AP-4: ⇒Audit Program for Inventory

Company Balance Sheet Date

The company has the following general ledger accounts that are classified in the inventory caption
of the balance sheet.
General
Ledger Description or Brief Purpose Cost Method Relative
Number of the Account Used Size

Audit Program for Inventory

Company Balance Sheet Date

Audit N/A Workpaper

Objectives Performed Index
Audit Procedures for Consideration by
FINANCIAL STATEMENT ASSERTIONS

E/O Existence or occurrence. V/A Valuation or

allocation.
C Completeness. P/D Presentation
 and disclosure.
R/O Rights and obligations.
AUDIT OBJECTIVES

A. Inventory reflected in the accounts represents a complete

listing of products, materials, and supplies owned by the company,
and such assets are physically on hand, in transit, or stored at
outside locations at the balance sheet date (assertions E/O, C, and
R/O).
B. Inventory listings are accurately compiled, extended,
footed, and summarized, and the totals are properly reflected in the
accounts (assertions E/O and V/A).
C. Inventory is valued in accordance with generally accepted
accounting principles consistently applied, at the lower of cost or
market (assertion V/A).
D. Excess, slow-moving, obsolete, and defective inventory is
reduced to net realizable value (assertion V/A).
E. Inventory is properly classified in the balance sheet, and
disclosure is made of pledged or assigned inventory, major
categories of inventory, and the methods used to value inventory
(assertions R/O and P/D).
IDENTIFICATION CODES

The letters preceding each of the above audit objectives, i.e., A, B,

etc., serve as identification codes. These codes are presented in the
left column labeled “Audit Objectives” when a procedure
accomplishes an objective. If the alpha code appears in a bracket,
e.g., [A], [B], etc., the audit procedure only secondarily
accomplishes the objective. If an asterisk precedes a procedure, it is
a preliminary step or a follow up step that does not accomplish an
objective.
BASIC PROCEDURES
A, [C] 1. Observe the company’s physical inventory. Use the
separate inventory observation program at AP-5.
* 2. Discuss the valuation procedures used by the client to
determine any changes in specific products, changes in production
methods, accounting policies used, methods used to accumulate
cost of inventory items, the pricing policies and procedures of the
company, results of physical observation during the year and their
effects on inventory valuation.
B 3. Test the clerical accuracy of the company’s physical
 inventory summary.

a. Trace test counts recorded during the observation to the

physical inventory summary.
b. On a test basis, compare the tag or count sheet control
numbers obtained during the observation to those used to compile
the inventory summary. Investigate any tags or count sheets added
or deleted.
c. If applicable, trace in quantities at remote locations that
were confirmed.
d. Test the extensions of several items and foot the totals.
Scan the listing for obvious decimal slides.
e. Reconcile the physical inventory summary to the general
ledger account balance. Investigate and explain major reconciling
items.
Practical Considerations:

¯ Time can be wasted comparing numerous tag control numbers

to the inventory summary. This can be performed by a scanning
procedure and documented with a brief note.

¯ If the inventory summary is computer-generated, consider the

benefits of using computer audit software (such as IDEAt or
ACLt) to test the mechanical accuracy.

¯ If the client uses packaged accounting software and the auditor

has determined that the client is unable to make changes to
program coding, testing the mechanical accuracy of the inventory
detail may not be necessary. If procedures are performed to test
mechanical accuracy in this situation, they may be limited.

¯ If footing is performed, use the client to foot the inventory

summary to a “blind total,” i.e., remove five pages and add them to
the client’s total.

¯ Preferably, a copy of the inventory summary should be

obtained for the workpapers. However, inventory summaries are
very voluminous, and it may be difficult to bind a copy in the
workpaper files. A separate “bulk file” can be used in these
circumstances. Be sure to arrange for an auditor’s copy of the
listing.
* 4. Review the physical inventory listing and determine
individually significant items of raw materials, work-in-process,
and finished goods. Document the items selected.
Practical Considerations:

¯ Normally, individually significant items would be:

