Auditing & Investigations II Audit of Inventory

Key issues Introduction to audit inventory. Accounting for Inventory Audit Procedure for Inventory Physical Inventory count Cut-off testing Valuation

1. Introduction Inventory tend to be one of the large asset in the statement of financial position. It is one of the items that carry inherent risk because its valuation can be exposed to judgement. The auditor must be diligent in his/her audit approach and should be sensitive to any issues that might cast doubt on the reliability of management’s assertions in relation to inventory.

Key inventory assertions Existence Completeness Rights and obligations Valuation Cut-off

Assertions Existence and occurrence Financial statement assertion Audit objective Existence and occurrence – Recorded purchases and sales represent inventories bought and sold. – Inventory on the statement of financial position physically exists. Completeness – All purchases and sales are recorded. – All inventory at year end is included on the statement of financial position. Rights and obligations – The entity has rights to inventory recorded in the period and at the year-end.

Assertions Financial statement assertion Audit objective Accuracy, classification and valuation – Costs are accurately determined in accordance with accounting standards. – Inventory is recorded at year end at the lower of cost and net realisable value (NRV). Cut-off – All purchases and sales of inventories are recorded in the correct period. Presentation and disclosure – Inventory is properly classified in the accounts. – Disclosures relating to classification and valuation are adequate and in accordance with accounting standards.

2. Accounting for Inventory The valuation and disclosure rules for inventory are laid down in IAS 2 Inventories. ‘Inventory should be valued at the lower of cost and net realisable value’.

Procurement Cycle Internal requisition (IR) Quotations Purchase Order (PO) Good/Services received Quality Control Good received note (GRN/GRV) Invoices Storage Custody Management (Store Mgt) Accounting processes

3. Audit Procedure Completeness Existence Rights and Obligations Valuation and Allocations Cut Off Accuracy Occurrence Classification Valuation

3.1.Completeness Audit Procedures Complete the disclosure checklist to ensure that all the disclosures relevant to inventory have been made. Trace test counts to the detailed inventory listing. Where inventory is held in third-party locations, physically inspect this inventory or review confirmations received from the third party and match to the general ledger. Compare the gross profit percentage to the previous year or industry data.

3.2. Existence Audit Procedures Observe the physical inventory count. Verify selected items count for availability.

3.3. Rights and obligations Audit Procedures Verify that any inventory held for third parties is not included in the year-end inventory figure. For any 'bill and hold' inventory (ie where the inventory has been sold but is being held by the entity until the customer requires it), identify such inventory and ensure that it is segregated during the inventory count. Confirm that any inventory held at third-party locations is included in the yearend inventory figure by reviewing the inventory listing.

3.4. Valuation and allocation Obtain a copy of the inventory listing and agree the totals to the general ledger. Cast the inventory listing to ensure it is mathematically correct. Vouch a sample of inventory items to suppliers' invoices to ensure it is correctly valued.

Continued……….. Confirm that an appropriate basis of valuation (eg FIFO) is being used by discussing with management. Make enquiries of management to ascertain any slow-moving or obsolete inventory that should be written down. Examine prices at which finished goods have been sold after the year end to ascertain whether any finished goods need to be written down.

Continued……….. Compare the gross profit percentage to the previous year or industry data. Compare raw material, finished goods and total inventory turnover to the previous year and industry averages. Compare inventory days to the previous year and industry average.

3.5. Cut-off Audit Procedures Note the numbers of the last GDNs and GRNs before the year end and the first GDNs and GRNs after the year end, and check that these have been included in the correct financial year.

3.6. Accuracy Audit Procedure Obtain a copy of the inventory listing and cast it, and test the mathematical extensions of quantity multiplied by price. Trace test counts back to the inventory listing.

Continued…. If the entity has adjusted the general ledger to agree with the physical inventory count amounts, agree the two amounts. Where a continuous (perpetual) inventory system is maintained, agree the total on the inventory listing to the continuous inventory records, using CAATs.

3.7. Occurrence and rights and obligations Audit Procedure Enquire of management and review any loan agreements and board minutes for evidence that inventory has been pledged or assigned. Enquire of management about warranty obligation issues.

3.4. Classification Audit Procedure Review the inventory listing to ensure that inventory has been properly classified between raw materials, work-in-progress and finished goods.

3.9. Accuracy and valuation Audit Procedure Review the financial statements to confirm whether the cost method used to value inventory is accurately disclosed. Read the notes to the accounts to ensure that the information is accurate and properly presented at the appropriate amounts.

4. Physical Inventory count Physical inventory count procedures are vital, as they provide evidence. Key Assertions: Existence Condition

4.1. Audit Procedures Evaluate management's instructions and procedures for recording and controlling the result of the physical inventory count Observe the performance of the count procedures Inspect the inventory Perform test counts

Subsequently test that they have been included in the correct period. 5. Cut-off testing Auditors should test cut-off by noting the serial numbers of GDNs and GRNs received and despatched just before and after the year end, and Subsequently test that they have been included in the correct period.

5.1. Audit Procedures The auditors should consider whether management has implemented adequate cut-off procedures. Check whether goods have been recorded in the appropriate period. Check document process pre and post yearend for cut off. Perform adjustment on any documents, if any inappropriate periods.

6. Valuation Auditing the valuation of inventory includes: Testing the allocation of overheads is appropriate Confirming inventory is carried at the lower of cost and net realisable value.

6.1. Assessment of cost and net realisable value Procedures Reviewing price changes near the year end Ageing the inventory held Checking gross profit margins to reliable management accounts

6.2. Audit procedures Analytical procedures may assist comparisons Check the reasonableness of the valuation Compare cost and NRV for each item of inventory Ultimate selling price should be compared with the carrying value at the year end.

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