How to Audit Cost of Goods Sold?
Cost of goods sold is the cost that company spends to acquire or manufacture the products which already been sold to the customer. It excludes other expense such as operating expenses, finance costs, and so on.
When company purchases the product from a supplier, it will be recorded as inventory on the balance sheet. It is the same as the cost of manufacturing a product. After production, the finished goods will be recorded as the inventory.
After the products are transferred to the customers, company will record the cost of goods sold. The cost move from the inventory account to the cost of goods sold account on income statement.
From the auditor’s perspective, cost of goods sold is the main account for manufacturing and trading company. After-sale account, the cost of goods sold is the second biggest account for most of these companies. The more sale company generate, the more cost of goods sold incurs.
For the manufacturing company, cost is very critical due to the complexity of the calculation. It involves many assumptions and complexity which is a huge room for error. They need to include the cost of raw materials, direct labor, and other costs. A slight mistake in the calculation will have a big impact on the income statement.
The auditor needs to spend on understanding the company business process. It helps them to verify the component and calculation of cost of goods.
Component of Cost of Goods sold
The business process of the company may be different from one to another, but the calculation of cost of goods sold will remain the same.
Cost of goods sold = Opening Stock + New Purchase/Produce – Ending Stock
As we can see, the cost of goods sold balance has a close relationship with the inventory. By verifying the cost of goods sold, it will help us to verify part of the inventory too.
Audit team members who test the cost of goods sold and inventory should be the same. It will allow them to cross-check everything together.
Audit Assertion for Cost of Goods Sold
- Occurrence: The cost of goods sold should be recorded only when the goods are sold to the customer. If the goods remain within the company, they should be recorded as inventory.
- Cut-off: The cost is recorded on the income statement must be properly cut off at the year-end.
- Completeness: All costs of goods sold must be recorded in the financial statement. The cost must not be understated or overstated.
- Accuracy: The transactional balance must be reflected in the real business.
- Classification: The cost of goods sold must be classified separately from other expenses in the income statement.
Substantive Analytical Procedure for Cost of Goods Sold
Cost of goods sold is one of the most components of the income statement. It is not always present on the income statement for all companies. It is mostly for manufacturing and trading companies. For manufacturing, it refers to the cost of material, labor, and overhead. For the trading company, it is the cost of purchasing a product plus some relevant costs.
The cost is a very significant expense that a company spends to operate the business.
Cost of goods sold is the variable cost that changes in relation to the sale quantity. If it cost $ 1 to produce one unit of product, it will require $ 100 to produce 100 units. When a company purchases one product that cost $ 10, they will spend $ 100 to purchase 10 products.
The auditor can build expectations based on this relationship. When the sales increase, the cost of goods should increase by a certain percentage as well.
Moreover, auditors can build the expectation of the cost of goods sold based on the gross margin percentage. If the company has a gross margin of 60%, it means every $ 1 sale made consists of a $ 0.60 cost of goods sold.
After getting independent expectations, auditor needs to compare the actual figure with the expectation. They have to investigate the significant variance and make the conclusion over the account balance.
Test of Detail for Cost of Goods Sold
- Occurrence: The company requires to record the cost of goods sold only when the goods are really sold to the customer. By that time, the cost of goods will move from inventory to the cost of goods sold.
Auditors need to verify that the company really sold the inventory to the customers. They have to verify the cost of inventory that is sold to the customers. They can verify by checking the document that proves the sale such as the invoice, goods despatch note, and so on.
- Cut-off: It is the cost that company purchases the inventory and it has been sold to the customer. It is recorded when the inventory has been transferred to other parties. The risk and reward are transferred from company to the customers.
Auditors have to define the point of sale that which goods change hand to customers. It is the time that company loses control over the goods and they have to reverse it from the balance sheet. At the same time, it is the time that company record the cost of goods sold which is the cost on income statement. The supporting document which supports the cut-off could be the goods received a note which has the signed received by the customer.
Auditor must pay high attention to sales at year-end which is highly likely the error or fraud. The company may record the cost of goods sold at the time of issuing invoices rather than delivering goods. Some companies create fake sales to meet the sales budget and get performance bonuses.
- Completeness: The company must record all the costs of goods that are sold to the customers. The cost has been recognized as the company record sales revenue. It has to follow the matching principle.
In some cases, the company wishes to decrease the cost to maximize the profit for some reasons. They may decide to exclude some expenses from the income statement.
Auditor can match the transaction from the sale listing to the cost of goods sold recording. They must ensure that the cost is recorded for every sale made.
- Accuracy: It is the cost of goods that are sold to the customers. It may be straightforward if the company purchases the goods and resell them without any modification. So there is almost no additional cost besides the cost to acquire the goods.
Auditor can recalculate the cost of goods per unit to ensure the accuracy of each unit sold. After that, they can multiply the number of units sold to get the total balance.
- Classification: The cost of goods sold is presented on the income statement and it will reduce the revenue to arrive at net income. But it must be classified separately from normal operating expenses. It must be present as the main account after the sale revenue. The revenue less the cost of goods sold will equal the gross profit.