¯¯ Those with extended totals that are individually significant to
the financial statements. (See paragraph 401.4 for guidance on
determining individually significant amounts.)
¯¯ Those key products that are representative of many other
similar items carried in the company’s inventory. (See paragraph
802.2.)
¯¯ Those products that have a prior history of costing errors or
are otherwise prone to misstatement.
¯ Most small businesses have a few key items of inventory that,
once tested, can be used as a basis to test the reasonableness of
other items in inventory. For example, if the cost of eleven gauge
steel is tested, the auditor can normally scan the costs of other
gauges of steel and determine if variations from the item tested are
reasonable. The same would be true of a finished product that is the
basic manufactured product of the company, all other products
being a derivative of this basic product.
¯ Selection of individually significant items is not sampling.
Normally the testing of such items coupled with analytical tests of
the remaining items in inventory provides adequate evidential
matter about pricing. However, sampling procedures should be
considered when the population has numerous items (none of
which are more significant than the other) or when effective
analytical procedures cannot be applied to the remaining population
strata. See CX-7a for a worksheet to determine the extent of
procedures to apply to the remaining balance. See Step 7 for steps
to be considered in a sampling procedure.
¯ SAS No. 96, Audit Documentation, requires documentation of
substantive tests of details involving inspection of documents to
include identification of the items tested. The authors believe items
tested can be identified by listing the items; by including a detail
schedule in the workpapers, such as a physical inventory listing, on
which the items are identified; or by documenting in the
workpapers the source and selection criteria. For example:
¯¯ For tests of significant items, documentation may describe the
auditor’s scope and the source of the items (for example, all
inventory items with an extended cost greater than $5,000 from the
12/31/X2 extended inventory listing).
¯¯ For haphazard or random samples, documentation should
include the identifying characteristics of the items (for example, the
specific product codes, SKUs, etc.).
 ¯¯ For systematic samples, documentation may indicate the
source, starting point, and sampling interval (for example, a
selection of inventory items from the 12/31/X2 extended inventory
listing, starting with product number 2150 and selecting every
100th item thereafter).
SAS No. 96 is effective for audits of financial statements for
periods beginning on or after May 15, 2002, with early application
permitted.
C 5. For raw materials or purchased finished goods identified in
Step 4, test the cost as follows:
a. To the extent considered necessary, vouch the cost to the
most recent vendor invoices for the period under audit (assuming
the FIFO method is used).
b. Determine if freight discounts and allowances are
consistently treated when computing the cost of the inventory.
c. Relate the cost of the items tested to the costs used to
extend similar product codes. Investigate and explain variations.
d. Relate the costs of other untested items to prices used for
the same item in prior years. Investigate and explain variations.
e. Inquire if future purchase costs of any major products will
be reduced. Briefly test replacement costs on the items tested by
examining current purchase price list or invoices for purchases
after year end.
f. Test the net realizable value of purchased finished goods by
reference to current sales prices for the products (disposition cost
should be deducted from the sales price before making the
comparison to cost).
g. Determine if the valuation method is in accordance with
GAAP, consistently applied.
Practical Considerations:

¯ Often significant time is incurred testing the net realizable

value of finished goods. If the company’s actual gross profit
margin is extremely high, then the exposure to significant numbers
of finished goods being costed above market (even after
considering disposition cost) would be limited. Accordingly, an
analytical test of overall gross profit may be adequate to waive any
additional testing.
¯ If the company is involved in the retail business, it may be
necessary to perform a test of the markon percentage that is applied
to the inventory count at retail value. This may be done by
comparing a selection of items at cost and retail value to determine
support for the percentage used by the client to reduce retail value
 to estimated cost. See the AP-4 additional procedures.
¯ The client’s website may be a good source of information
about current sales prices of products. The website may provide
information about products being offered at reduced prices and also
may give auditors an indication of which products the client is
emphasizing or not emphasizing.
C 6. For work-in-process and finished goods manufactured by
the company that were identified in Step 4, test the costs as
follows:

a. Determine the nature of the cost accounting system used to

accumulate finished goods cost, i.e., a job order system or process
cost system. Determine the source documents used to compute
finished goods costs.
b. For finished goods selected for testing (normally testing a
limited number of items is adequate if the manufacturing process
for other items is basically the same) obtain a copy of a recent job
order or process production report for the manufacture of the item.
c. Trace quantities of raw material and labor charged during
manufacturing to appropriate supporting documents such as bills of
material, requisition forms, time cards, etc. Vouch the cost of
material to the raw material inventory summary or to vendor
invoices. Vouch the labor hours and rates to payroll records. If
labor is applied based on machine hours, consider observing an
order-in-process to test the reasonableness of the hours.
d. Test the company overhead rate by:

(1) Determining which general ledger expense accounts

should be included in overhead.
(2) Adjust the total of these balances for any abnormal cost
and idle capacity cost.
(3) Divide the total adjusted cost in (2) by an estimate of
direct labor hours or machine hours incurred during the period.
(4) Compare the resulting rate to the rate used by the
company and explain variations.
e. For work-in-process, test the pricing by computing the
overall percentage complete times the finished goods cost.
Alternatively, test the cost of material and labor charged to work-
in-process at the physical inventory date. Recompute the overhead
charge.
f. Test the net realizable value of manufactured finished
goods by comparing costs to current sales prices (after deducting
reasonable disposition costs).
 g. Determine if the valuation method is in accordance with
GAAP, consistently applied.
Practical Considerations:

