This chapter described details of the controls over inventories and cost of goods sold, the auditors' consideration of these controls, and substantive tests of inventories and cost of goods sold. To summarize:

• The audit of inventories presents the auditors with significant risk because: (a) they often represent a very substantial portion of current assets, (b) numerous valuation methods are used for inventories, (c) the valuation of inventories directly affects cost of goods sold, and (d) the determination of inventory quality, condition, and value is inherently complex.

• Effective internal control over inventories requires appropriate controls over purchasing, receiving, and issuing, supplies and materials, producing and shipping products, and cost accounting. A perpetual inventory system is also important.

• The auditors' objectives in the audit of inventories and cost of goods sold are to: (a) consider inherent risks; (b) consider relevant controls; (c) establish the existence of, and the client's rights to, inventories; (d) establish the completeness of inventories; (e) determine that inventories and cost of goods sold are valued in accordance with GAAP; and ( f ) determine that presentation and disclosures of inventory accounts are appropriate.

• The auditors' consideration of inherent risks and the controls over inventories, purchases, and production will allow them to design appropriate substantive tests of inventory and cost of goods sold accounts.

• In the audit of inventories, auditors are primarily concerned about the existence assertion, that is, the possibility of overstatement of year-end balances. Therefore, a primary substantive test for inventory accounts is observation of the client's physical inventory. Other substantive procedures include price tests of the valuation of inventory items, cutoff tests, analytical procedures, and tests of the financial statement presentation and disclosure.

Describe the nature of inventories and cost of goods sold.

Describe the auditors' objectives for the audit of inventories and cost of goods sold.

Describe the documents, records, and accounts that are involved in the purchases and production (conversion) cycles and the fundamental controls over inventories, purchasing, and production.

Assess the risks of material misstatement (inherent and control risks) of inventories, purchases, and cost of goods sold.

Design typical tests of controls used by auditors to support the assessed risks of material misstatement (inherent and control risks) for the financial statement assertions related to inventories and cost of goods sold.

Explain how the auditors design substantive audit procedures to address the risks of material misstatement of inventories and cost of goods sold.