ACCA F8 (INT) Audit & Assurance - 2010 - Study text

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Chapter 12: Substantive testing: inventory

 Inventory being incorrectly disclosed in the financial statements (the

presentation and disclosure assertion).

1.3 Substantive procedures for inventory

The figure for inventory in the financial statements reflects:

 the quantity of inventory on hand at the end of the reporting period, and

 the value of each item of that inventory.

Substantive procedures for inventory will therefore focus largely on the existence

and valuation assertions and these are covered in the following sections. However,

by carrying out test counts in both directions (see section on the physical inventory

count below) the completeness assertion will also be covered.

In order to satisfy the rights and obligations assertion the auditor will need to

check, when he attends the year-end physical inventory count (see below), that

inventory belonging to third parties is separated and not included in the count.

To satisfy the presentation and disclosure assertion the auditor will need to ensure

that:

 the schedule of year-end inventory (on which he bases his substantive

procedures below) agrees to the financial statements

 inventory is correctly disclosed and classified (e.g. between raw materials, work

in progress and finished goods) in the financial statements.

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Valuation of inventory

 IAS 2: Inventories

 Substantive procedures

 Cost or net realisable value?

2 Valuation of inventory

2.1 IAS 2: Inventories

IAS 2 requires that inventory should be valued at the lower of cost or net realisable

value, on an item-by-item basis:

 Cost includes the costs of purchase and all other costs incurred in bringing

inventories to their present location and condition. In the case of work-in-

progress and manufactured finished goods, this includes an amount for

production overheads. (The absorption rate for production overheads should be

based on normal levels of activity). Cost can be estimated by using a number of

methods (such as first-in-first-out or average cost). The method chosen should

provide a close approximation to the actual cost of the inventory.

 Net realisable value (NRV) is the estimated selling price of the inventory in the

ordinary course of business, minus (1) any estimated costs to complete the items

(and make them available for sale) and (2) the estimated costs of making the sale.

2.2 Substantive procedures

Substantive procedures on inventory should be designed to allow for the nature of

the inventory and the nature of the situation that the auditor is facing.

 If the entity is a retailing organisation, the only major component of the cost of

inventory is likely to be the purchase cost of the goods for resale.

 If the entity is involved in manufacturing or processing, the cost of inventory

will include an amount for direct labour and production overhead, in addition to

the cost of the raw materials and components.

Substantive procedures for the valuation of inventory items are suggested below. In

the exam, which procedures are the most appropriate will depend on the particular

scenario given.

Cost of raw materials or the cost of goods purchased for resale

For raw materials and goods held for resale, the cost of inventory will be the actual

purchase cost of the items (plus any costs of delivery that the entity may have had to

pay). The auditor should carry out the following tests for valuation:

 Confirm the approach adopted by the client company to estimate the cost of

materials or goods used/sold (for example first-in-first-out, or weighted average

cost).

Chapter 12: Substantive testing: inventory

 Check the figures for the cost of inventory by comparing them with prices in

purchase invoices or official supplier price lists.

Cost of manufactured goods and work in progress

For work-in-progress and items of finished (manufactured) goods, the auditor needs

to check each of the elements in the cost: direct materials, direct labour and

production overheads. He should therefore carry out the following tests:

 Obtain schedules showing the make-up of the cost figures for each item of work-

in-progress and finished goods.

 Check the accuracy of the calculations.

 Materials

− Perform the same substantive tests as for raw materials, shown above.

− Check that the correct quantity of materials has been used in the valuation.

 Labour

− Check pay rates for direct labour cost against payroll/personnel records for

the employees who produced the work-in-progress or finished goods items.

− Check the hours worked (and used to calculate labour costs in the inventory)

with the time records for the employees concerned.

 Production overheads

− Confirm that only production overheads (as opposed to selling and

administration overheads) are included in the valuation.

− Confirm that overhead absorption rates are based on normal levels of

output.

