Inventory

Study Guide

Recall the four assertions that that Professional Standards identify for account balances at the end of
the period: (1) existence; (2) completeness; (3) rights and obligations; and (4) valuation and allocation.

I. Relevant AICPA Guidance—The relevant AICPA guidance is provided by AU 501, Audit Evidence

—Specific Considerations for Selected Items. Part of this standard focuses specifically on
inventory, which is summarized here. The standard states that the auditor's objective is to
obtain sufficient appropriate audit evidence about the existence and condition of inventory.

II. Related to the Existence Assertion—The auditor participates in the client's physical count of
inventory (the observation of inventory):

A. Note—The client counts the entire inventory and the auditor observes the client's

taking of the inventory (while taking independent test counts ). The auditor participates
in this process for two primary reasons, referred to as dual purpose tests.

1. Internal control objectives—The auditor should study the client's written

procedures and instructions given to the employees or others counting the
inventory to assess the adequacy of the design of these procedures in achieving
an accurate physical count; the auditor's focus here is assessing control risk
related to inventory reporting.

2. Substantive audit objectives—The auditor should take a sample of inventory

items and verify the physical existence of quantities reflected in the client's
detailed records supporting the ending inventory; the auditor's focus here is
assessing the fairness of the reported inventory.

Recall that the direction of the test is critical to the inference associated with an audit procedure:

To test existence for inventory—The auditor should select items from the client's (final) inventory
listing, which is essentially the subsidiary ledger for the adjusted general ledger balance. The auditor
should agree those selected items to the underlying inventory count tags (and the auditor's own count
sheets) that serve as source documents.

To test completeness for inventory—The direction of the test is just the opposite. The auditor should
select items from the underlying inventory count tags (including the auditor's own count sheets) and
agree those to the client's inventory listing to establish that there were no omissions from the client's
inventory listing.

B. Related to Audit Procedures—Emphasizing quantities:

1. Auditor's attendance at physical inventory counting—Involves (a) inspecting

the inventory to ascertain its existence and evaluate its condition (and
 performing test counts); (b) observing compliance with management's
instructions and the performance of procedures for recording and controlling
the results of the physical count; and (c) obtaining audit evidence about the
reliability of management's count procedures

2. Review the client's written inventory-taking procedures to determine that the

physical count will be complete and accurate (regarding dates, locations,
personnel involved, and instructions about accounting for the prenumbered
inventory tags, cutoff procedures, and error resolution procedures)

3. Assessing the accuracy of the client's reported inventory quantities. The auditor

should perform test counts for a sample of the prenumbered inventory tags,
trace these counts into the client's count sheets (to verify the accuracy of the
client's counts on a test basis) and to the client's final inventory listing that
supports the general ledger balance. Note that the entity's final inventory listing
(reflecting both quantities and dollar amounts) serves as the “subsidiary ledger”
for inventory and represents the dollar amount for inventory to which the
general ledger account will be adjusted.

4. Focus on the client's prenumbered inventory tags. Determine that all tags have
been properly accounted for (i.e., all tags are used, unused and returned, or
have been voided and returned to a responsible official).

5. The auditor should be alert for and inquire about obsolete or damaged items
(e.g., dusty or damaged cartons) related to the valuation assertion; the auditor
should also be alert for empty containers or hollow spaces.

C. If the physical count of inventory occurs on a date other than the date of the financial
statements, the auditor should perform audit procedures to determine whether
changes in inventory between those dates are properly recorded.

D. If the auditor is unable to attend physical inventory counting due to unforeseen

circumstances, the auditor should make some physical counts on an alternative date
and perform audit procedures on intervening transactions.

E. If attendance at physical inventory counting is impracticable, the auditor should perform

alternative audit procedures to obtain sufficient appropriate audit evidence regarding
the existence and condition of inventory. If that is not possible, then the auditor should
appropriately modify the auditor's opinion.

F. If there is a material amount of inventory stored in a public warehouse, the auditor can
confirm such inventory with the custodian (or could consider physical observation).

III. Related to the Valuation Assertion

 A. Price Tests—Regarding the unit costs (not selling prices!) attributed to inventory items:

1. Affected by the client's inventory methods (perpetual versus periodic inventory

system) and cost flow assumptions (LIFO, FIFO, average)

2. For merchandising (nonmanufacturing) inventory—Examine the appropriate

underlying invoices

3. For manufactured inventory—Review the supporting job order cost records (or
the process cost worksheets) and test to underlying documents.

B. Test Extensions—Recalculate the product of quantity times cost/unit for selected items:

1. Add up these extensions to verify that the items tested are reflected in the total
of the detailed inventory listing supporting the client's general ledger balance.
This can be described as “verifying the mathematical accuracy” to establish the
connection between the general ledger balance and the supporting detailed
listing;

2. Scan the detailed inventory listing for any unusual items;

3. Review the client's reconciliation (or the adjusting journal entry) of the general
ledger balance to the detailed inventory listing.

C. Lower of Cost or Market Considerations—Inquire of management as to the existence of

any damaged, obsolete, or excess inventory items that might require a write-down from
historical cost to net realizable value; be attentive to these issues when participating in
the observation of inventory.

IV. Related to the Completeness Assertion—Procedures that might identify material omissions of
inventory:

A. Test inventory cutoff (recall “FOB-shipping point” versus “FOB-destination” as a

technical issue determining when title to goods is transferred):

1. Related to increases in inventory—Review “receivers” (receiving documents

used by the entity's receiving department to capture deliveries) for a few days
before and after year-end (part of “purchases” cutoff test);

2. Related to decreases to inventory—Review shipping documents for a few days

before and after year-end (related to “sales” and, hence, “cost of goods sold”
cutoff test).

B. Analytical Procedures (Perhaps by Location or by Product-Line)—Compare the current

year to the prior year and inquire about any significant differences in:

1. Gross profit rates

 2. Inventory turnover (primarily applicable to the valuation assertion regarding
slow-moving inventory)

3. Shrinkage rates

4. Total inventory

V. Related to the Rights and Obligations Assertion

A. Inquire of management about any inventory that might be held on consignment or

pledged as collateral for borrowings (and review loan agreements to identify such
collateral).

B. Document such inquiries (and management's response) in the management

representations letter.

VI. Other Issues Related to Auditing Inventory

A. Use of Specialists—An auditor may need to engage an outside expert if the

determination of quantities and/or quality is too complex (e.g., electronics, precious
jewels).

B. If an auditor is unable to verify the beginning inventory for a first-year audit, but is able

to verify the ending inventory:

1. The auditor may render an opinion on the balance sheet and disclaim an
opinion on the income statement, statement of retained earnings, and the
statement of cash flows (due to the inability to verify cost of goods sold and,
hence, net income).

2. It may be possible to establish the reasonableness of a new client's beginning

inventory from alternate procedures—through the use of analytical procedures
or by reviewing a predecessor auditor's working papers.