1. Special Note: Physical Inventory Observation Importance of Inventory Major component of current assets on the balance sheet. Significant effect on net income. Valuation is usually very subjective. –Potential obsolescence –Goods have not been sold, so marketability may be uncertain.

2. Special Note: Physical Inventory Observation AICPA Professional Standards specifically address the need to observe the client's inventory counting procedures: "it will always be necessary for the auditor to make, or observe, some physical counts of the inventory and apply appropriate tests of intervening transactions" (AU 331.12). If the client is on a perpetual system, the auditor may make test counts at a time other than year-end. –If inventory is observed on a date other than fiscal year-end, the auditor must be able to rely on the client's internal controls in order to roll-forward (or back) inventory quantities to fiscal year- end balances.

3. Special Note: Physical Inventory Observation If possible, try to stop flow of goods on inventory date Make TEST COUNTS –From INVENTORY LISTING, choose sample of items to count (Existence) –From WAREHOUSE FLOOR, choose sample of items to count to TRACE to final INVENTORY LISTING (Completeness) –Record all counts in working papers

4. Special Note: Physical Inventory Observation Use tags to indicate whether all items have been counted Be wary of "Hollow squares" and "empty boxes” Tour shipping and receiving areas Watch for OBSOLETE and SLOW-MOVING inventory (Valuation) Inventory on CONSIGNMENT and at other locations should be CONFIRMED (Rights and obligations) For Specialty Inventory, consider the use of SPECIALISTS Inventory in transit must be confirmed.

5. Inventory Cost Testing Valuation (Price Tests) –VENDOR INVOICE or cost records (include cost of inventory, freight, and other costs) –Consider COST FLOW ASSUMPTION –Evaluate LOWER OF COST OR MARKET for inventory Check Extensions and Footings of INVENTORY LISTING and agree to PERPETUAL INVENTORY RECORDS.

6. Purchase Cutoffs Verify CUT-OFFs for purchases –Examine Receiving Reports and Vendor Sales Invoices occurring around year-end to ensure inventory received is included in the appropriate period.

7. Analytic Procedures Verify REASONABLENESS of COGS –Calculate Gross Profit Margin –Compare to prior year, industry averages Verify REASONABLENESS of ending inventory –Days Sales in Inventory - provides evidence concerning management's assertion about valuation. –Inventory Turnover - provides evidence concerning management's assertion about valuation.