KA T
H E A R N
Auditing
inventory
Tests
of
detail
We are in the middle of looking tests of
detail for various different Financial Statement items:
Non current assets and intangibles Inventory
Receivables Cash and Bank
Liabilities, capital and directors emoluments
Learning
objectives
By the end of this lecture you should be able to
Explain the process for auditing inventory,
including describing the audit procedures required to address the financial statement assertions.
Explain what is meant by two way testing.
Appreciate that auditing inventory can be
Introduction
Inventory is a very important area of the audit
since:
figure is likely to be material
can be a high risk of material misstatement
affects both the SFP (current asset) and P&L (reduces
COS).
As with all audit procedures – we need to
ensure that they address the FS assertions.
What are the FS assertions in relation
FS
assertions
What are the FS assertions in
relation to inventory?
Existence
Risk that inventory does not exist at year end.
Completeness
Risk that not all inventory is recorded at year
end.
Valuation
Risk that inventory is not valued at the lower of cost or NRV
(or that these are mis-calculated)
Rights and obligations
Risk that inventory belonging to third parties is included
Cut off
Risk that purchases and sales are recorded in the incorrect
Auditing
inventory:
Basic
procedures
Existence
Attendance at inventory count.
Trace a sample of inventory in the count
sheets to the physical item.
Completeness
Trace a sample of inventory in the warehouse
Auditing
inventory:
Basic
procedures
Valuation
Compare cost & NRV.
Review post year end sales.
Review aged inventory listing for slow moving
items.
Rights and obligations
Enquire whether there is any third party
inventory.
Review contracts re. holding 3rd party
Inventory
counts
Attendance at the stock count is required by
ISA 501, unless it is impracticable to attend.
The auditor usually:
tests controls over count carries out test counts
follows up any weaknesses
There are lots of different stages in the
Before
the
stock
count
Contact client to obtain a copy of the inventory
count instructions, to understand how the count will be conducted and assess the
effectiveness of the count process.
Review prior year working papers to
understand the inventory count process and
identify any issues that would need to be
taken into account this year.
Ascertain whether any inventory is held by
third parties, and if applicable determine how to gather sufficient appropriate
Before
the
stock
count
(continued)
Consider the need for using an expert to
assist in valuing the inventory being counted.
Send a letter requesting direct confirmation of
inventory balances held at year end from any third party warehouse providers used
During
the
stock
count
Observe the count to ensure that the
instructions are being followed.
Attend the inventory count (if one is to be
performed) at the third party warehouses to
review the controls in operation: verifies
During
the
stock
count
(continued)
Perform a two way test count
Select a sample of items from the inventory
count sheets and physically inspect the
items in the warehouse: verifies existence.
“Sheet to floor”
Select a sample of physical items from the
warehouse and trace to the inventory count sheets to ensure that they are recorded
accurately: verifies completeness. “Floor to
During
the
stock
count
(continued)
Ensure that goods held on behalf of third
parties is segregated and recorded
separately: verifies rights and obligations.
Inspect the inventory being counted for
evidence of damage or obsolescence that
may affect the net realisable value: verifies
During
the
stock
count
(continued)
Record details of the last deliveries prior to
the year end. This information will be used in final audit procedures to ensure that no
further amendments have been made thereby overstating or understating inventory:
verifies cut-off.
Obtain copies of inventory count sheets at the
end of the inventory count, ready for checking
against final inventory listing after the
After
the
stock
count
Trace the items counted during the inventory
count to the final inventory list to ensure it is the same as the one used at the year end and to ensure that any errors identified during
counting procedures have been rectified:
verifies completeness.
Cast the list (showing inventory categorised
between finished goods, WIP and raw
materials) to ensure arithmetical accuracy and agree totals to financial statement
After
the
stock
count
(continued)
Inspect purchase invoices for a sample of
inventory items to agree their cost
and
Inspect post year end sales invoices for a sample
of inventory items to determine if the net
realisable value is reasonable. This will also assist in determining if inventory is held at the lower of cost and net realisable value has been used:
verifies valuation.
Inspect the ageing of inventory items to identify
old/slow moving amounts that may require provision, and discuss these with management:
After
the
stock
count
(continued)
Recalculate work in progress and finished goods
valuations using payroll records for labour costs and utility bills for overhead absorption: verifies
valuation.