¯ Modify the above procedures depending on the characteristics

of the cost accounting system. However, before performing any
test, evaluate how significant the labor and overhead components
of finished goods are to the financial statements. Often
manufactured finished goods are material cost intensive, and
detailed testing of labor and overhead is not warranted.
¯ The client’s website may be a good source of information
about current sales prices of products. The website may provide
information about products being offered at reduced prices and also
may give auditors an indication of which products the client is
emphasizing or not emphasizing.
C 7. If a sample is selected to test the pricing of inventory:
a. Determine the sample size using the guidance in Chapter 4.
b. Document the sampling plan, including the items selected.
c. Test the items selected by performing program Steps 5 and
6.
d. Evaluate the results and project the misstatement.
Practical Considerations:

¯ Normally the scope of items selected in Step 4 is adequate to

test the pricing.
¯ Use the “Sampling Planning and Evaluation Form—
Substantive Tests” (CX-7b) to document the sampling process.
¯ Extreme care should be exercised in projecting the
misstatement. Misstatements noted in an inventory price test are
often not random, i.e., they are peculiar to the category of the item
tested. In such cases, it is generally preferable to isolate and
separately evaluate items that may be susceptible to or affected by
those same types of misstatements. For example, a misstatement
caused when converting ton price to pound price for steel may only
apply to the steel component of inventory. In that case, it may be
more appropriate to review product codes susceptible to or affected
by this misstatement and evaluate them separately. See also the
case studies in Chapter 8.
D 8. Determine whether allowances have been made for scrap,
obsolete, unsalable, slow-moving, or overstocked items. Perform
the following procedures:
a. Determine the client’s method for identifying potential
 problems.
b. Compare information obtained in the observation of
physical inventory count to the final inventory listing.
c. Review perpetual records, sales analyses, and other
information to determine actual usage of the items during the year.
d. Review old or inactive jobs and determine whether
individual items are properly valued based upon potential market
value.
e. Compare the prior year listing of obsolete items to the final
inventory listing of the current year to determine that prior year
valuations have not been increased.
f. Investigate and explain any unusual exceptions to these
steps.
Practical Considerations:

¯ Care should be taken not to assume that positive comments

made by client employees provide adequate evidence to offset
other indications of obsolescence problems.
¯ Much of the critical obsolescence work must be accomplished
at the physical count date when the auditor actually observes the
condition of the inventory. See the inventory observation program
at AP-5.
¯ Obsolescence problems do not always appear through physical
inspection. Tests of records that might identify slow-moving items
should be considered if there is any significant potential for such
problems in the company or industry.
¯ The client’s website may be a good source of information
about current sales prices of products. The website may provide
information about products being offered at reduced prices and also
may give auditors an indication of which products the client is
emphasizing or not emphasizing.
A 9. Trace all shipping and receiving transactions selected for
testing during the inventory observation (see Step 6 of the program
at AP-5) to the appropriate journals or detail lists of accounts
payable. Determine that these transactions are properly reported in
the period to which they apply.
Practical Consideration:

¯ AP-13 includes additional procedures the auditor may perform

to test sales cutoff.
E 10. From a review of bank confirmations, debt confirmations,
directors’ minutes and inquiry of management, determine whether
 any inventory has been pledged or assigned to others to
collateralize debt. Summarize any such situations for disclosure.
* 11. Consider the need to apply one or more additional
procedures. The decision to apply additional procedures should be
based on a consideration of whether information obtained or
misstatements detected by performing substantive tests or from
other sources during the audit alter your judgment about the need to
obtain a further understanding of control activities, the assessed
level of risk of material misstatements (whether caused by error or
fraud), and on an evaluation of whether the basic procedures have
been sufficient to achieve the audit objectives. Attach audit
program sheets to document additional procedures.
Practical Considerations:

¯ Certain common additional procedures relating to the

following topics are illustrated following this program:

¯¯ Intercompany profit.

¯¯ Retail inventory method.

¯¯ LIFO inventory method.

¯¯ Inventory tested at an interim date.

¯ Additional procedures in response to the fraud risk assessment
for inventory are illustrated in the additional procedures section
following the “Audit Program for Inventory Observation” at AP-5.
¯ Practitioners may refer to PPC’s Guide to Fraud Investigations
for more extensive fraud detection procedures if it is suspected that
the financial statements are materially misstated due to fraud.
* 12. Consider whether procedures performed are adequate to
respond to identified fraud risk factors. If fraud risk factors or other
conditions are identified that require an additional audit response,
consider those risk factors or conditions and the auditor’s response
in connection with the performance of Step 11 in AP-1b.
Practical Consideration:

¯ Specific responses to identified fraud risk factors are addressed

in individual audit programs. In connection with evaluation and
other completion procedures in AP-1b, the auditor considers the
need to perform additional procedures based on the results of
procedures performed in the individual audit programs and the
cumulative knowledge gained from performing those procedures.
* 13. Consider whether the results of audit procedures indicate
 reportable conditions in internal control and, if so, add to the memo
of points for the communication of reportable conditions. (See
section 1504 for examples of reportable conditions, and see CX-18
for a worksheet that can be used to document the points as they are
encountered during the audit.)
CONCLUSION

We have performed procedures sufficient to achieve the audit

objectives for inventory, and the results of these procedures are
adequately documented in the accompanying workpapers. (If you
are unable to conclude on any objective, prepare a memo
documenting your reason.)

