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Discrepancies. “(4) The inventories should be compared with the stores ledger, work in progress ledgers and finished product records and stock records as to quantities, prices and values, and any material discrepancy should be thoroughly traced.

Book Inventory. “(5) Where stock records are kept and no physical inventory is taken at the time of the audit, ascertain when the last physical inventory was taken and compare it with the book records. If no recent comparison is possible, select a few book items of importance and personally compare with the actual stock on hand.

Physical Inventory. “(6) Where no stock records are kept, a physical inventory should be taken preferably under the general direction of the auditor. After the inventory is completed, he should apply the same tests to verify its accuracy as if the inventory had been taken before his arrival upon the scene.

Inadequate Cost Systems. “(7) When the cost system of a company does not form a part of the financial accounting scheme there is always a chance that orders might be completed and billed, but not taken out of the work in progress records. Especially is this the case when reliance is placed on such records to the extent that a physical inventory is not taken at the end of the period to verify the information shown therein. In these cases the sales for the month preceding the close of the fiscal period should be carefully compared with the orders in progress as shown by the inventory, to see that nothing that has been shipped is included in the inventory in error. Cost systems which are not coordinated with the financial accounts are unreliable and frequently misleading. Special attention should be called to every case in which the cost system is not adequately checked by the results of the financial accounting.

Goods in Transit. “(8) Ascertain that purchase invoices for all stock included in the inventory have been entered on the books. Look for post dated invoices and give special attention to goods in transit.

Consigned Goods. “(9) See that nothing is included in the inventory which is not owned but is on consignment from others. If goods consigned to others are included, see that cost prices are placed thereon, less a proper allowance for loss, damage, or expenses of possible subsequent return. This does not include goods at branches, as the valuing of such stocks will be governed by the same principles as apply at the head office.

Goods Awaiting Shipment. “(Io) Ascertain that nothing is included which has been sold and billed, and is simply awaiting shipment.

Legitimate Costs. “(II) If duties, freight, insurance, and other direct charges have been added, test them to ascertain that no error has been made. Duties and freight are legitimate additions to the cost price of goods, but no other items should be added except under unusual circumstances.

INVENTORIES IO3

Obsolete Stock. “(12) As a check against obsolete or damaged stock being carried in the inventory at an excessive valuation, the detailed records for stores, supplies, work in progress, finished products, and purchased stock in trade, should be examined and a list prepared of inactive stock accounts, which should be discussed with the company's officials and satisfactory explanations obtained.

Cost or Market Price. “(13) The auditor should satisfy himself that inventories are stated at cost or market prices, whichever are the lower at the date of the Balance Sheet. No inventory must be passed which has been marked up to market prices and a profit assumed that is not and may never be realized. If the market is higher than cost, it is permissible to state that fact in a footnote on the Balance Sheet.

Average Price Used. “(14) It may be found that inventories are valued at the average prices of raw materials and supplies on hand at the end of the period. In such cases the averages should be compared with the latest invoices in order to verify the fact that they are not in excess of the latest prices, and also with the trade papers, when market prices are used, to see that they are not in excess of market values.

Reasonable Quantities. “(15) Make an independent inspection of the inventory sheets to determine whether or not the quantities are reasonable, and whether they accord in particular instances with the average consumption and average purchases over a fixed period. Abnormally large quantities of stock on hand may be the legitimate result of shrewd foresight in buying in a low market, but may, on the other hand, arise from serious errors in stock taking.

Gross Profit Test. “(16) Always attempt to check the totals by the “gross profit test' and compare the percentage of gross profit shown with that of previous years. In a business where the average gross profit remains fairly constant this test is a dependable one, because, if the rate of gross profit is apparently not maintained and the discrepancy can not be satisfactorily accounted for by a rise or fall in the cost of production or of the selling price, the difference will usually be due to errors in stock taking.

Testing the Cost System. “(17) In verifying the prices at which the work in progress is included in the inventory, a general examination and test of the cost system in force is the best means of doing this work satisfactorily. In a good cost system little difficulty will be found with the distribution of the raw materials, stores, and pay roll, but the distribution of factory overhead cost is one that should receive careful consideration, the main points to be kept in view being:

“(a) That no selling expenses, interest charges, or administrative expenses are included in the factory overhead cost.

“(b) That the factory overhead cost is distributed over the various departments, shops, and commodities on a fair and equitable basis.

Cost vs. Selling Price. “(18) No profit should be included in the price of finished products or stock-in-trade. The price list should be examined to see that the cost prices of stock are below the selling prices after allowing for trade discounts, and, if they are not, a reserve should be set up on the Balance Sheet for this loss. If the company takes immediate steps to increase the selling price, however, the amount of this reserve may be limited to the loss on goods which may have been sold since the close of the period to the date of the discovery.

