There are many audit procedures and approaches that auditors could use to perform during their detailed testing of the inventories report by management in the financial statements. Before going into detail on the procedure, it is good to start with the overview of inventories first.
Inventories are the current assets that reporting in the entity balance sheet at the end of the reporting period. These inventories could rank from trade inventories to non-inventories.
Non-trading inventories are the inventories that entities make or purchase for their 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 materials that the entity purchases from suppliers, work in progress, and finish goods that are ready for sales or delivery.
Inventories are normally considered significant accounts from an 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 management 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 an entity’s financial statements, we should start by trying to obtain as much information related to the control over inventories.
It could be ranked from understanding the system that the entity uses to control its inventories, key people who manage, and how inventories are physically controlled.
Other key control including reviewing and delivering inventories should also be confirmed. Key authorization over inventories is also important for auditors and it is subject to review.
Once auditors understood these key controls, auditors will be able to tailor the audit procedure effetely for them to address the risks with 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 are committed by entity staff frequently happens to most of the entity’s inventories, based on my experiences.
It was sometimes 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 inventories are the common key concerning areas for auditors and they have to make sure that the risks are addressed in the procedures.
Confirm existing of inventories:
Inventories are the accounting balance in the balance sheet. And if the auditor decided to perform their review on the entity’s inventories, existence is one of the financial statements assertions that the auditor needs to confirm.
Physical verification is one of the procedures that auditors use to confirm this assertion. The auditor may consider joining the observation of a client’s year-end inventories count or performing their 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 assess the procedures that clients use to perform their year-end counts.
When an auditor assesses the counting procedures performed 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 in financial statements.
Inventories are the current assets and an entity could recognize the inventories in its financial statements only if those inventories meet the definition provided by IFRS Conceptual Framework.
Normally, the auditor reviews the ownership (Right and Obligation) of the entity over the inventories by reviewing the Contracts, Quotations, Invoices, and Delivery Noted. Term and Conditions in the contract are very important for ownership verification.
Assess the value of inventories:
IAS 2 is the current standard issued by IFRS for dealing with inventories measurement, recognition, and disclosure, and so on. Measurement of inventories should be at the lowest cost and net realizable value.
Normally, the cost of inventories includes the cost of acquisition, cost of conversion, and other related costs 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. At 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 other forms that prove the delivery and receive date are important 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
Why is auditing inventory important?
Inventories account is considered as the significant account in most companies. This is because of its nature (qualitative factor) and the balance (quantitative factors) of inventories in the financial statements. That means if the inventories account is incorrectly recognized and measured, the impact on the financial statements is not the inventories account itself. It will affect the costs of goods sold and maybe affect the revenues account. This is the reason why it is important for auditors to importantly audit the inventories.
What is the implication of auditing inventories?
Most of the time, the company has a lot of purchase and sales transactions on daily basis. and if the company is also involved in the production processes, then there will be a lot of inventories-related transactions. Those include moving from raw material to production (work in progress). A significant amount of inventories are also stored which will give the inventories account consider as significant accounts. Auditors will have to perform a lot of testing to comfort themselves.
Regarding implication, auditing inventories are also involving reviewing the costing method that the company uses to measure the inventories as well as reviewing the valuation gross and valuation net of inventories (provision). This involves a lot of judgment make by management and require more attention from auditor for their testing.