⇒Additional Audit Procedures for Inventory

Instructions: Additional procedures will occasionally be necessary on some small
business engagements. The following listing, although not all-inclusive, represents
common additional procedures and their related objectives.

Intercompany Profit
C Determine if the inventory amount includes any significant
intercompany profit. Determine the amount of such profit for
elimination, if appropriate.

Retail Inventory Method

C If the company uses a retail inventory method, perform the
following procedures:
a. Trace the total retail value of sections test counted to the
summary listing. Determine explanations for any difference.
b. Compare subtotals by department or category in the
 summary to amounts reported by subtotal in previous counts and
explain major differences.
c. Obtain the vendor cost and retail sales price of several
representative items in each significant department and determine
the reasonableness of the percentages used to convert the inventory
count at retail to vendor cost.
d. Recompute the conversion by department of retail amount
to estimated cost.
e. Determine whether analytical procedures revealed any
unusual relationships for the retail inventory and gross profit
percentages.

LIFO Inventory Method

C For LIFO inventory pricing:
a. Determine the following pricing elections made when the
company originally adopted LIFO:
(1) Whether “dollar value” vs. “specific item” LIFO is used.
(2) Number of pools.
(3) Method used to determine current year increment or
decrement, i.e., double extension, link chain, indexes, etc.
(4) Method of pricing current year increments, i.e., first
purchase price, average price, last purchase price, etc.
b. If the double extension method is used, test the base period
prices and extensions for the product codes selected in Steps 5 and
6.
c. If an index is used, test the rationale and computation of the
index.
d. Test the pricing of current year increments or decrements
to LIFO layers.
e. Based on the above procedures, evaluate the adequacy of
the LIFO allowance account.
f. Prepare financial statement disclosures, especially the effect
of any liquidations of LIFO layers.

Inventory Tested at an Interim Date

A, [B], If inventory was tested at an interim date,
[C] perform the following steps:

a. Obtain or prepare a reconciliation of

the inventory detail records as of the balance
 sheet date to the general ledger control
b. Obtain a schedule of month end
inventory balances from the interim date to the
balance sheet date. Investigate significant
variations.
Practical Considerations:

¯ The schedule should be prepared in as

much detail as practical, such as finished
goods, work-in-process, and raw materials by
product line.
¯ Consider whether the trends in inventory
balances are consistent with trends in
purchases, sales, and production.
c. Scan inventory activity in the
accounting records during the period from the
interim date to the balance sheet date.
Investigate and explain the nature and origin
of any unusual entries.
Practical Considerations:

¯ If the client’s accounting system can

produce a rollforward of the inventory balance
from the interim date to the balance sheet date,
it may be more effective and efficient to
obtain the rollforward and perform tests of
details of the rollforward activity.
¯ Consider the likelihood that any
misstatements that occurred at interim may
have arisen again during the rollforward
period.
¯ If the results of the rollforward procedures
are unsatisfactory, consider the need to
reperform substantive procedures as of the
balance sheet date.
d. Perform a test of inventory cutoff as
of the balance sheet date.

⇒Additional Audit Procedures for Inventory

Beginning Balance in Initial Audit
Company Balance Sheet Date

Audit N/A Workpaper

Objectives Performed Index
Audit Procedures for Consideration by
Instructions: Additional procedures will be necessary in an
initial audit. These procedures are applied to opening balances and
differ depending on whether you are relying on your review of a
predecessor’s work or placing no reliance on a predecessor’s audit.
(Section 1803 discusses considerations when replacing a
predecessor auditor, including a discussion of what the term
reliance means when used in this program.) These procedures may
be applied in conjunction with the basic procedures applied to the
ending balance. The asterisks preceding the procedures indicate
that they are an intermediate step in achieving audit objectives for
the ending balance.
* 1. If a predecessor’s audit of the prior period’s financial
statements is to be relied on:
a. Review the predecessor’s workpapers for the inventory
observation and consider whether the predecessor:
(1) Made test counts.
(2) Observed adherence to counting instructions.
(3) Accounted for used, voided, or unused count sheets or
tags.
(4) Tested shipping/receiving cutoff procedures.
(5) Inquired about items held at outside locations or in transit,
sufficient to establish the adequacy of the company’s procedures
and controls for recording an accurate count.
b. Review the predecessor’s workpapers for testing the
clerical accuracy and pricing of the physical inventory summary
and reduction of items to net realizable value, including
identification of excess, slow-moving, obsolete, and defective
items; consider whether the predecessor’s procedures were
adequate to establish valuation in accordance with GAAP; note the
accounting methods for pricing, expense accounts included in
overhead, and treatment of freight, discounts, and allowances for
comparison to methods in the current period.
c. Consider whether any items identified as excess, slow-
moving, obsolete, or defective in the current period should have
been identified in the prior period.
d. Consider whether any significant losses recorded during
the current period for sales or commitments are attributable to the
prior period.
* 2. If no reliance on a predecessor is planned or possible:
a. Inquire about how inventory quantities were determined in
the prior period and obtain copies of instructions, count sheets or
tags, and summary and final listings.
Practical Consideration:

