CHAPTER 4.

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AUDIT OF INVENTORY

Contents
• Audit assertion
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• Accounting for inventory

• Audit procedures for inventory

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 References

BPP, ACCA study text:

• F8 Chapter 13

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• F3 Chapter 7

• IAS 02 and related IAS & IFRS

Audit assertions

Key audit assertions relating to inventory

• Existence
• Completeness
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• Rights and obligations

• Accuracy
• Valuation
• Cut-off 4

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Audit assertions
Financial statement Audit objective
assertion
Existence and – Recorded purchases and sales represent
occurrence inventories bought and sold.
– Inventory on the statement of financial position
physically exists.

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Completeness – All purchases and sales are recorded.
– All inventory at year end is included on the
statement of financial position.
Rights and – The entity has rights to inventory recorded in the
obligations period and at the year-end.
Accuracy, – Costs are accurately determined in accordance
valuation and with accounting standards.
allocation – Inventory is recorded at year end at the lower of 5
cost and net realisable value (NRV).

Audit assertions
Financial statement Audit objective
assertion
Classification – Inventory is recorded in the proper accounts
Cut-off – All purchases and sales of inventories are
recorded in the correct period.
Presentation – Inventory is properly classified in the accounts.
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(classification and – Disclosures relating to classification and

understandability, valuation are adequate and in accordance with
completeness, accounting standards.
accuracy and
valuation)

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 Accounting for inventory
• IAS 2 requires inventories to be disclosed in the
financial statements in classifications
appropriate to the enterprise.

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• These classifications will normally be raw
materials, work in progress and finished goods.

Inventory accounting methods

• Perpetual system:
- Maintain detailed records of each purchase and sales of
inventory.
- Keep continuous records of inventory on hand.
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- Determine cost of goods sold each time a sale occurs.

• Periodic system:
- Do not keep detailed records of the goods on hand.
- Cost of goods sold determined by counting inventory at the
end of the accounting period.
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 Accounting for inventory

Inventory costing methods:

• FIFO (First in, First out)

• AVCO (Average cost)

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• Specific identification

Accounting for inventory

Inventories should be stated in the financial

statements at the lower of cost and net realizable
value.
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Risks related to inventory

• Inventory lost/stolen
• Inventory deteriorated/damaged/slow moving
• Inventory valuation
• Inventory over-stocking/shortage

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Audit Tests for inventory

Risk Assessment Audit Planning and risk assessment

Procedures
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Tests of Control Chapter 3 – Tests of control for

inventory system

Detect material misstatements in a

Substantive transaction class, account balance, and
Procedures disclosure component of the financial
statements. 12

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Audit procedures for inventory
Completeness assertion:
• Obtain a copy of the inventory listing and agree the totals to
the general ledger.
• Cast the inventory listing to ensure it is mathematically
correct.

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• Trace test counts to the detailed inventory listing.
• Where inventory is held in third party locations, physically
inspect this inventory or review confirmations received from
the third party.
• Compare the gross profit margin to the previous year or
industry data. 13

Audit procedures for inventory

Existence assertion:
• Observe the physical inventory count
• Test count
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 Audit procedures for inventory
Rights and obligation:
• Check to purchase invoice/contract
• Verify that any inventory held for third parties is not
included in the year-end inventory figure
• For any ‘bill-and-hold’ inventory, identify such inventory

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and ensure that it is segregated during the inventory count
• Confirm that any inventory held at third party locations is
included in the year-end inventory figure
• Inquire of management and review any loan agreements
and board minutes for evidence that inventory has been
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pledged or assigned.

Audit procedures for inventory

Accuracy, valuation and allocation:
• If a continuous (perpetual) inventory system is maintained, agree
the total on the inventory listing to the continuous inventory
records.
• Vouch a sample of inventory items to suppliers' invoices to ensure
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it is correctly valued.
• Obtain a copy of the inventory listing and cast it, and test the
mathematical extensions of quantity multiplied by price.
• If the entity has adjusted the general ledger to agree with the
physical inventory count amounts, agree the two amounts.
• Confirm that an appropriate basis of valuation (eg FIFO) is being 16
used by discussing with management.

