Audit Inventory
Introduction
As auditors, we usually audit inventory by testing the various audit assertions including existence, completeness, rights and obligations, and valuation. In the audit process of inventory, physical inventory count may be the most important part of the inventory audit. This is due to physical inventory count can provide evidence on existence and completeness.
It is also important for us to evaluate whether the inventory reported in the financial statements is correctly valued. The misstatement on inventory not only affects the balance sheet but also the income statement. Likewise, the whole financial statements may be materially misstated due to the over or undervaluation of the inventory.
Audit Assertions for Inventory
In the audit of inventory, we usually test the audit assertions included in the table below:
| Audit assertions for inventory | |
|---|---|
| Existence | Inventory balances reported on financial statements actually exist at the reporting date. |
| Completeness | Inventory reported on the balance sheet includes all inventory transactions that have occurred during the accounting period. |
| Rights and obligations | All inventory reported on financial statements as at the reporting date really belongs to the company. |
| Valuation | Inventory balances truly reflect its economic value. |
| Presentation and disclosure | Inventory is properly classified and sufficiently disclosed in the notes to financial statements. |
In the audit of inventory, we usually focus more on existence and valuation. This is due to we concern more about whether the inventory does actually exist; and that it has been properly valued in accordance with applicable accounting standards.
Audit Procedures for Inventory
In the audit of inventory, we want reasonable assurance that the inventory actually exists and is really owned by the client. And inventory balances are all included on the balance sheet and their value reflects actual economic value on the market.
Existence
In the audit of inventory, existence or occurrence assertion tests whether the inventory on balance sheet actual exists and whether inventory transactions actually took place.
Example: test of existence in physical inventory count procedure
- Observe the annual inventory counting procedures of the client
- Select a sample of items in the inventory record
- Count the actual inventory on hand to make sure they match with the record.
Example of the inventory addition test:
- Select a sample of additions of inventory during the year
- Vouch them to the supporting documents such as supplier’s invoice and good receive note. (This is to ensure the occurrence of inventory addition)
Completeness
Completeness assertion in the audit of inventory tests whether all the inventory at year-end is included in the balance sheet and all purchases and sales of inventory are recorded. One high risk of inventory is that the company bought the inventory but the purchases were not recorded into the inventory account. This could be the result of intentional fraud or unintentional error, in which they both lead to an understatement of inventory.
Example: test of completeness
- Select a sample of inventory received notes (or good received notes) and
- Trace them back to detail inventory listing
- Reconciled detail inventory listing to general ledger
Example: test of completeness in inventory count procedure
- Observe the annual inventory counting procedures of the client
- Select a sample of counted items in the store or warehouse
- Trace the counted items to detail inventory listing.
Rights and obligations
In the audit of inventory, completeness assertion tests whether all the inventory recorded in the balance sheet really belongs to the company.
Example: test of rights and obligations
- Check to see if there is any inventory held for the third party and if there is, make sure it is not included in the balance sheet and appropriately separated from other inventory during the inventory count.
- Review the purchase invoice or purchase agreement to ensure that the inventory really belongs to the company.
Valuation
Valuation assertion tests whether the inventory figures in the client’s account are correct and the evaluation method used by the client in determining the cost of various items for inventory valuation is appropriate.
One important rule that always applies to the inventory valuation is that the value of the inventory is measured at the lower of cost and net realizable value. As the auditors, we need to confirm that the client correctly follows the above rule or the misstatement might occur.
More likely than not, the overstatement statement tends to happen in this case as the client sometimes determines the value by cost on all of the inventory including obsolete inventory which their net realizable value is usually lower than the cost.
One more important aspect of the inventory valuation is whether the overhead allocation made by the client is appropriate. We usually meet this case when testing the working-in-progress and finished goods of the client’s manufacturing products.
Example: test of valuation
- Determine whether the inventory valuation method used by the client is appropriate
- Recalculate the client’s inventory valuation
- Inquire the related personnel such as production and warehouse personnel about the existence of obsolete inventory.
- Make sure that the obsolete inventory is properly labeled and separate from other inventory
- Make sure that the cost of the obsolete inventory value is written down to the market value (if any)
Summary
All in all, inventory existence and valuation are primary concerns that we need to pay close attention to. This is due to the overstatement of inventory at the end of the accounting period will lead to the understatement of the cost of goods sold which then makes the net profit higher than it actually is. In this case, it is considered as a risky area as the company usually links the management’s bonus to the net profit.