Inventory Observation (Objective and Explanation)

Overview:

Auditors generally observe the inventory count performed by the client at the end of the year or accounting period.

Most of the accounting book is closing at the end of the calendar year, and normally entity performs a full inventory count to assess the actual quantity and calculate the exact amount of inventory closing balance.

An entity might want to assess the internal control system on inventory and whether it is running correctly through an annual inventory count.

If a significant variance is found between balances per record and actual, the inventory internal system might need to review, and an investigation might need to perform.

The objective of inventory observation:

Normally, inventory count is performed by the entity’s staff and observed by auditors.  Auditors are not involved in the counting process.

This is to ensure that there is no conflict of interest involved. However, during the counting process, the auditor might request to recount certain items that are noted as unusual by them.

Auditors perform an inventory observation for many reasons. For example, the auditor wants to confirm does the client performs annual inventory counts and wants to assess the appropriateness of inventory counts.

This is important for auditors. If the counting process is not proper, then the inventory balance in the financial statements might have some problems.

Auditors might also want to assess the inventory’s condition and its existence. In financial statements, inventory amounts are normally material. Therefore, auditors should ensure that the inventories exist.

Procedure for Inventory Observation by an Auditor

Inventory observation is a critical component of an audit, as it helps the auditor to verify the accuracy of a company’s inventory records and ensure that the company is properly accounting for its inventory. The following is a typical procedure for inventory observation:

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1. Review of Inventory Records

The first step in inventory observation is to review the company’s inventory records, including its general ledger, purchase orders, receiving reports, and other relevant documents. This will help the auditor to get a general understanding of the company’s inventory system and identify any areas of concern.

2. Physical Count of Inventory

Once the records have been reviewed, the auditor will perform a physical count of the inventory. This typically involves counting the inventory on hand at the end of the period and comparing it to the inventory records. If there is a significant discrepancy between the two, the auditor will investigate the cause and determine if there are any adjustments that need to be made to the inventory records.

3. Testing of Inventory Valuation Methods

The auditor will also test the company’s inventory valuation methods to ensure that they are consistent with Generally Accepted Accounting Principles (GAAP) and that the inventory is being valued correctly. This may include testing the company’s cost of goods sold (COGS) calculations, calculating inventory obsolescence, and reviewing the company’s process for inventory write-downs.

4. Observation of Inventory Processes

The auditor will observe the company’s inventory processes to ensure that they are being performed accurately and in accordance with GAAP. This may include observing the company’s receiving process, inventory storage process, and cycle counting process.

5. Testing of Inventory Control Systems

The auditor will also test the company’s inventory control systems to ensure that they are functioning correctly and that inventory is being properly tracked and recorded. This may include testing the accuracy of barcode scanning systems, inventory management software, and any other systems used to track inventory.

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6. Reporting of Findings

Finally, the auditor will prepare a report of their findings and any recommendations for improving the company’s inventory processes. This report will be reviewed by the company’s management and may be used to make improvements to the inventory system.

In conclusion, inventory observation by an auditor is a critical component of an audit and involves a comprehensive review of the company’s inventory records, a physical count of inventory, testing of inventory valuation methods, observation of inventory processes, testing of inventory control systems, and reporting of findings. The goal of inventory observation is to ensure that the company’s inventory records are accurate and that its inventory processes are in compliance with GAAP.