There are many audit procedures and approach that auditors could use to perform during their detail testing the inventories that report by management in the financial statements. Before to go to detail on the procedure, it is good to start with the overview of inventories first.
Non-trading inventories are the inventories that entity make or purchases for their own use and normally have a useful life for less than one year.
Trading inventories are the inventories that make or purchase for trading. These include raw material that entity purchases from suppliers, work in progress and finish goods that are ready for sales or delivery.
Inventories are normally considered as significant accounts per audit perspective. This is because inventory normally has large amounts at the reporting date as well as nature is sensitive compared to other assets. The fraud over inventories is likely to happen by staff or managements due to this sensitivity.
In this article, we will write about the auditor procedure for testing inventories in the entity’s financial statements. We will also explain the assertion that auditors should confirm, common risks related to inventories, and the procedures to address the assertion and risks.
As the best audit practice and as required by the standard, the auditor should performance an understanding of key control over financial reporting. And if we want to perform an audit of inventories in entity’s financial statements, we should start by trying to obtain as much as information related to the control of over inventories.
It could be rank from understanding the system that the entity uses to control its inventories, key people who managing, and how inventories are physically controlled.
Others key control including reviewing and delivering inventories should also clearly confirm. Key authorization over inventories also importance for auditors and it is subject for review.
Once auditor understood these key controls, auditors will be able to tailor the audit procedure effetely for them to address the risks at less effort.
- Existing: Auditor should confirm this assertion whether the inventories that recording in the entity balance sheet really exists.
- Valuation: Value of inventory is really important especially the slow-moving and high tech inventories.
- Ownership: It is important to review the ownership of inventories that records in the financial statements and store in the entity’s warehouse.
- Accuracy: Check whether inventories amount and value are correctly calculated in the financial statements.
- Cut off: Whether inventories records are properly cut off. Example, inventories that should be recorded in 2016 were recorded in 2016 and the inventories that should be recorded in 2017 were recorded in 2017.
- Occurrence: Auditor might want to test whether inventories that purchases and sold during the year have really occurred.
- Completeness: Test whether inventories are completely recording in the list as well as financial statements.
- Right and Obligation: Check whether the entity has the right to manage the inventories.
Common Risks Related Inventories:
Fraud over the inventories that committed by entity staff frequently happens to most of the entity’s inventories, based on my experiences.
It was sometime committed by normal staff and sometimes it is committed by the management of the entity and sometimes the collusion among the key players. Auditors should also consider the review and assess the fraud risks related to this area.
Understand of inventories are the common key concerning areas for auditors and they have to make sure that the risks are address in the procedures.
Confirm existing of inventories:
Inventories are the accounting balance in the balance sheet. And if auditor decided to perform their review on the entity’s inventories, existence is one of the financial statements assertions that auditor needs to confirm.
Physical verification is one of the procedure that auditor use to confirm this assertion. The auditor may consider to join the observation of a client’s year-end inventories count or perform their own sampling.
Physical verification is not only helping the auditor to confirm the existence of inventories that report in the balance sheet, but it also helps auditors to assess the condition of inventories, physical controls and asses the procedures that client use to perform their year-end counts.
When auditor assesses the counting procedures that perform by its client, auditors should focus on three main areas including the procedures before the count, during the count, and the procedure after the count.
These procedures are really important for the client to ensure that any error to the quantity of inventories report is identified and reflected financial statements.
Inventories are the current assets and entity could recognize the inventories in its financial statements only if those inventories meet the definition provided by IFRS Conceptual Framework.
Normally, auditor review the ownership (Right and Obligation) of the entity over the inventories by reviewing the Contracts, Quotation, Invoices, and Delivery Noted. Term and Condition in the contract are very important for ownership verification.
Assess the value of inventories:
IAS 2 is the current standard that issued by IFRS for dealing with inventories measurement, recognition, and disclosure and so on. Measurement of inventories should be at the lowest of cost and net realizable value.
Normally, the cost of inventories including cost of acquisition, cost of conversion, and others related cost that bring inventories into their present location and condition. Auditor should:
- Review the costing method and accounting policy that uses by the entity to value its inventories.
- For raw material, review the cost of purchasing and other related delivery costs.
- For WIP and finish goods, review the cost of conversion that brings raw material into WIP and Finishes goods.
- Review if there any other costs that not related to inventories or not allow by IAS 2 are included in the cost of inventories.
The LIFO method is not allowed by IAS 2.
Review cut off:
Cut off is very important because if there is any problem in cut off, there will be a problem in the total amount of inventories at the reporting date. In this point, the auditor should review and confirm inventories are records in the period that they are belonging to.
Goods received noted at the client’s warehouse and goods delivery noted that provided by client’s suppliers are the important documents to verify cut off.
Shipping documents and any others form that prove the delivery and receive date are importance for auditors to review cut off.
The auditor should perform an analytical review on inventories to identify the unreasonable event or transactions related to inventories including the slow-moving, unreasonable low & high amount of inventories, and unreasonable adjustments.
This analytical review will help the auditor to have a better picture to perform the additional review to that the risks related to inventories more efficiently.
Reviewing the trend of sales revenues against the cost of goods sold as well as purchases might help auditors get a better understanding of what happens to the inventories during the period and where to test it.
Others Procedure to consider:
- Review Consign Inventories: Some inventories that store in the entity warehouse maybe not belong to the entity. And some inventories that including in the inventories list, as well as financial statements, are not in the entity warehouse. These types of inventories called consigned inventories. Auditors should also review this.
- Inventories in transit. Inventories in transit are sometimes large and sometimes small amount.
- Review inventories are written off during the year