Audit of Inventories Lecture Notes

Key Concepts

• Focus on classic inventory audit problems:
  • Demand problems
  • Computing adjusted balances
  • Ensuring correctness and completeness of inventory records

Procedure for Inventory Audit

• Objectives: Verification of Existence and Condition of Inventory
  • Primary Methods:
    • Attendance at physical inventory counting
    • Performing additional procedures to ensure records reflect actual inventory
• Internal Control Measures
  • Procedures understood from section note lectures
  • Focus on detecting substantial problems with inventory entries

Types of Audit Procedures

• Risk Assessment
  • Assess risk at both the overall and assertion levels
• Tests of Controls
  • Evaluate whether controls are designed and operating effectively
• Substantive Procedures
  • Aim to detect material misstatements (focus of many audit problems)

Typical Inventory Audit Problems

• Physical Attendance at Inventory Count (Mandatory if not impracticable)
  • Inspect inventory to ascertain its existence
  • Evaluate inventory condition
  • Perform test counts
  • Ensure management’s instructions are followed
  • Verify results are accurately recorded
• When Physical Attendance is Impracticable
  • Inspect documentation of subsequent sales
  • Inspect other reliable evidence if attending physical count is unsafe or not feasible

Inventory Assertions and Related Audit Objectives

• Existence and Condition
  • Ascertain physical quantities on hand
• Rights and Ownership
  • Verify inventory is owned by the client
• Valuation and Allocation
  • Ensure proper inventory pricing
• Completeness
  • Verify all inventory owned by the client is included
• Presentation and Disclosure
  • Examine loan agreements and inventory pledges for proper disclosures

Audit Transactions and Adjustments

1. Item Errors (General Rules)

• Items inside warehouse: included
  • Items outside warehouse: excluded (unless owned by client)
  • Properly include/exclude based on terms of shipment (f.o.b. shipping point/destination)
  • Consignment goods owned by the entity: included
  • Held by the entity for consignment: excluded

2. Adjusting Entries Based on Audited Findings

• Example problem requires adjusting for:
  • Inventory excluded erroneously (should be included)
  • Sales recorded erroneously before shipment
  • Purchases not recorded
  • Adjust by debiting/crediting appropriate accounts (e.g., sales, accounts receivable, inventory, P&L summary)

Process and Techniques

• Sales and Purchases Cut-off Tests
  • Ensure transactions are recorded in the correct accounting period
  • Use sequentially numbered documents to test completeness and accuracy
• Evaluating Errors and Missed Entries
  • Compare recorded entries against actual transactions and adjust

Practical Problems and Solutions

• Audit Procedures Based on Specific Cases
  • Sales invoices lacking shipment details
  • Inventory improperly included/excluded based on physical counting and shipment terms
  • Adjust for physical discrepancies noted during counting
  • Reconcile audiobook balances by assessing audit observation results

Conclusion

• Inventory audit involves both computational and procedural reviews
• Ensure all findings are properly documented and included in the final audit report
• Perform detailed reviews for items that could be erroneously omitted from inventory or sales records

Practical Tips

• Be aware of different cycles and how they affect inventory accounts (revenue receipt, expenditure disbursement, production cycle)
• Systematically trace and vouch transactions for completeness and existence verification
• Regularly post and review adjusting entries to ensure accurate financial accounts