 Work in progress: in addition to the above tests, the auditor may also need to

check the stage of completion of the work in progress, in respect of both

materials and conversion costs (labour and overheads).

2.3 Cost or net realisable value?

In his substantive testing of inventory, the auditor should also look at the

procedures of the client entity for deciding whether each item of inventory should

be valued at cost or at net realisable value (NRV). The auditor may therefore carry

out the following tests:

 Review and test the procedures in place for comparing NRV with cost for each

item of inventory.

 Follow up any information obtained from other audit work suggesting that for

certain items of inventory, NRV may be lower than cost. Information may be

obtained from the physical inventory count (where the auditor has observed

evidence of deterioration of the inventory) or from the amount of returns and

allowances granted to customers.

 Review inventory records and order books for evidence of slow-moving items,

whose selling price might need to be reduced and whose NRV may therefore be

less than cost.

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 Review prices at which goods have been sold after the reporting period, for

evidence that NRV is higher than cost

 In the case of work in progress, compare costs incurred to date with selling price

minus costs to complete (NRV). Estimated costs to complete may be assessed by

the auditor from the client’s management accounts.

As discussed in a previous chapter, where the client has an IT system in place over

inventory, audit software may be used to improve the efficiency and accuracy of

audit testing in this area.

Chapter 12: Substantive testing: inventory

Inventory quantity: the physical inventory count and ISA 501

 Physical inventory counts: purpose and responsibilities

 Timing of the count

 Counting procedures

 Cut-off

 Audit work relating to the inventory count

 Audit work before the count: planning

 Audit work during the count: observing and recording

 Audit work after the count: follow up

 Possible control weaknesses in an inventory count

3 Inventory quantity: the physical inventory count and

ISA 501

3.1 Physical inventory counts: purpose and responsibilities

Many organisations rely on a physical inventory count at the end of their financial

year in order to arrive at a figure for inventory in their financial statements. Even if

an entity maintains ‘sophisticated’ inventory records, with continuous accounting

records for inventory, the accuracy of these records should be checked by means of

regular physical counts of inventory.

There are several reasons for physical counts of inventory:

 Physical counts may be fairly easy to arrange, particularly where most items of

inventory are held in a limited number of physical locations.

 Physical counts provide evidence of the actual existence of the inventory. This

evidence is important to the client company (for preparing the financial

statements) as well as for the auditor (for checking the reliability of those

statements).

 Physical counts can be used by the entity to check the accuracy of its inventory

records, where it maintains continuous inventory records.

 Where the entity does not have continuous inventory records, a physical count

of inventory is probably the only way of establishing the quantity of inventory at

the year-end.

 Discrepancies between the physical count of inventory and the entity’s inventory

records may indicate weaknesses in physical controls over inventory, and losses

due to theft or for losses from other causes.

 A physical count of inventory can also be used to check the physical condition of

inventory, and whether there has been any deterioration in condition.

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It is important to appreciate the relative responsibilities of management and

auditors with respect to inventory counts.

 It is the responsibility of management to arrange for physical counts to be made

and to establish appropriate procedures for counting, to ensure that a complete

and accurate count is taken. (It is the responsibility of the company’s directors to

ensure that the valuation of inventory in the financial statements is reliable.)

 It is the responsibility of the auditor to gather evidence from which he can reach

a conclusion on the figure for inventory in the financial statements. Observation

and other audit procedures performed by the auditor at the inventory count will

provide some of this audit evidence.

The auditor’s attendance at the physical inventory count is covered by ISA 501 Audit

evidence – Additional considerations for specific items. The requirements of ISA 501 in

respect of inventory state that if inventory is material to the financial statements, the

auditor should obtain sufficient appropriate audit evidence regarding the existence

and condition of inventory by attendance at physical inventory counting unless

impracticable. The purpose of such attendance is given as being to:

 Evaluate management’s instructions and procedures for recording and

controlling the results of the count.

 Observe the performance of management’s count procedures.