¯ If inventories were not determined by physical count, or if

records of the count were not retained, it is not usually possible to
accomplish audit objectives related to cost of sales in the current
period, and a disclaimer of opinion on results of operations and
cash flows may be necessary.
b. Compare count instructions of the prior period to those of
the current period and the procedures observed in the current
period; consider the implications for the accuracy of the prior
count.
c. Vouch selected quantities on inventory listings to count
sheets or tags, trace selected items from count sheets or tags to
listings; test the footing and extensions of listings.
Practical Consideration:

¯ See the practical considerations for basic procedures 3 and 4.

d. Inquire about methods of pricing in the prior period and
vouch selected prices to vendor’s invoices, price lists, or cost
sheets. Document the items tested. Note the accounting methods,
expense accounts included in overhead, and treatment of freight,
discounts, and allowances and compare to those of the current
period.
Practical Considerations:

¯ Perform this procedure with current price tests (basic

procedures 4–7).
¯ Often it is sufficient to compare prices to those determined in
the current period and consider for reasonableness; investigate
significant differences.
¯ Watch for items that were individually significant in one
period but not the other.
e. Compare sales and cost of sales for the last month of the
prior period and the first month of the current period and consider
the reasonableness of cutoff.
f. Consider whether any items identified as excess, slow-
moving, obsolete, or defective in the current period should have
been identified in the prior period.
 g. Consider whether any significant losses recorded during
the current period for sales or commitments are attributable to the
prior period.
h. Compare gross margins (by product code) for the current
period to gross margins for the two prior periods and investigate
significant fluctuations.

AP-5: ⇒Audit Program for Inventory

Observation
Company Balance Sheet Date

The company’s inventory locations and physical observation dates are:

Type of Approximate % of Date and Telephone
Address Inventory the Total Inventory Time of Count Number

Audit Program for Inventory Observation

Company Balance Sheet Date

Audit N/A Workpaper
Objectives Performed Index
Audit Procedures for Consideration by
Instructions: The inventory observation program is an
addendum to the audit program for inventory. Procedures in this
observation program are designed to obtain evidential matter for
the financial statement assertions of existence and completeness.
AUDIT OBJECTIVES

A. The company’s procedures and controls for recording an

accurate count of inventory on hand, in transit, or at outside
locations are adequate and operating effectively.
B. Excess, slow-moving, obsolete, and defective inventory
observed during the count is identified on separate tags or count
sheets for appropriate valuation.
C. Significant current year additions or retirements of
property, plant, and equipment, and defective or obsolete
equipment noted during the observation is identified for tracing to
the property accounts.
IDENTIFICATION CODES

The letters preceding each of the above audit objectives, i.e., A, B,

etc., serve as identification codes. These codes are presented in the
left column labeled “Audit Objectives” when a procedure
accomplishes an objective. If the alpha code appears in a bracket,
e.g., [A], [B], etc., the audit procedure only secondarily
accomplishes the objective. If an asterisk precedes a procedure, it is
a preliminary step or a follow up step that does not accomplish an
objective.
BASIC PROCEDURES
Planning
* 1. In advance of the physical inventory date, obtain an
understanding of the location of the company’s inventory and the
date of the count. Determine those locations that should be
observed. For locations not observed, determine if a confirmation
letter for these inventories would be appropriate.
Practical Considerations:

