Inventory is probably the most difficult area to deal with in an audit, leaving aside very complicated areas like you might find in banks and insurance companies. Inventory in any manufacturing company or retailing company is also likely to be material. and inventory can be subject to risks it can be stolen it can go past its sell-by date and there's always a risk that it becomes unfashionable and won't sell. we have to find what quantity of inventory there is and that can be a problem. think of a factory with inventory all over the place perhaps scattered around a warehouse or a storage area we have to make sure we we find all the inventory there isn't some kind of left in a place a room a shed around the back of the factory somewhere that we've forgotten about we have to know what the inventory is and it's not always easy knowing that if you went to a company was dealing in light engineering and a different sorts of steel the steel will be of different grades and of course different weights and lengths and so on and assessing what's what so you actually know what item of inventory you're talking about can be really difficult particularly for the auditor who cannot be expected to be an expert in metal or in wood or many of the other elements that you might find in a manufacturing business we have to assess its condition has it deteriorated is it still legal to sell it. its value and we'll see the value should be the lower of cost than that realizable value and its ownership just because an item of inventory is sitting in a warehouse or in a shop doesn't necessarily mean it's ours some shops take an inventory on a sale or return basis meaning that the inventory sits there we hope that we sell it but until it is sold it remains the inventory of the supplier so the physical presence of inventory doesn't actually prove its ownership. a very common type of question for you to get in the exam is what auditors should do if they're asked to attend and observe a physical stock take. many businesses do try to keep a book stock but really the best test in many ways the best evidence you can get about the inventory which is truly present at year end and its condition is to do a stock take at year end let's say on the 1st of January this is nearly always something that the most junior member of the team is assigned to and the 1st of January is New Year's Day and not many people want to work then, It is winter and very often the stock is out of doors, which is not so pleasant, and you are sent off as the most junior person to do your duty to attend the stock take and observe. It is not the auditor's duty to count the stock as such. They are not performing the stock take. They will perform some test counts, but it is the client's duty to perform their stock take. Just as it is the client's duty to prepare the financial statements. the auditor is sent along to observe that the stock take seems to be being carried out in a in a proper manner so that any figures we end up with can be relied upon. the first thing that needs to be done is there needs to be careful planning by the client. Stock takes may only be done once a year and people are not necessarily practiced at it. There may have been a turnover of staff who've never done one before in this factory. And even if the same staff are there doing kind of something once a year, it will generally mean you're not much of an expert at it. So there has to be careful instructions issued to staff. And ideally some sort of briefing meeting where managers instruct the staff on exactly how the stock take is to be performed. Stock takes tend to be a kind of once in a year opportunity and if it's messed up on the 1st of January and then the business starts trading on the 2nd of January, so stock is moving in, stock is moving out, you're kind of chasing a moving target. 1st of January works quite well because generally speaking, there will be no sales or deliveries on that date. A set of instructions will be sent to the auditors who should read these instructions and see if they seem to be addressing the right problem seem to seem to be comprehensive enough to give a hope of a decent stock take taking place the inventory also has to be tidied in advance. In other words, you collect inventory, which is the same sort, kind of put it all together and so on. You know where all the inventory is. You have searched all the places where inventory might have been forgotten and the inventory is in a properly ordered pattern so that the count will go pretty easily.