Calculate inventory turnover/days and compare
this to prior year, to assess whether inventory is being held longer and therefore requires greater provision: verifies valuation.
Calculate gross profit margin and compare this to
prior year, investigate any significance
After
the
stock
count
(continued)
Trace the goods received immediately prior to the
yearend to year end payables and inventory balances:
verifies cut-off.
Trace goods despatched immediately prior to the
yearend to the nominal ledgers to ensure the items
are removed from inventory and a sale (and
receivable where relevant) has been recorded:
verifies cut-off.
Inspect any reports produced by the auditors of
third party warehouses in relation to the adequacy
of controls over inventory.
Inspect any documentation in respect of third party
After
the
stock
count
(continued)
Inspect the ageing of inventory items to
identify old/slow moving amounts that may require provision, and discuss these
with management: verifies valuation.
Recalculate work in progress and finished
goods valuations using payroll records for labour costs and utility bills for overhead
After
the
stock
count
(continued)
Calculate inventory turnover/days and compare
this to prior year, to assess whether inventory is being held longer and therefore requires greater provision: verifies valuation.
Calculate gross profit margin and compare this to
prior year, investigate any significance
differences that may highlight an error in costs of sales and closing inventory: verifies valuation.
Trace the goods received immediately prior to
After
the
stock
count
(continued)
Trace goods despatched immediately prior
to the year end to the nominal ledgers to
ensure the items are removed from inventory and a sale (and receivable where relevant)
has been recorded: verifies cut off.
Inspect any reports produced by the auditors
of third party warehouses in relation to the adequacy of controls over inventory.
Inspect any documentation in respect of
What
happens
if
sales
are
on-going?
Companies like Amazon allow customers to
purchase goods 24/7.
If you count their stock how do you know
what’s been sold or not?!
What
happens
if
sales
are
on-going?
Stock purchase / sales
freeze
Quarantine
Auditing
inventory
If you were attending the audit of a high end
jewellery store, what would you be most concerned about?
Cubic zirconia vs diamond?!
Solution?! An expert should attend the
count with the auditor.
Remember the auditor remains responsible for the
Consignment
inventory
Imagine a company that sells
jewellery on consignment…
How does the auditor get comfort over the
Consignment
inventory
Solution?!
Attend a stock count on board the cruise liner
Inspect documentation:
How much jewellery went out on the ship when it
left the dock?
Get copies of any jewellery sold
From this reconcile how much inventory is left at
Things
to
watch
out
for?
If auditing containers, what happens if they
aren’t all full?!
You might test a few barrels of oil to see if
they are - full, but the others may be
half-empty, or completely empty – this could lead
to inventory being severely overstated.
What can you do about it?!
Inventory
fraud
An audit firm had been auditing their client for
many years, and each year had attended various stock counts around the country.
Due to practical reasons, the stock counts
took place on different dates (all around the year end) and in the past, the auditors had sent different auditors to each count.
One year was different, and the same audit
Garage
1
At garage 1, the auditor selected a sample of
cars to count, performing 2 way testing
(floor to sheet and sheet to floor).
Garage
2
At garage 2, early the next morning, the
auditor attended the next count and started their sheet to floor and floor to sheet testing…
…they leaned on one of the cars and thought
it was a little odd that the bonnet was warm….
That was a bit odd, given that it
was early morning and none of
the cars would have been taken
Garage
2
(continued)
… having subtly felt a few more car
bonnets, the auditor discovered that all of the car engines were warm…
…and so the auditor started looking at the
number plates…
…and recognised some of the
What
was
discovered?!
It turned out that the client had been moving
cars around the country to different garages to
overstate their inventory – i.e. to make it look like they had many more cars in stock than
they actually did.
Why wasn’t this discovered sooner?
It was just good luck that the auditor
spotted the fraud that year.
The fact that it had been missed in previous
Summary
of
learning
objectives
You should now be able to:
Explain the process for auditing inventory,
including describing the audit procedures required to address the financial statement assertions.
Explain what is meant by two way testing.
Appreciate that auditing inventory can be
