Risk of Material Misstatement for Inventory
Risk of material misstatement for inventory is the probability that there is a material misstatement in inventory, but the internal control cannot prevent or detect such misstatement.
It is the combination of inherent risk and control risk that could occur in the inventory account. The inherent risk here is the risk that inventory account is susceptible to misstatement where control risk is the risk that is due to having no internal control procedures to prevent or detect such misstatement or the internal control procedures are not properly executed.
In this case, the level of risk of material misstatement will entirely depend on the susceptibility of inventory account to misstatement and the internal control that is put in place to eliminate or minimize such susceptibility.
Risk of material misstatement is directly related to the substantive procedures that auditors will perform in the audit process. Hence, if the risk of material misstatement for inventory is low, auditors can reduce the substantive procedures required on such account or balance.
Inherent Risk of Inventory
Inherent risk is the risk of material misstatement on financial statements before considering any control in place. It is the susceptibility of the account or balance to misstatement.
In this case, inherent risk of inventory is its susceptibility to misstatement. It is directly related to nature, size and complexity of the inventory transactions. Usually, the bigger and more complex they are, the higher the inherent risk is.
In most cases, the inventory is an inherently risky asset. This is due to the inventory is usually the material item on the balance sheet, especially for companies that are in the production or trading industry. In this case, the level of inherent risk of inventory tends to be high.
Examples of inherent risk of inventory may include:
- Inventory may be misstated due to its complication of valuation.
- Inventory may be intentionally overstated to increase profit (i.e. overstatement of inventory leads to an understatement of cost of goods sold).
- There may be an overstatement of inventory to disguise unauthorized removal of valuable products.
- There may be an inventory thief due to it is easily concealed and stolen, especially for the small inventory with high value.
- The company may change accounting policy regarding inventory valuation, e.g. from LIFO to FIFO.
- Inventory counts may be falsified to overstate ending inventory and understate the cost of goods sold.
- Inventory may be misappropriated by the company’s employees, e.g. employees may take home the legitimate inventory.
- The company may not write down obsolete or damaged merchandise.
- There may be an unreasonable net realizable value of inventory.
- There may be a misstatement of inventory due to the complexity of working in progress, e.g. complex valuation of the quantity and type of raw materials, labor hours invested in each semi-assembled product, and allocation of manufacturing overhead, etc.
- There may be a misstatement in inventory valuation carrying from the previous period.
- Inventory inspected by auditors may be held on consignment, etc.
Control Risk of Inventory
Control risk is the risk that financial statements contain the material misstatement but the internal control cannot prevent or detect that misstatement. Likewise, such misstatement can happen due to error or fraud.
In this case, control risk of inventory is the risk that the company’s internal control cannot prevent or detect a material misstatement that occurs in the inventory accounts.
Auditors usually evaluate the control risk with their assessment of inherent risk in inventory so that they can make an overall assessment of the risk of material misstatement for inventory.
For example, if the inherent risk of inventory is high and the control risk is low, it means that the client’s internal control can reduce the risk of material misstatement to some extent. In this case, auditors can rely on the client’s internal control to reduce some of their substantive procedures.
However, auditors need to perform the test of controls to obtain audit evidence to support their assessment that the control risk is low before relying on the client’s internal control.
On the other hand, if the control risk is high, auditors do not need to perform the test of controls. There is no need to prove that internal control is weak. In this case, auditors usually ignore the test of controls and go directly to substantive tests (e.g. by performing more works).
Examples of the internal control procedures that can reduce the risk of material misstatement for inventory may include:
- Regularly inventory count
- Properly inventory tagging
- Physical safeguard of inventory
- Inventory only be accessible to authorized personnel
- Proper authorization in inventory requisition and payment procedures
- Proper segregation of duties in inventory management, in which no single individual handles all or most aspects of the inventory transaction including authorization, preparation, and payment.
- Those who have physical access to inventory should not have access to the accounting records, such as the inventory records, cost accounting records, or the general ledger.
- Those who work in the inventory department should not have the authority to request for inventory items, etc.