Profits on Partial Shipments. “(19). In the case of companies manufacturing large contracts it is frequently found necessary to make partial shipments thereof. The question then arises as to whether it is permissible to include the profits on these partial shipments in the Profit and Loss account. As a matter of fact, it is evident that the actual cost can not be known until the order is completed. It may be estimated that a profit will ultimately be made, yet unforeseen conditions, such as strikes, delays in receiving material, etc., may arise to increase the estimated cost. It is better not to include the profits on partial shipments, but information of this character which may have its influence in the decision of the banker upon a proposed loan may properly be laid before him. Of course, an exception should be made in cases where the profit on the partial shipments largely exceeds the selling price of the balance of the order.

Contract Prices. “(20) The selling prices for contract work in progress should be ascertained from the contracts, and where it is apparent that there will be a loss on the completed contract a due proportion of the estimated loss should be charged to the period under audit by setting up a reserve for losses on contracts in progress.

Unsalable Stock. “(21) If a company has discontinued the manufacture of any of its products during the year, the inventory of such products should be carefully scrutinized and, if unsalable, the amount should be written off.

Charges to Fixed Assets Must Not Be Included. “(22) The inventory should be scrutinized to see that no machinery or other material that has been charged to plant or property account is included therein.

Partial Deliveries. “(23) Partial deliveries received on account of purchase contracts for material, etc., should be verified by certificates from the contractors, both as to quantities and prices.

Advance Payments. “(24) Advance payments on account of purchase contracts for future deliveries should never appear in an inventory, but be shown on the Balance Sheet under a separate heading.

INVENTORIES 105

Discounts. “(25) Trade discounts should be deducted from inventory prices, but it is not customary to deduct cash discounts. However, this may be done when it is the trade practice so to do.

Turnover. “(26) While the inventory is being verified, the auditor should ascertain the aggregate sales for the last year. If the turnover has not been rapid, it may be due to a poor stock of goods. Some business men dislike to sell below cost and would rather accumulate a big stock of old goods than dispose of the old and unseasonable stock at a sacrifice. The usual outcome is that the stock becomes unwieldy and funds are lacking to purchase new goods. The inventory and the gross sales may, therefore, have a direct connection.

Interest Not a Part of Cost. “(27) It may be well to reiterate that interest, selling expenses, and administrative expenses form no part of the cost of production, and therefore should not be included in the inventory in any shape.”

3. AUDITING PROCEDURE

The inventory of December 31, 1918, was checked as to extensions and footings. Also, tests were made by actual count of some of the items listed. The secretary of the Company certified that the inventory represented only the materials and goods in process and on hand at the plant and in store as ascertained by actual count. The total of the inventory of materials and work in process amounted to $55,000.00; finished stock $80,000.o.o.

It would have been much better had the raw materials and the work in process been kept separate, but in this case it seems that there were practically no raw materials on hand other than those in process of manufacture, consequently there is no separate item for raw materials. In verifying the value of the work in process, it was found that the actual cost price of the raw materials consumed, plus the direct labor and the overhead factory expenses had been added. The item of $2,875.00, which represents the factory pay roll accrued, but not paid, was found to represent direct labor which had not been included in the value of the work in process, as valued at $55,000.00.

In arriving at the value of the finished goods, there was taken into consideration the actual cost of production which included the overhead factory expenses, but no selling expenses, interest charges nor administrative expenses were included in the factory overhead cost. A number of items listed were checked by an actual count and found to be correct. The inventory was verified by J. I. King, junior accountant. All extensions and footings were verified.

4. INCOME TAX PROCEDURE

Inventories shall be Taken Upon such Basis as may be Prescribed.

Income Tax Law. Section 203. “That whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.”

Basis of Inventory Valuations. (T. D. 2609, December 19, 1917.) “For the purpose of income and excess profits tax return, inventories of merchandise, etc., and securities, will be subject to the following rules:

“A. Inventories of supplies, raw materials, work in process of production and unsold merchandise must be taken either (a) at cost, or (b) at cost or market price whichever is lower, provided that the method adopted must be adhered to in subsequent years unless another be authorized by the Commissioner of Internal Revenue.

“B. A dealer in securities who in his books of account regularly inventoried unsold securities on hand either (a) at cost or (b) at cost or market price whichever is lower, may, for the purposes of income and excess profits taxes, make his return upon the basis upon which his accounts are kept, provided that a description of the method employed shall be included in or attached to the return, that all the securities must be inventoried by the same method, and that that method must be adhered to in subsequent years unless another be authorized by the Commissioner of Internal Revenue.

“C. Gain or loss resulting from the sale or disposition of assets inventoried as above must be computed at the difference between the inventory value and the price or value at which sold or disposed of.

“In all other cases inventories must be taken at cost or at value as of March 1, 1913, as the case may be.”

Need of Inventories. (Art. 1581. Reg. No. 45, 1918.) “In order to reflect the net income correctly, inventories at the beginning and ending of each year are necessary in every case in which the production, purchase or sale of merchandise is an income-producing factor. The inventory should include raw materials and supplies on hand that have been acquired for sale, consumption or use in productive processes, together with all finished or partly finished goods. Title to the merchandise

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