 Inspect the inventory.

 Perform tests counts.

 Perform audit procedures over the final inventory records to determine whether

they accurately reflect the results of the count.

Each of these areas, along with other issues, are considered below.

3.2 Timing of the count

An entity can take any of three different approaches to the timing of the physical

inventory count: These are:

 an annual count at the end of the reporting period (periodical counting)

 an annual count shortly before or after the end of the reporting period

(periodical counting)

 ‘continuous counts’ at a variety of dates during the period (perpetual counting).

Annual count at the end of the reporting period

An annual count at the end of the reporting period is the ‘traditional’ approach to

the physical inventory count. As the term suggests, all inventory is counted at the

end of the reporting period.

The annual inventory count may be a lengthy process, involving many staff. In

order to count all of the inventory at the end of the reporting period, it may

therefore be necessary for the entity to close down its production facility. This will

ensure an accurate physical count, by making sure that no items of inventory are

produced or used, from the end of the reporting period until the physical count has

ended.

Chapter 12: Substantive testing: inventory

Annual count shortly before or after the end of the reporting period

Companies often hold their ‘year end’ counts shortly before or shortly after the end

of the reporting period. There are usually practical reasons for this:

 The count may be held early to allow extra time for management to process the

information from the inventory count (and put their valuation to closing

inventory) before the audit begins.

 The end of the reporting period may fall at an inconvenient time. In the UK, for

example, the financial year end for many companies is 31

December, which is a

time when many staff are on holiday.

 It may be convenient to hold the count on a Saturday or Sunday when business

activity is at a lower level, and when the count can therefore be completed more

quickly. The chosen Saturday or Sunday may be just before or just after the end

of the financial year.

Timing the annual count to take place just before or just after the end of the

reporting period is acceptable for audit purposes, provided that the accounting

records are sufficiently adequate to allow the auditor to check the changes in

inventory between the date the count took place and the end of the reporting

period.

Continuous counting: counts take place at a variety of dates during the

financial period

An entity may decide to hold several physical counts of inventory throughout the

financial year, in order to avoid the potential disruption of an annual count at the

end of the reporting period. This involves counting certain items of inventory at

different dates during the financial year.

This system is acceptable for audit purposes, provided that certain conditions are

satisfied. The main conditions are as follows:

 The entity should have a system for maintaining accurate and up-to-date

inventory records. This is because the figure in financial statements for inventory

at the end of the reporting period will be based on these records. Only a portion

of the entity’s inventory will be physically counted at the end of the reporting

period.

 Every item should be counted at least once a year.

 Counting should be systematic, and properly organised and controlled.

 Counts must be fully documented and reviewed by management. Any

differences between inventory records and the figures from the physical

inventory counts must be investigated.

3.3 Counting procedures

It is the responsibility of management to arrange the inventory count and to

establish effective procedures to ensure that a complete and accurate count is taken.

The auditor attends the count as a means of obtaining audit evidence. This evidence

will be used, together with other appropriate evidence, to reach a conclusion on the

value of inventory in the financial statements.

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It is important that the auditor should be confident that the inventory counting

procedures organised by the client’s management will ensure a complete and

accurate count.

The following procedures should therefore be in place:

 The directors of the client entity should issue written instructions for the

inventory count, well in advance of the count.

 The instructions should be reviewed by the auditor before the count takes place.

 The auditor needs to be satisfied that the instructions for the count are such that

a complete and accurate count will be taken.

 If the auditor is not confident in the instructions, the matter should be brought to

the attention of management, and suitable amendments to the counting

procedures should be requested.

The instructions issued by management for the inventory count should cover the

following areas:

Area Comments

(1) Adequate planning of

the count.

Planning must be sufficient to ensure that the work

will be carried out precisely and systematically. The

planning should provide for the following:

 The early issue of counting instructions to the

staff who will do the counting. There should be

arrangements for the staff to comment on the

instructions and discuss them with management,

and for suitable amendments to be made to the

instructions if appropriate.

