24.3 Auditing Practice: Inventory, Property, and Liabilities
Key Takeaways
Purchases in transit FOB shipping point and goods out on consignment belong in the buyer's or consignor's inventory; goods held for others do not.
Sales shipped FOB destination but recorded before delivery must be reversed and the goods restored to inventory.
Expensed capital costs are corrected by capitalizing them and adding depreciation from the in-service date; capitalized repairs are expensed and their depreciation reversed.
The search for unrecorded liabilities examines disbursements and invoices after year-end to detect understatement of payables and accruals.
Summarizing all adjustments by their effect on profit is a standard final requirement in auditing practice problems.
Auditing Practice: Inventory, Property, and Liabilities
This section continues the auditing practice problems with inventory ownership and cutoff, property, plant, and equipment capitalization errors, the search for unrecorded liabilities, and the combined effect of adjustments on profit. The method is the same as in the cash and receivables problems: determine the correct balance, record adjusting entries, and summarize the effect on profit.
1. Inventory: Ownership and Cutoff
Inventory belongs to the party that holds legal title, which depends on the shipping terms and on consignment arrangements:
| Situation at year-end | Include in the buyer's or owner's inventory? |
|---|---|
| Purchases in transit, FOB shipping point | Yes; title passed when shipped, so the buyer includes them and records the payable |
| Purchases in transit, FOB destination | No; the seller still owns them until delivery |
| Goods out on consignment (held by a consignee) | Yes; the consignor still owns them |
| Goods held on consignment for another company | No; exclude them from the count |
| Sales in transit, FOB destination, already recorded as sold | Yes; the sale is not complete, so reverse it and restore inventory |
Example. The physical count on December 31 is PHP 2,400,000 at cost. The auditor finds:
| Finding | Adjustment to count (PHP) |
|---|---|
| Purchase shipped December 29, FOB shipping point, received January 3; invoice recorded in January (cost 150,000) | +150,000 |
| Purchase shipped December 30, FOB destination, received January 4 (cost 90,000) | 0 |
| Goods out on consignment at a dealer, not counted (cost 200,000) | +200,000 |
| Goods held on consignment for a supplier, included in the count | (80,000) |
| Goods sold FOB destination, shipped December 30, arrived January 3, excluded from the count and recorded as a December sale of 100,000 (cost 70,000) | +70,000 |
| Correct inventory | 2,740,000 |
Related entries: record the unrecorded purchase (Purchases or Inventory / Accounts payable PHP 150,000) and reverse the premature sale (Sales / Accounts receivable PHP 100,000). Under a periodic system, the count adjustments flow to cost of goods sold through the corrected ending inventory.
2. Property, Plant, and Equipment
Typical errors are costs that should have been capitalized but were expensed, and ordinary repairs that were capitalized.
Example. For the year ended December 31 (straight-line depreciation, no residual value):
- Installation cost of PHP 300,000 for a machine placed in service on July 1 (10-year life) was charged to expense. Correction: capitalize PHP 300,000 and record 6 months of depreciation = 300,000 / 10 x 6/12 = PHP 15,000.
- An ordinary repair of PHP 80,000 was debited to Machinery on October 1 and depreciated over 5 years. Correction: expense PHP 80,000 and reverse the depreciation recorded = 80,000 / 5 x 3/12 = PHP 4,000.
| Adjusting entry | Debit (PHP) | Credit (PHP) |
|---|---|---|
| Machinery / Installation expense | 300,000 | 300,000 |
| Depreciation expense / Accumulated depreciation | 15,000 | 15,000 |
| Repairs expense / Machinery | 80,000 | 80,000 |
| Accumulated depreciation / Depreciation expense | 4,000 | 4,000 |
Effect on profit: +300,000 - 15,000 - 80,000 + 4,000 = +PHP 209,000.
Other PPE procedures include vouching additions to invoices and board approval, inspecting major additions physically, examining disposals and retirements for unrecorded gains or losses, recomputing depreciation, and reviewing repairs expense for items that should be capitalized.
3. Liabilities: Search for Unrecorded Liabilities
Because the main risk for liabilities is understatement (completeness), the auditor examines disbursements and invoices after year-end, unpaid invoices, and receiving reports near year-end, and traces them back to the December 31 records.
Example. January payments examined by the auditor:
| January payment | December 31 liability? | Adjustment (PHP) |
|---|---|---|
| PHP 120,000 for December services, invoice dated December 28, not recorded | Yes | Expense / Accounts payable 120,000 |
| PHP 90,000 for goods shipped FOB destination and received January 5 | No | None |
| PHP 45,000 for salaries earned December 16-31, paid January 5, not accrued | Yes | Salaries expense / Accrued salaries 45,000 |
| PHP 150,000 for the FOB shipping point purchase in Section 1 | Yes | Already recorded with the inventory adjustment |
Other liability procedures include confirming loans with banks, recomputing bond discount or premium amortization using the effective interest method, reviewing board minutes and lawyers' letters for provisions and contingencies, and checking that current and noncurrent portions of debt are properly classified, including debt in covenant breach at year-end.
4. Summary of Effects on Profit
| Adjustment | Effect on profit (PHP) |
|---|---|
| Inventory count adjustments (+150,000 + 200,000 - 80,000 + 70,000) | +340,000 |
| Unrecorded purchase added to cost (purchases) | (150,000) |
| Reversal of premature sale | (100,000) |
| PPE corrections | +209,000 |
| Unrecorded December services | (120,000) |
| Unaccrued salaries | (45,000) |
| Net effect on profit | +134,000 |
Recording the unrecorded purchase raises cost of goods sold, and adding the same goods to ending inventory lowers it, so the two effects offset. Excluding goods held for others and restoring consigned goods affect only ending inventory. Preparing this summary is a common final requirement in board problems.
A company's year-end count at cost is PHP 1,000,000. It includes PHP 60,000 of goods held on consignment for a supplier and excludes PHP 90,000 of its own goods out on consignment, PHP 40,000 of purchases in transit shipped FOB shipping point, and PHP 25,000 of purchases in transit shipped FOB destination. What is the correct inventory?
PHP 1,070,000
PHP 1,095,000
PHP 1,190,000
PHP 1,010,000
In searching for unrecorded liabilities at December 31, which item should the auditor propose to record as a year-end payable?
A purchase order issued December 20 for goods to be shipped January 15
An invoice dated January 3 for goods shipped FOB shipping point on December 28 and received January 2
Goods shipped FOB destination on December 30 and received January 4
January office rent paid on January 5
On October 1, a company charged to repairs expense a PHP 600,000 overhaul that extended the useful life of equipment. The overhaul should be depreciated straight-line over 5 years with no residual value. What is the effect of the error on the year's profit before correction?
Understated by PHP 600,000
Understated by PHP 480,000
Overstated by PHP 570,000
Understated by PHP 570,000
Sections you finish are checked off in the contents.