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Audit procedures for inventory

Valuation - Cost
• Valuation of raw materials and bought-in components
• Refer to suppliers' invoices.
• check the basis of the standards, compare standard

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costs with actual costs

• Valuation of work-in-progress and finished goods

• Cost comprises the cost of purchase plus the costs of
conversion
• Check overhead allocation 17

Audit procedures for inventory

Valuation - Cost:
• For labour costs, agree costs to wage records.
• Review standard labour costs in the light of actual costs and
production.
• Reconcile labour hours to time summaries.
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• Compare actual manufacturing overhead costs with budgeted

or standard manufacturing overhead costs.

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Valuation: Cost vs NRV
NRV is likely to be less than cost when there has
been:
• An increase in costs or a fall in selling price
• Physical deterioration

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• Obsolescence of products
• A marketing decision to manufacture and sell
products at a loss
• Errors in production or purchasing
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Audit procedures for inventory

Valuation:
• Make enquiries of management to ascertain any slow-moving
or obsolete inventory that should be written down.
• Examine prices at which finished goods have been sold after
the year end to ascertain whether any finished goods need to
be written down.
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• If significant levels of finished goods remain unsold for an

unusual period of time, discuss with management and
consider the need to make allowance.
• Review inventory aging report
• Identify damaged inventory during stock take
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Audit procedures for inventory
Accuracy, valuation and allocation:
• Compare the gross profit percentage to the previous year or
industry data.
• Compare raw material, finished goods and total inventory
turnover to the previous year and industry averages.
• Compare inventory days to the previous year and industry

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average.

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Audit procedures for inventory

Cut-off:
• Select a sample of GRN’s immediately prior to the year
end/after the year end and check to inventory/payables
to ensure that the purchases are recorded in the correct
period.
• Select a sample of GDN’s immediately prior to the
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year end/after the year end and check to

sales/receivables to ensure that the invoice was raised
in the correct period.

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Audit procedures for inventory
Classification and understandability:
• Review the inventory listing to ensure that inventory has
been properly classified between raw materials, work-in-
progress and finished goods.

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• Read the notes to the accounts relating to inventory to
ensure they are understandable.

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The physical inventory count

• Physical inventory count procedures are

vital, as they provide evidence which cannot
be obtained elsewhere or at any other time
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about the quantities and conditions of

inventories and work-in-progress.

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The physical inventory count
• Evaluate management's instructions and procedures
for recording and controlling the result of the
physical inventory count
• Observe the performance of the count procedures

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• Inspect the inventory
• Perform test counts

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Inventory count
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Before During After

Planning Performance Valuation

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 Planning an inventory count
• Identifying risk of material mis-statement
• Nature of internal controls relating to inventory
• Existence of adequate procedures established and
proper instruction given to personal involved in stock

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count at client end
• Timing of count
• Location of inventory count
• Need for an expert

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Performing an inventory count

— Auditor would observe stock count and would carry out test
counts
— Observe whether stock count instructions are being properly
followed by the stock counters.
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— In performing test counts the auditor would follow a

two- way test approach to ensure existence and
completeness
÷ Records to Floor testing
÷ Floor to Record testing
— Retention of any stock documents for further procedures
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— Cut-off procedures

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 Performing an inventory count
• Where any inventory is in the third party
control, the auditor should send confirmation to
verify inventory balances.
• However if the auditor consider that the

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inventory items are material he could:
• Test the integrity of management
• Observe the third party counts by himself
• Obtaining the other auditor report on stock counts
• Inspecting document of inventories held by third parties. 29

Valuing inventory
• Ensure that, inventory has been properly valued based on stock
counts sheets available with the auditor.
• Ensure proper rate for inventory valuation has been picked up on
the basis of FIFO or Weighted average cost method
• Ensure that all stock variance has been closed out
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Valuing inventory
• Ensure that all work papers pertaining to inventory has been
properly signed by client personal available at stock
• Ensure all adjustments identified by the auditors is reflected
in the financial statements where agreed.
• Ensure proper inventory control sheet and inventory physical

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observation report has been filed in audit work papers

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Inventory held by third party

• Direct confirmation from the third party

regarding quantities and condition
• Inspection or other appropriate audit
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procedures (if third party's integrity and

objectivity are doubtful)

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