¯ If the client has inventory in several locations, the auditor

should consider the following factors when considering which
locations to observe:
¯¯ The relative materiality of each location.
¯¯ The degree of centralization of records or information
processing.
¯¯ The effectiveness of the control environment at each location
(particularly with respect to management’s or the owner/manager’s
direct control and ability to supervise activities at the location).
¯¯ The frequency, timing, and scope of monitoring activities by
the company or others at the location.
¯ SAS No. 43 (AU 331.14) states that if significant inventories
are in the hands of public warehouses or other outside custodians,
the auditor ordinarily should obtain direct confirmation in writing
from the custodian. If such inventories represent a significant
portion of current or total assets, to obtain reasonable assurance
with respect to their existence, the auditor should apply one or
more of the following procedures as considered necessary in the
circumstances.
¯¯ Test the owner’s procedures for investigating the
warehouseman and evaluating the warehouseman’s performance.
¯¯ Obtain an independent accountant’s report on the
warehouseman’s control procedures relevant to custody of goods
and, if applicable, pledging of receipts, or apply alternative
procedures at the warehouse to gain reasonable assurance that
information received from the warehouseman is reliable.
¯¯ Observe physical counts of goods, if practicable and
reasonable.
¯¯ If warehouse receipts have been pledged as collateral,
confirm with lenders pertinent details of the pledged receipts (on a
test basis, if appropriate).
¯ If the value or quality of the inventory will be based on the
work of an outside specialist (e.g., an appraiser), the requirements
of SAS No. 73, Using the Work of a Specialist, should be
followed. The additional procedures at AP-1 contain audit
procedures regarding using the work of a specialist.
¯ See CL-13 and CL-14 for confirmation letters of inventory
held by a third party.
¯ The additional procedures section of this audit program
includes procedures to be performed if the auditor is not able to
observe physical inventory counts at the balance sheet date.
¯ If the client performs cycle counts rather than taking a
complete physical inventory at the balance sheet date, this program
can be adapted to cycle count observation. Because a complete
physical inventory is not being taken at one time, auditors should
be careful to ensure the client properly identifies the items counted
so that appropriate perpetual records are updated. See also the
additional procedures for cycle counts included in the additional
 procedures section of this program.
* 2. Inquire about the procedures that will be used to count the
inventory. If possible, supplement this information with a tour of
the inventory locations before the count. CX-10, “Inventory
Counting Procedures,” can be used to document this information.
* 3. Determine those items of inventory that, when priced and
extended, will result in individually significant items. Instruct the
audit personnel observing the count to pay special attention to
these items when recording test counts.
Practical Considerations:

¯ Most small business inventories contain individually

significant dollar items. Such items can be identified in a number
of ways: (1) inquiry of the owner/manager, (2) review of the prior
year’s inventory summary, and (3) touring the inventory facilities.
¯ Observation of the counting of individually significant dollar
items and recording test counts for later testing can maximize audit
efficiency.
Observation
A, B 4. Observe the physical inventory count by performing the
following procedures for raw materials and finished goods:
a. Observe the counting by employees and determine whether
(1) their attitude and conduct is likely to produce accurate results,
(2) the client’s inventory instructions are being followed, and (3)
the counts are neatly and accurately recorded.
b. Make test counts to the extent considered necessary,
preferably including each section of the plant or store. Record
several test counts for tracing to the physical inventory summary.
Be sure to obtain adequate test counts of items that will result in
significant amounts when priced and extended. If you observe
differences in the count and your test, determine if they are isolated
or whether an entire section must be recounted. Verify that all
differences you note are corrected.
c. While observing physical count procedures, determine
whether any inventory appears to be obsolete or very old and
whether the client has properly identified those items. Be aware of
items stored in inaccessible areas, items that are deteriorated, items
that appear to be in the same location and condition as the prior
year, and items with the prior year’s inventory tags or count control
stickers still attached. Make test counts of these items and, if
possible, have the client identify all such items on the tag or sheet
to ensure that they are properly handled in the subsequent pricing
of the counts.
 d. When the counting of all areas is complete, tour the plant
or store to determine if all areas appear to be counted. Obtain an
adequate explanation of any omissions. When you are satisfied,
instruct the client to accumulate the tags (if they are used) and if
possible, accompany the personnel when the tags are pulled to
prevent invalid tags from being introduced in the accumulation
process.
e. Determine that all count sheets or tag numbers are
accounted for as used, voided, or unused. Obtain the sequences of
tag or count sheet numbers that fall into these three categories. For
partially complete count sheets, see that the client lines through the
unused portions.
f. Select several count sheets or tags and have the client
relocate and count the item.
g. If count sheets are used, if possible, obtain a photocopy of
all completed and partially used sheets before you leave the plant
or store.
Practical Considerations:

