What is an Inventory Audit?
In an inventory audit, the auditor uses several analytical procedures to check the company’s inventory methods and confirm that the financial records and actual physical count of goods match. An inventory audit is considered a generally accepted auditing procedure.
Inventory is a key asset in a company’s financial statements, as it can be used as collateral for bank loans and also can be misappropriated for fraudulent reporting purposes. Companies typically put in place internal controls, such as a custodian of inventory or a segregation of duties between the custodian of inventory and the individual with access to the perpetual records, to reduce risks of inventory fraud or misappropriation.
Recall the four assertions related to account balances in an audit. Inventory is a balance sheet account, and so the relevant assertions are existence, rights, completeness, and valuation. Existence refers to whether the inventory is actually present. Rights refers to whether the company undergoing the audit actually owns the rights to the goods. Valuation refers to pricing, as well as any impairment issues. Completeness addresses whether all the goods that should be recorded are fully recorded.
Inventory Audit Procedures
There are two types of substantive procedures related to auditing inventory. Substantive procedures are methods of verifying the actual numbers on financial statements. This is different from testing of controls, which are procedures that test the systems/policies that give rise to the numbers.
- Analytical Procedures
A) Procedures with inventory typically include:
- Comparing gross margin numbers with previous years
- A comparison of the inventory turnover ratio with previous years
- A comparison of the unit costs of inventory with previous years
- Tests of Details of Balances
The practice of having auditor observation at the inventory count
The Inventory Count – Before
Before the client performs their inventory count, the auditor typically reviews the client’s proposed policies/procedures pertaining to the inventory count. “Best practices” typically include:
- Two-person count teams
- Pre-numbered tags and proper sequencing
- Halting the shipping and receiving of goods during the inventory count
- Segregation of goods that are held on consignment
- A master count sheet that is controlled only by the supervisor of the inventory
The auditor also selects, in advance, a sample of items to test on the day of the count. They will use both representative and specific item (stratification) testing when possible.
The Inventory Count – During
- The auditor observes whether the client complies with the proposed policies/procedures for the count – Are these procedures being performed correctly and efficiently?
- Observe the quality and the condition of the goods – is there any sign of impairment/obsolescence?
- The auditor runs their own tests and makes note of the results. Any necessary adjustments must be followed up to ensure that the inventory records and general ledger reflect the adjustments.
- Obtain important cut-off information to make sure that the inventory is counting goods that need to be counted and not counting goods that shouldn’t be counted. For example, examine the last five shipping documents and receiving reports.
The Inventory Count – After
- Match the quantities brought forward from the count to the recorded amounts on the ledger and book any adjustments that need to be made
- Inventory must be valued at the lower of either cost or market value (also known as net realizable value)
- Cost: Calculate the unit cost of inventory again to make sure pricing is accurately determined
- Market Value: Examine subsequent sales of inventory to see if it was sold for more/less than cost, or look at the gross profit margins.
Other Inventory Audit Issues
Another issue that may arise and be of concern to an auditor is the timing of the inventory observation. The observations usually take place at the end of October or the end of December. Typically, due to year-end holidays and/or weather issues, inventory observations are held in October. However, if the client is more prone to fraud/manipulation and is notorious for that, auditors may show up at the end of December to obtain more reliable data.
Another issue is whether the auditor needs to bring in a specialist or run some off-site testing to make sure that the inventory in the warehouse is genuine. For example, for some goods such as jewelry or high-tech products, it is uncommon for a regular auditor to be able to differentiate between real and fake goods. Auditors may want to bring in a specialist for a thorough examination or send some samples to a lab for testing.
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