinks is that one can or bottle can spoil the rest of the inventories in batches especially during transportation. Thus, it is very important to ensure that no single can or bottle leaks.

Required:

1. Identify the risks relating to inventory for Best Drink Sdn Bhd. Explain your answers

(3 Marks)

2. Suggest six (6) suitable substantive tests of details that you would conduct.)

(12 Marks)

(Total: 15 Marks)

Answer 1

Inventory accounting is governed by the accounting standard, MFRS 102– Inventories. ... It requires that inventories be measured at the lower of cost and net realizable value (NRV)

Inventory accounting is governed by the accounting standard, MFRS 102– Inventories. The standard lays down the rules of accounting for all types of inventories. It requires that inventories be measured at the lower of cost and net realizable value (NRV). It also provides guidelines for determining inventory costs (including cost formulas) and subsequent recognition of inventory as expense, including any write down to net realizable value. The standard defines inventory as assets held for sale in the ordinary course of business (finished goods), assets in the production process (work-in-progress) and materials and supplies consumed in the course of production (raw materials). However, the standard does not apply to agricultural produce and commodities which are measured at fair value. 10.5 INVENTORY MEASUREMENT The standard requires that inventory be measured at costs, and costs can include the following elements: a. Costs of purchase (including taxes, transport, and handling) net of trade discounts received; b. Costs of conversion (including fixed and variable manufacturing overheads), and c. Other costs incurred in bringing the inventories to their present location and condition. The standard cost and retail methods may be used for the measurement of cost, provided that the results approximate actual cost. For consistency, the same cost formula should apply for all inventories with similar characteristics, but for groups of inventories that have different characteristics, different cost formulas are permitted. A key concept about accounting measurement of an asset is that it must be reliably measured. An asset is said to be reliably measured if its value can be determined in terms of cost, be it purchase cost or a cost based on fair market value. Whatever costs that go into inventory is important because it affects profits and by extension, income taxes. For example, a car is a finished product, but what goes into the cost of making the car may include the following costs: a. Steel; b. Glass; c. Leather; d. Labour; Chapter 10.indd 232 Accounting for Inventory 233 e. Factory overheads; f. Shipping cost of raw materials purchased; g. Insurance on materials on transit; h. Design; i. Import duties; j. Engine; k. Accessories and spare parts; l. Tyres, and m. Computerized equipment. Therefore, the cost of a finished product in the inventory

is the sum of all the costs incurred to bring the product to its intended use

MFRS102/IAS2 requires to value inventories based on the lower of cost and NRV.The reasons are mainly due to:

Permanent fall in marketprice

Excessively priced inventories

High inventory levels and liquidity problems

Deteriorating

Obsolescence

Marketing strategy to penetrate a market

Test and checks we have to consider

Cost of purchase must include	Further comments
Purchase price	Inventory should be recorded at the spot rate at the date of the transaction if purchased in a foreign currency.
Import duties and other taxes	These costs should be included unless recoverable from the relevant authorities.
Transport and carriage costs	These costs should be included to the extent that they are directly attributable to the purchase of inventory.
Trade discounts and rebates	Any trade discounts or rebates should be deducted from the cost amount.

For work in progress

Cost of conversion (work in progress) must include:	Further comments
Costs directly related to converting raw materials into finished goods	For example: – Direct labour (to include: gross wages, employers NIC, pensions, employee benefits) – Subcontractor costs – Specific components
Variable production overheads	For example: – Indirect materials (adhesives, packaging etc.) – Indirect labour (to include: gross wages, employers NIC, pensions, employee benefits)
Fixed production overheads	For example: – Depreciation of plant, equipment, factory buildings – Maintenance of plant, equipment, factory buildings – Factory management costs and administration

Substantive procedures we have to check

• Cutoff analysis. The auditors will examine your procedures for halting any further receiving into the warehouse or shipments from it at the time of the physical inventory count, so that extraneous inventory items are excluded. They typically test the last few receiving and shipping transactions prior to the physical count, as well as transactions immediately following it, to see if you are properly accounting for them.

• Observe the physical inventory count. The auditors want to be comfortable with the procedures you use to count the inventory. This means that they will discuss the counting procedure with you, observe counts as they are being done, test count some of the inventory themselves and trace their counts to the amounts recorded by the company's counters, and verify that all inventory count tags were accounted for. If you have multiple inventory storage locations, they may test the inventory in those locations where there are significant amounts of inventory. They may also ask for confirmations of inventory from the custodian of any public warehouse where the company is storing inventory.

• Reconcile the inventory count to the general ledger. They will trace the valuation compiled from the physical inventory count to the company's general ledger, to verify that the counted balance was carried forward into the company's accounting records.

• Test high-value items. If there are items in the inventory that are of unusually high value, the auditors will likely spend extra time counting them in inventory, ensuring that they are valued correctly, and tracing them into the valuation report that carries forward into the inventory balance in the general ledger.

• Test error-prone items. If the auditors have noticed an error trend in prior years for specific inventory items, they will be more likely to test these items again.

• Test inventory in transit. There is a risk that you have inventory in transit from one storage location to another at the time of the physical count. Auditors test for this by reviewing your transfer documentation.

• Test item costs. The auditors need to know where purchased costs in your accounting records come from, so they will compare the amounts in recent supplier invoices to the costs listed in your inventory valuation.

• Review freight costs. You can either include freight costs in inventory or charge it to expense in the period incurred, but you need to be consistent in your treatment - so the auditors will trace a selection of freight invoices through your accounting system to see how they are handled.

• Test for lower of cost or market. The auditors must follow the lower of cost or market rule, and will do so by comparing a selection of market prices to their recorded costs.

• Finished goods cost analysis. If a significant proportion of the inventory valuation is comprised of finished goods, then the auditors will want to review the bill of materials for a selection of finished goods items, and test them to see if they show an accurate compilation of the components in the finished goods items, as well as correct costs.

• Direct labor analysis. If direct labor is included in the cost of inventory, then the auditors will want to trace the labor charged during production on time cards or labor routings to the cost of the inventory. They will also investigate whether the labor costs listed in the valuation are supported by payroll records.

• Overhead analysis. If you apply overhead costs to the inventory valuation, then the auditors will verify that you are consistently using the same general ledger accounts as the source for your overhead costs, whether overhead includes any abnormal costs (which should be charged to expense as incurred), and test the validity and consistency of the method used to apply overhead costs to inventory.

• Work-in-process testing. If you have a significant amount of work-in-process (WIP) inventory, the auditors will test how you determine the percentage of completion for WIP items.

• Inventory allowances. The auditors will determine whether the amounts you have recorded as allowances for obsolete inventory or scrap are adequate, based on your procedures for doing so, historical patterns, "where used" reports, and reports of inventory usage (as well as by physical observation during the physical count). If you do not have such allowances, they may require you to create them.

• Inventory ownership. The auditors will review purchase records to ensure that the inventory in your warehouse is actually owned by the company (as opposed to customer-owned inventory or inventory on consignment from suppliers).

• Inventory layers. If you are using a FIFO or LIFO inventory valuation system, the auditors will test the inventory layers that you have recorded to verify that they are valid.