¯ Test counts are primarily reperformance procedures to test the

company’s counting procedures. After the count, they will be used
to test the existence of quantities recorded in the inventory
summary. The number of test counts necessary is a matter of
professional judgment and varies depending on factors such as (1)
the concentration of items that will result in individually significant
dollars when extended on the inventory summary, (2) the number
of count teams involved, and (3) the arrival time of the auditor to
observe the count. If there are concentrations of high dollars in a
few inventory codes, test counts of these codes could minimize the
need for numerous other test counts. Conversely, inventories
composed of a large number of individual items (like a wholesale
auto parts company) will require numerous counts of all major
locations within the plant or store. If numerous count teams are
involved, test counts should be expanded to determine that all
teams are complying with instructions. If the auditor is present
throughout the entire count, observing the counting procedures in
process supplements the reperformance procedures of test counts.
Accordingly, test counts would not be as numerous as they would
if the auditor arrived at the completion of the counting.
¯ Ordinarily, auditors take more test counts than they record.
Auditors are not required to document all of the test counts they
take.
¯ The auditor should consider taking some test counts when not
in the client’s presence. Some inventory frauds have been
 perpetrated by the client observing what items were counted by the
auditor and going back later to change counts for items not counted
by the auditor.
¯ Often inventory with identical product codes is stored in
different locations of the plant or store. For example, there may be
a “shelf supply” designed for easy access and a “back up supply” at
a different location. Normally (and preferably) these different
storage locations are counted on different tags or count sheets,
necessitating a summarization procedure to accumulate one grand
total quantity. You should determine if the company’s
summarization procedure leaves an adequate audit trail to enable
test counts taken at one of the several locations to be reconciled
with the final total on the inventory listing. If not, record test
counts at all separate locations of the product to test the grand total
that will appear on the final listing.
¯ You should not leave the inventory location until you are
satisfied that company counting procedures are adequate and
operating effectively. Naturally, all isolated miscounts you note
should be corrected by the company before the tags or sheets are
accumulated. However, if you conclude that counting mistakes are
numerous and systematic, you should require that the area (if it can
be isolated) be recounted or advise the company that a new
inventory count should be taken.
A, B 5. Identify work-in-process inventory and apply the same
count procedures identified in Step 4 for items selected for test
counting. Also perform the following procedures:
a. Determine that the information recorded on the count tags
or sheets is adequate to properly price work-in-process, i.e.,
percentage complete of material, labor, and overhead.
b. Determine that items of raw material or finished goods
counted as part of work-in-process are not counted again as raw
material or finished goods.
Practical Consideration:

¯ Normally, production should be stopped during the count to

allow an accurate assessment of the stage of completion of work-
in-process. See paragraph 802.16.
A, B 6. To determine the accuracy of the shipping/receiving cutoff
procedures, perform the following steps:
a. Determine the last five shipping and receiving transactions
of the year and the first five transactions after year end. (If the
inventory is observed as of an interim date, determine the last five
transactions before the count and the first five transactions after the
count.) Prepare a list of those transactions or obtain copies of the
 documentation for those transactions.
b. By observation, determine that there is no movement of
inventory between raw materials, work-in-process, and finished
goods. If a major movement occurs, obtain adequate information
(quantity and product description) to test the treatment of the item.
c. Tour the shipping and receiving area (including rail cars or
trucks in loading bays). Obtain information about the status of
numerous pallets or boxes of items in these areas. Determine
whether they should be counted or excluded from the count. Obtain
documents for these items to test the accounting cutoff.
Practical Considerations:

¯ A sometimes overlooked problem is inventory in transit from

one location to another. If this exists, the auditor should obtain
information concerning transfers of this nature between the
company’s locations.
¯ The auditor may also decide to obtain cutoff information for
transfers between departments as well as with various locations,
although this is rarely needed.
¯ Cutoff information should be obtained in a form that can be
traced to the final transaction journals to determine proper
accounting treatment. This requires that proper descriptions be
obtained at the physical count date. A photocopy of the
shipping/receiving documents is helpful.
A 7. Inquire of the owner/manager, production personnel, and
counters if inventory held by the company for others is segregated
and excluded from the count. Also inquire about inventory held
related to “bill and hold” transactions.
Practical Consideration:

¯ The additional procedures section of AP-13 includes

procedures related to “bill and hold” transactions.
C 8. During the time of the physical count, perform the
following procedures related to other audit areas:
a. Identify major property and equipment additions and
observe the condition and description (serial number, if necessary).
b. Observe the condition and existence of any obsolete or
damaged equipment. Inquire if there are any assets that were
retired and removed from the premises. List significant items for
later tracing to property records.
c. Identify the last check number written for later testing of
held checks. Ask if there are any checks written that are being held
for release after year end. Obtain a list of them.
 d. Following the guidance in the cash audit program, mail
bank confirmations and requests for cutoff statements.
e. Following the guidance in the liability audit program,
select the accounts payable vendors for confirmation, prepare and
mail the requests.
f. Perform a count of cash or securities on the premises only
if they are material to the financial statements. Obtain a receipt that
they were returned intact.
Practical Consideration:

¯ Each of these procedures is dependent upon the scope of

procedures described in other appropriate audit programs. The
important point is to make any idle time at the physical count
productive.
* 9. Consider the need to apply one or more additional
procedures. The decision to apply additional procedures should be
based on a consideration of whether information obtained or
misstatements detected by performing substantive tests or from
other sources during the audit alter your judgment about the need
to obtain a further understanding of control activities, the assessed
level of risk of material misstatements (whether caused by error or
fraud), and on an evaluation of whether the basic procedures have
been sufficient to achieve the audit objectives. Attach audit
program sheets to document additional procedures.
Practical Considerations:

¯ Certain common additional procedures relating to the

following topics are illustrated following this program:

¯¯ Inventory observed subsequent to balance sheet date.