It's also important for client staff to identify damage stock or third party stocks. the auditor might be able to identify some damaged stock but really it is a client very often who is the only one who has really got the expertise to say whether or not a piece of inventory is still usable or whether it'll have to be sold more cheaply because of certain deterioration about it. and then what should happen really in preparation for the stocktake well imagine a room a kind of warehouse with lots of shelves around it what should happen is each one of these shelves is given a number a unique number and below the number there will generally be spaces for the two stock takers to sign generally you send people around in pairs so one can count the other one can observe the other one can do a test count and so on they will sign this off as it's counted and this means you're cutting down the chance that you count the same shelf the same inventory twice and remember inventory as well as being difficult to assess also has a unique quality that closing inventory you can put any value you like in as closing stock and everything will balance because the double entry for closing inventory is debit the balance sheet debit the assets and credit the cost of sales So you could put in $10, $100, $10 million, and the double entry is complete. this means that if you think about it every extra dollar you find of closing inventory is going to be an extra dollar on profit because every extra dollar of closing stock is reducing the cost of sales so we have to be really careful to count all the inventory once and once only it's not going to show itself up as something which doesn't balance. you'll also have probably when you're pre-numbering these shells and putting these spaces on for people to sign you'll also probably have spaces there to to note down the quantity of inventory is found and some sort of description of the inventory which is found and also ideally a kind of unique locator. So it'll say, you know, warehouse set of shelves, number five, shelf number two, so that we can later on, if there's some query arises about that stock, we can go and find where the actual stock has been located. Then you issue sequentially pre-numbered inventory sheets. they have to be sequentially pre-numbered these are issued to your stock takers the people because you want to make sure you get them all back because if one of these sheets went missing it's not going to show itself up in something not balancing so you count them all out and you count them all back, basically and these inventory sheets will simply have on them a column for the shelf of the location where the inventory is to be found it will have on it then a column for the product codes which are found on that shelf and then we'll have a column for the quantity that has been counted it might have another column which says whether the inventories in good condition a bad condition and so on and then we'll have two blank columns at the end not to be used just yet where eventually we'll put in the cost of the inventory and then the quantity times the cost will allow us to work out the total cost price of the inventory. at a bottom of the inventory these will be signed by the two inventory takers so that again if there's some query about what is on these inventory sheets we can go to the people who are responsible for it. so they start off with these sheets you go around each location counting the inventory noting it down on the stock sheet marking off the shelf and on with a double a two-way sort of audit trail here the shelf number is noted on the stock sheet and the stock sheet number should be noted on the shelf number so we can always trace back forwards from one to the other. so we're checking as auditors then the The client staff will be kind of going ahead of us then. And when some of the stock sheets are returned in, we'll take one or two of these and we'll do some test counts ourselves. We'll go from the stock sheet, we'll go to the shelf and we'll count, can I find those numbers in there? Do they appear to be the right description? We'll choose a shelf at random and see if we can trace that back to the stock sheet to make sure all the inventory has been counted. all the inventory sheets will then be brought in and then we have to basically get on with quite a large amount of work and working out the value of the inventory. it says here in a very simple situation that you can simply check maybe two suppliers invoices to find the cost price of the inventory and therefore you can have on the stock sheet quantity times cost per unit gives us the value of the stock you add those up and what the auditors must do is to re-perform the additions on all of these stock sheets because again if you happen to add in an extra hundred thousand by accident then there's an extra hundred thousand profit. one of my best findings ever as a junior auditor was found as i was given us very very dull task really of adding up sheets of figures and they hadn't been set out very neatly the the figures were kind of zigzagging down the sheet and the client staff did add in instead of adding in ten thousand they added in a hundred thousand and this meant that essentially the closing stock was overstated by ninety thousand and the profit was overstated by ninety thousand and as the profit that was reported was only thirty thousand correcting this turned a profit of thirty into a loss of sixty thousand and really created quite a fuss in the company and certainly created quite a fuss in the holding company the owner of the company when they found out about this discrepancy.
Okay, inventory valuation, expanding out a little bit here. It's important that we know what accounting policy is used for the valuation of inventory. The two allowable ones is FIFO and average stock. And this may mean that we have to go and re-perform some of the calculations. Go to the inventory. Let's say there's 50 items in it. 70 came from a previous delivery. 30 came from a later delivery. Have they traced the these deliveries back to the particular invoices to bring in the right cost or might be average stock and again we might have to re-perform some of the calculations just to ensure that the accounting policy has been adhered to. Always kind of creeping up behind us is the knowledge that we have to value stock at the lower of cost than it relies on value. Cost in many ways is relatively easy to get. You go to invoices in a simple trading company. Net realizable value means that you have to assess whether or not this inventory is likely to be sold at a price which is above its cost. How are we going to find this out? Well, we'd be looking at is the inventory selling quite well? Are those items of inventory still selling quite well? If you see items of inventory which haven't sold for three months, then you might begin to assume almost that these things have gone way out of fashion and the only way they're going to sell them is to hugely reduce the selling price of these just just to get rid of them and that may bring the selling price way down below the net realizable value. you maybe need to talk to the marketing and sales people ask them about these items of stock which don't seem to be moving very well and see what their hopes are what what do they put in the budget for next year with reference to these amounts, sometimes you look and see what competitor products there are if the competitor has launched a new product which is a very good product but at a much lower cost or price than you were trying to charge it may force you again to lower your selling price way down below cost so the for the cost you trace the supplier invoices by and large for the the cost of manufactured goods and work in progress you have to go slightly more than that because if you are manufacturing goods then the cost is worked out by the cost of the material which has gone into it the cost of the labor which it has enjoyed and then the cost of the relevant factory production overheads which would be absorbed into that and this may mean you have to go and actually verify that the fixed overhead absorption rate is reasonable because again every time you manage to absorb more fixed costs into your closing inventory the higher you're putting up your value of closing stock and the higher you're managing to get your profit. other items to look at inventory days here we have a an analytical procedure if inventory days last year we held 20 days worth of inventory and this year we're holding 50 days worth of inventory get we get worried why have they done that Is it because they simply have bought the wrong stuff and it's not going to sell? Or is it that they are actually planning a big sales drive and are simply laying in the stock for the big television adverts or special promotional offers and they don't want to be caught short in that?