 Deciding the date of the count.

 Identifying the locations at which inventory is

held.

 Ensuring that sufficient staff are available to

conduct the count.

 There should be procedures for identifying high-

value items (for which accurate counting is

essential).

 There should be procedures to control or stop

production and the movement of inventory

during the count, in order to make sure that all

inventory is counted.

 There should be procedures for ensuring a clean

inventory cut-off (see below).

(2) The inventory should

be divided into

manageable sections

for the purpose of

controlling the count.

Chapter 12: Substantive testing: inventory

Table continues

Area Comments

(3)

There should be

proper instructions for

counting, weighing,

measuring, and

checking.

The instructions should give clear guidance about

the units of measurement that should be used for the

count; for example, single units, units of 100, units of

1,000 etc, measurement by weight, and so on.

Counting should be carried out by teams of two (one

person to act as counter and the other person to act

as a checker).

(4) There should be

procedures for

identifying inventory

on the entity’s

premises that is

owned by third

parties.

This inventory should be excluded from the

inventory valuation for the statement of financial

position. For example, inventory may be supplied to

the entity on a sale or return basis; this is legally

owned by the supplier.

(5) There should be

procedures for

identification of

defective, damaged,

obsolete and slow

moving inventory.

These procedures are necessary in order to identify

inventory whose NRV may be below cost.

(6) There must be

appropriate

documentation for

recording the count.

Pre-numbered documents should be used. Typically,

these are tags for attaching to counted inventory

items (containing details of the counted items) and

sequentially-numbered sheets on which details from

the tags are summarised, with the tags listed in

numerical order.

Controls over documentation should include

keeping records of the tags and sheets that have

been used, and accounting for all these documents at

the end of the count.

Records should be kept of the documentation issued.

(7) There should be

procedures for

identifying and

quantifying

inventory belonging

to the client but held

by other entities.

For example, the entity may supply goods to

customers on a sale or return basis.

The auditor will probably seek to verify the quantity

and value of these items of inventory by writing to

the other entities concerned and asking them for

written confirmation of the amount of the client’s

inventory that they are holding.

3.4 Cut-off

Cut-off is the process of ensuring that all transactions are fully recorded in the

correct accounting period. Unless a correct (‘clean’) cut-off is achieved, there can be

significant distortions in the figures reported for two consecutive financial periods.

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Cut-off affects many areas of the financial statements:

 inventory

 sales revenue recognition

 cost of sales

 receivables

 payables.

Sales cut-off

Cut-off is concerned with making sure that sales are recorded in the correct

accounting period. For example, sales that occur around the end of the financial

year should be recognised in the appropriate year. This in turn affects the recording

of receivables and inventory at the year-end.

For example, if a sale is recorded in the year to 31 December Year 4, the following

should also be recorded in that period:

 a receivables balance

 the goods must be removed from inventory

 a cost of sales entry.

This is an example of sales cut-off. In particular, it is important to ensure that the

same item is not reflected as both a receivable balance and an inventory item.

Purchases cut-off

Similarly, all purchases that occur around the end of the year should be recorded in

the correct financial year. This in turn will affect the recording of payables and

inventory in the year-end statement of financial position.

For purchases cut-off, if goods are received in the year ended 31 December Year 4

and included in closing inventory, the following entries should also be recorded in

that period:

 an inventory purchase

 a payables balance.

It is important to ensure that if an asset (inventory) is recorded, a corresponding

liability (a trade payable) must also be recorded.

The auditor’s work should include substantive testing on cut-off. This is described

below.

3.5 Audit work relating to the inventory count

The main financial statement assertion addressed by the auditor’s attendance at the

inventory count is existence. However, the audit work at the count (and after the

count) will also generate evidence relating to:

ACCA F8 (INT) Audit &amp; Assurance - 2010 - Study text - Emile Woolf Publishing

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