¯¯ Additional procedures in response to fraud risk assessment.

¯¯ Cycle counts
¯ Practitioners may refer to PPC’s Guide to Fraud Investigations
for more extensive fraud detection procedures if it is suspected that
the financial statements are materially misstated due to fraud.
* 10. Consider whether procedures performed are adequate to
respond to identified fraud risk factors. If fraud risk factors or other
conditions are identified that require an additional audit response,
consider those risk factors or conditions and the auditor’s response
in connection with the performance of Step 11 in AP-1b.
Practical Consideration:
 ¯ Specific responses to identified fraud risk factors are addressed
in individual audit programs. In connection with evaluation and
other completion procedures in AP-1b, the auditor considers the
need to perform additional procedures based on the results of
procedures performed in the individual audit programs and the
cumulative knowledge gained from performing those procedures.
* 11. Consider whether the results of audit procedures indicate
reportable conditions in internal control and, if so, add to the memo
of points for the communication of reportable conditions. (See
section 1504 for examples of reportable conditions, and see CX-18
for a worksheet that can be used to document the points as they are
encountered during the audit.)
CONCLUSION

We have performed procedures sufficient to achieve the audit

objectives for the observation of inventory, and the results of these
procedures are adequately documented in the accompanying
workpapers. (If you are unable to conclude on any objective,
prepare a memo documenting your reason.)

⇒Additional Audit Procedures for Inventory

Observation
Instructions: Additional procedures will occasionally be necessary on some small
business engagements. The following listing, although not all-inclusive, represents
common additional procedures and their related objectives.

Inventory Observed Subsequent to Balance Sheet Date

A If the auditor is unable to observe the physical inventory at the
balance sheet date, perform the following procedures:
 a. Observe the physical inventory at a subsequent date by
performing Steps 1–6 of the basic procedures at AP-5.
b. Obtain or prepare for the workpapers a rollforward of
inventory from the balance sheet date to the date of the subsequent
physical inventory procedures. Vouch inventory purchases to
receiving documents and vendor invoices. Vouch cost of sales
transactions to customer purchase orders and shipping documents.
c. If the client performed a physical inventory at the balance
sheet date, review documentation of the count. Trace selected
quantities from the inventory listing to the count sheets or tags.
Also trace selected quantities per the count sheets or tags to the
inventory listing.
d. Compare gross profit for the last month of the year under
audit to gross profit for the first month of the subsequent period to
assess reasonableness of cutoff.
Practical Considerations:

¯ In some cases, the auditor may not be able to observe

inventories at the balance sheet date (for example, if the auditor did
not accept the engagement until after the balance sheet date).
¯ If the auditor is not able to observe some physical inventory
counts, then the auditor’s report should be modified for a scope
limitation. (Chapter 4 of PPC’s Guide to Auditor’s Reports
provides guidance on modifying the auditor’s report for a scope
limitation.)
¯ The additional procedures for initial audit at AP-4 contain
procedures related to beginning inventory balances.

Additional Procedures In Response to Fraud Risk Assessment

A If the auditor, based on his or her consideration of fraud risk
factors, decides to modify procedures related to inventory
quantities, the following additional procedures should also be
considered:
a. Observe inventories on an unannounced basis.
b. Have the entity count all locations at the same time.
c. Examine the contents of boxed items more rigorously.
Verify that labelling corresponds to the actual contents of the
container.
d. Examine the manner in which inventory is stacked (for
example, to detect hollow squares).
e. Test the quality (purity, grade, or concentration) of certain
inventories (for example, perfumes, specialty chemicals, steel,
diamonds, etc.).
 f. Perform extended testing of count sheets, tags, or other
records. Consider obtaining copies of all records to minimize the
risk of subsequent alteration or inappropriate compilation.
g. When taking test counts, be alert and make sure client
personnel are not noting your test counts so they can alter items
that were not test counted.
Practical Considerations:

¯ It is important for audit staff to be properly instructed so that

they know the fraud detection purposes of the procedures being
applied.
¯ Practitioners may refer to PPC’s Guide to Fraud Investigations
for more extensive fraud detection procedures if it is suspected that
the financial statements are materiality misstated due to fraud.

Cycle Counts
A If the client performs cycle counts, perform the following
additional procedures:
a. Trace test counts made by the auditor to the client’s
perpetual records.
b. Examine the client’s schedule of cycle counts for the
period under audit to determine that counts of substantially all
inventory items were made.
c. Review worksheets, entries in the perpetual inventory
records, and other evidence of the regularity of cycle counts and
evaluate the results.
Practical Consideration:

¯ When evaluating the results of cycle counts, auditors should

consider the frequency of counts, significance of differences
between counts and perpetual records, and quality of investigation
of significant differences between physical counts and perpetual
records.