Also for net realizable value you can look at invoices issued after year-end. So if you see that the actual selling value of items in January is below the cost, then you would have to write them down. So sales budgets, talk to the sales director. And finally, as in many of these things, if there's a really important issue, you'll probably scrutinize or hope to find reference to that in the board minutes. So the sales director will come along to board minutes and will in a way have to confess that the sales budget next year is going to be a bit down because we can't sell these items of stock. I'm proposing that we reduce their selling price.
Very important element in inventory accounting. And to some extent in both receivable and payable accounting is cut off. Cut-off where we have mentioned at the moment so far is making sure that a sale you book into the year actually occurred in the year or a purchase that you have put into this year's profit and loss account has actually occurred in the period. But in fact it gets slightly more awkward than that. Above all, cut-off is in a way really kind of looking for what I will call consistency. so here we're looking at cut-off in purchases, so purchases implies goods coming in to the business and these goods are the ones that are going to be there at year-end in closing inventory, think of some goods being delivered let's say the 28th of December so it will be physically present in the warehouse and we will count them as closing inventory but maybe the invoice isn't received by us until maybe the 10th of January. So what we're doing is we're being unfair to this. We're not being consistent. We're taking the asset of the extra closing inventory without recognising the expense of buying that and the liability that we still owe for it. Sometimes you will get invoices before you get the goods. So we get an invoice on the 27th of December, we debit purchases, we credit payables, but the goods don't actually turn up until the 2nd of January. so here we have taken the expense of purchases we've recognized the liability but we have missed out the closing inventory because it doesn't actually be there again as being inconsistent what we want is if something is in closing stock it must be in purchases and if it's appeared very close to year-end it's probably in creditors quite obviously if it appears sometime in September and is still in inventory in December it will be in purchases and of course it may have been paid, but that's okay as long as you've encountered for the the debits and credits. so what are we looking at here is our goods received notes and really the dates of the goods received notes will normally determine whether the goods were received before or after year-end. So, if we have a goods received note, which has been received before year end, then we should discover, or would hope, because the goods have been received, remember, that the amount should be in purchases. If it's in purchases, the double entry should be debit purchases, credit the payables. It should be there. And of course, it should also be in closing inventory. That's all beautifully kind of consistent. If we find a goods receive note before year end, presumably the goods are going to be in the closing inventory, but we can't find the invoice till after year end then it hasn't gone through purchases and what you would need to do in here is to set up what's called a purchase accrual, you can't really credit the payables credit the supplier properly until you get their invoice but what you can do is you can set up an accrual, debit purchases, credit accruals for inventory that's been received but which hasn't had an invoice yet. if we have a good receive note dated after year end the presumption is that the goods were not there at year end, and in this case then you would expect it wouldn't be in purchases wouldn't be in payables it wouldn't be inventories, the stuff hasn't simply hasn't appeared yet. so if it hasn't gone on to our premises it's not in closing stock we haven't bought it we don't owe anybody for it and again we need that to be consistent and say the danger there is maybe we receive even invoice a bit in advance and we process that. You could argue we shouldn't have processed until we get to goods but sometimes it happens and you might possibly be showing an expense and a liability without showing the asset of the closing stock.
the same problems happen on sales if goods have left the premises because they've been delivered to a customer the goods should not be in closing stock but we should have a sale made and we should have a receivable. What we don't want is goods being shifted out to customers, yet we haven't got round at year end to debiting receivables and crediting sales. All we're doing there is eating into closing stock and eating into profit without recognising the sale that has been made. So generally speaking, it's going to be goods delivery notes or goods dispatch notes here. And what we want to see is if something is not in inventory, the goods dispatch note is made out before year end. Implication is therefore the goods have left before year end. Then we should be able to see that there's an invoice being processed to sales and receivables. If the goods dispatch note is dated after year end, then we haven't really made the sale. So the goods should still be in inventory and what we shouldn't have is a sale, what we shouldn't have is a receivable, but we still have the inventory. Again, it is consistency. If you've sold the goods, you should have a sale. you should have a receivable. If you haven't sold the goods, you should still have the goods but you can't at the same time count it in sales and receivables.
So these cut-off tests are very, very important. These can be partly done or partly helped by attendance of the inventory take what the auditor can do is they can note down the last numbers at the end of the year of the goods received notes and the dispatch notes because this gives an indication of when the cutoff actually was for sales and purchases