In this article, we will cover the substantive audit procedures for inventory. It is important to have a clear understanding of inventory audit, which is one of the most essential parts of inventory management. An inventory audit is a process of estimating the inventory maintained in a company’s books and comparing it against the auditor’s physical stock count report to verify they match. It is important to evaluate whether there is any misstatement on inventory because it affects both the balance sheet and the income statement.
Objectives of Inventory Audit
One of the main objectives of the audit of inventory is to provide accurate information about the inventory of a company. The audit process should be carried out using multiple analytical procedures to identify and assess a company’s inventory method so that accurate information about the stock can be judged at different levels. The inventory audit can be conducted depending on the size of the business.
In addition, this audit is also to ensure that no fraudulence may cause the incorrect inventory presented in the financial statements. This fraud is commonly incurred by all levels of staff and management that deal with the inventory.
Relevant Standard for the Accounting for Inventory
IAS 2 – Inventory covers all various aspects of the accounting for inventory, such as scope, inventory measurement, inventory recognition, and disclosures, as well as other topics on inventory. As per IAS 2, each entity shall value its inventory at the lower of costs or net realizable value. For more detail on the valuation, please refer to another article on “Valuing Inventory: Lower of Cost or Net Realizable Value”
Key Assertions of the Audit of Inventory
There are various assertions and the relevant objectives of each assertion that the auditor can carry out to test the inventory during the course of the audit. Below are the key inventory assertions that are necessary for the course of the audit:
The existence assertion means that the inventory balance recognized in the financial statements actually exists at the end of the period. In addition, this ensures that an entity has properly recorded the purchases and sales of such inventories that the entity bought and sold to customers.
Completeness is inventory reported on the balance sheet, including all inventory transactions occurring during the period. Those inventories should have been recorded and presented appropriately in the financial statements at the year-end or at the end of the accounting period.
Rights and Obligations
The rights and obligations assertions mean that all inventory reported on financial statements at the reporting date belongs to the entity.
Valuation assertion is inventory is recognized as per IAS 2 inventories which requires inventory to be valued at lower of cost and net realizable value.
This assertion ensures that an entity records the inventories in the correct period that the purchase or sales transaction occurs.
Presentation and disclosure
The presentation and disclosure assertion requires all inventory is appropriately classified in the accounts and disclosed in the notes to the financial statements.
Key Audit Procedures for Inventory Audit
In this section, we will cover various substantive audit procedures for inventory for each type of assertion that we mentioned in the above section.
Audit procedures to Ensure Completeness
To ensure the completeness of inventories, we shall need to perform the below procedures:
- The auditor shall need to prepare the disclosure checklist to ensure that all the disclosures regarding the inventories have been made properly.
- The trace test count should be carried out and traced back to the inventory listing to ensure the completeness of the inventory.
- Perform inspection of inventory at third parties’ location where applicable if such inventories are held as consignment at third parties’ location. Alternatively, the auditor can perform the review of confirmation from the third parties. This procedure enables the auditor to ensure that such an inventory record is matched to the general ledger.
- Auditors also can perform the analytical procedure by comparing the gross profit percentage of the current year to the prior year. This enables the auditor to see any abnormal fluctuation that may raise doubt so that they can perform detailed audit testing. In this analytical procedure, the auditor may also compare such gross profit percentage to industrial data where necessary and applicable.
Audit Procedures for Cut-off Analysis
The cut-off is the process of ensuring inventory is recorded in the right accounting period. Auditors should follow procedures, and review and confirm inventories are recorded in the correct accounting period to which those inventories belong to.
In order to ensure the inventories are recorded in the correct period, the auditor can perform the analysis by looking at the number of the last Goods Delivery Notes (GDNs) and Goods Received Notes (GRNs) before the year-end and the first GDNs and GRNs after the year-end. Then, the auditor can perform the checking to see if the entity has recorded and included the inventories correctly in the financial year.
Audit Procedures to Ensure the Existence
The relevant audit procedure to ensure the existence assertion is to perform the observation of the physical inventory count. Auditors shall need to follow the best practice of inventory count procedures.
During the inventory counting process, there can be no inventory movement into and out of the warehouse. Auditors follow and discuss the counting procedures with the client, observe the count, perform test counts of some inventory items, trace their counts to the client’s recorded amounts, and verify all inventory count tags.
In addition, where the inventories are held at the third parties’ premise, for example, as consignment, the auditor shall need to join and observe the physical count at the third parties’ location to ensure the existence of inventories. Alternatively, where the physical count cannot be performed, the auditor shall obtain confirmation from the third parties and verify the general ledger to ensure its existence.
Audit Procedures for Valuation and Allocation
Below are the procedures necessary to ensure the valuation and allocation are carried out properly or not.
- Freight Cost Analysis
This procedure helps determine shipping costs when a business ships products to different locations. Freight costs can be either included in inventory or charged to expenses, and auditors will detect a selection of invoices to see how they are handled.
- Finished Goods Costs Analysis
For finished goods items, the auditors should review the bill of materials and test them to see how accurate the costs are.
- Overhead Analysis
The procedure of overhead analysis helps to predict indirect business costs that will assist in budgeting for the upcoming period. This procedure is optional but is required when the overhead costs are counted as part of the inventory calculation.
- Work in progress Testing
When there is a significant amount of work-in-progress inventory, the auditor should determine the percentage of completion for those work-in-progress items. Generally, at the end of the accounting period, work-in-progress is measured.
- High-value Items Testing
It is one of the most common types of inventory testing. When there are high-value items in the inventory, auditors must ensure that they are correctly valued and trace them into the valuation report.
- Inventory Valuation Testing
The auditor should check that the lower cost or market value rule is followed by comparing the market value to the recorded cost. While performing unit cost tests for inventories under the FIFO formula, auditors are required to compare the unit cost mentioned in the inventory list to the supplier’s invoices to find out whether there are any discrepancies.
- Direct Labor Cost Testing
When direct labor is included in the inventory cost, the auditor should verify whether the labor costs included in the valuation are supported by relevant documents and records.
- Casting and Vouching
In this procedure, the auditor shall need to perform the casting of the inventory listing to ensure that it is free of mathematical errors.
In addition, the auditor shall perform the vouching to supporting documents such as suppliers’ invoices to ensure that the inventories are recorded correctly at the right amount.
Audit Procedures to Ensure the Rights and Obligations
Below are the audit procedures to ensure the rights and obligations of inventories recorded in the accounting book of an entity.
- Inventory Ownership
Auditors review the ownership of inventories by checking the purchase records to ensure the inventories in the warehouse are actually owned by the entity.
- Inventories held at Third Parties’ Location
The auditor shall verify that any inventories held at the location of third parties, for example, for consignment, shall be segregated appropriately during the inventory count.
For those inventories, the auditor shall perform the confirmation and review of the inventory listing to ensure that the entity has included such inventories in the accounting book at the end of the financial year.
- Inventories Sold but on Hold in the Premise
In case the inventories have been sold, and the bill has been raised; however, such inventories are still on hold in the entity’s premise due to customers’ preference until they require, the entity shall segregate such inventories. Then auditor shall perform the testing by identifying those inventories as if such inventories were included in the accounting book at the end of the financial year or not.
Audit Procedures for the Presentation and Disclosures
This involves the reviewing of inventories to determine whether the entity being audited presents or classifies the inventories properly or not. In addition, whether such entity has proposed disclosure notes in the financial statements. There are two important combined assertions to consider as follows:
- Classification and Understandability
To ensure this, the auditor shall need to review the entity’s inventory listing and then looks at the classification. This is to ensure that the entity being audited has classified the inventory properly between the inventories and work in progress (WIP) or any finished goods.
In addition, typically, in the management accounts that the entity submitted to the auditor, there are disclosure notes there. Thus, the auditor must read the disclosure note relating to the inventory and make sure that such a note is easily understandable.
- Accuracy and Valuation
Similar to the classification and understandability, the auditor must review the financial statements to ensure that the proper cost methods have been used in valuing inventories and appropriately disclosed.
Other Audit Procedures for Inventories
- Occurrence, Rights, and Obligations
This involves the inquiry of management, and then the auditor shall need to review any loan agreements to find out any evidence that the entity has put the inventories as a pledge. Or to see if the inventories have been assigned to others.
In addition, auditors shall enquire with management to see if there is any warranty obligation issue or not.
The matching procedure is matching the number and costs of inventory items with the financial records to ensure the right amount is charged at the right time.
Reconciliation involves tracing the valuation from the physical inventory count to the entity’s general ledger to identify any errors that will be re-checked and reconciled to the entity’s financial records.