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THE FUNDAMENTALS OF STOCKS

(1) The importance of stocks:

Factors which make this asset important from the audit view point include the following:

(a) Misstatement of stock balances has a direct effect on reported profit. It is the easiest asset for
management to manipulate and thereby manipulate profits from one accounting period to
another.

(b) Some stocks can be very difficult for an auditor to identify. There may be thousands of different
lines of stock; there may be some stock items of a very specialist nature.

(c) The quantities of stock held at a given moment may be difficult to establish. It may not be
possible to cease stock movements during the stock-take and cut-off may be hard to establish with
precision.

(d) Valuation may be difficult. The problems of specialist stock have already been mentioned; but
even for less specialised lines there may be difficulties to do with obsolescence, etc., and as a
consequence net realisable values may be hard to establish.

(e) Stock losses from pilferage, wastage, etc., may be difficult to control.

(f) Some very significant work in progress balances may be intangible in nature.

(2) Legal and professional requirements

There are a variety of official pronouncements in connection with stock, including:

(a) ISA 501 – Part A – Attendance at physical inventory counting.

(b) IAS 2 Inventories.

(c) The Companies Ordinance, 1984.

The Companies Ordinance, 1984

The Companies Ordinance, 1984 requires stock to be disclosed under four categories:

a) Raw materials and components.

b) Work-in-progress.

c) Finished goods and goods for resale.

d) Other stocks.

Consumable (stores, spare parts and loose tools) are to be shown separately, and where practicable, each
must be distinguished from the other.

Current assets (including stock) must be stated at the lower of their net realisable value and their purchase
price or production cost.

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Chartered Accountants

IAS 2 ‘Inventories’

IAS 2 defines Inventories as;

Inventories are assets:

(a) held for sale in the ordinary course of business;

(b) in the process of production for such sale; or

(c) in the form of materials or supplies to be consumed in the production process or in the rendering
of services.

The standard requires individual items of stock to be stated at the lower of cost and net realisable value.

The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in
bringing the inventories to their present location and condition.

The costs of purchase of inventories comprise the purchase price, import duties and other taxes, and
transport, handling and other costs directly attributable to the acquisition. Trade discounts, rebates and
other similar items are deducted in determining the costs of purchase.

The costs of conversion include costs directly related to the units of production, such as direct labour.
Conversion cost also includes a systematic allocation of fixed and variable production overheads that are
incurred in converting materials into finished good.

Net realisable value is the estimated selling price in the ordinary course of business less the estimated
costs of completion and the estimated costs necessary to make the sale.

Recent Changes in IAS 2 (Applicable from 1 January 2005):

- Exchange differences arising directly on the recent acquisition of inventories invoiced in a

foreign currency cannot be included in the costs of inventories.

- When inventories are purchased with deferred settlement terms, the difference between the
purchase price for normal credit terms and the amount paid is recognised as interest expense over
the period of financing.

- An entity will use the same cost formula for all inventories having a similar nature and use to the
entity.

- An entity is not allowed to use LIFO formula to measure the cost of inventories.

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Chartered Accountants

ISA 501 – Part A

In paragraph 5, ISA 501 states as follows;

When inventory is material to the financial statements, the auditor should obtain sufficient appropriate
audit evidence regarding its existence and condition by attendance at physical inventory counting unless
impracticable.

Paragraph 8 says that in planning attendance at the physical inventory count, the auditor considers the
following;

- The risks of material misstatement related to inventory.

- The nature of the internal control related to inventory.

- Whether adequate procedures are expected to be established and proper instructions issued for
physical inventory counting.

- The timing of the count.

- The locations at which inventory is held.

- Whether an expert’s assistance in needed.

The standard further states that, to obtain audit evidence that management’s control activities are
adequately implemented; the auditor would observe employees’ procedures and perform test counts. When
performing test counts, the auditor performs procedures over both the completeness and the accuracy of
the count records by tracing items selected from those records to the physical inventory and items selected
from the physical inventory to the count records.

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Chartered Accountants

Inventory Count Attendance Programme

Guidelines for observation of physical inventories

1. The attendance at the client’s physical inventory is now regarded as a compulsory audit
procedure. It is from the physical inventory that a client establishes that quantities in inventory
which are valued to give the inventory amount in the balance sheet. It is clearly pointless for the
auditor to verify the valuation of inventories if he has not satisfied himself as to the accuracy of
the quantities held.

2. The purpose of observing the physical inventory is to determine that the client’s procedure result
in an accurate count. It should be remembered that while the auditor will himself carry out test
counts and extract certain cut-off information he is primarily there to observe that the client’s
procedures are satisfactory.

3. Where the client has an efficient system for inventory records, the physical inventory may be
carried out on a continuous basis as opposed to counting everything in one go at the year-end. In
the case of a client using the continuous basis, the auditor will still be required to observe a part
of this continuous inventory counting.

4. The work of the auditor will normally cover three stages – before, during and after the physical
inventory.

5. The following tasks should be carried out before the physical inventory begins:

(a) Obtain a copy of the client’s inventory instructions

(b) Review adequacy of instructions and discuss any weaknesses in instruction with the
client.

(c) Details of last number prior to physical inventory in respect of:

 Goods received

 Goods despatched

 Internal movement of goods

(d) Arrange for letters to be sent to third parties holding inventories on behalf of client,
requesting confirmation of these inventories to be sent direct to the auditors with a
copy to the client.

6. The main task during the count is to see that the client’s employees are carrying out their
instructions properly.

During the count the physical inventory pre-printed checklist should be completed. Further tasks
which should be performed, as the need arises, include;

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o Conduct of test counts by the auditor.

o Preparation of details of any old, obsolete, damaged or excess inventories noted during
the attendance.

o Comments on adequacy of custody.

7. At the final audit the information obtained at the physical inventory will be followed up. The
work to be carried out will include:

(1) An overall review of the working papers to assess the effectiveness of the physical count
and whether the final audit programme work should be altered as a result.

(2) A check of the cut-off using the information obtained or the last goods received and
despatched note numbers.

(3) A check of the auditor’s test count items to the final inventory sheets.

(4) A follow up of all outstanding queries including obsolete etc items noted at the
attendance of the physical inventory.

(5) A test to ensure that inventory records have been adjusted to agree with the physical
inventory.

(6) A discussion with management of any weakness which arose, and if appropriate includes
points in the management letter.

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Client ___________________________

Date of count _____________________

Observation of Physical Inventory Count Checklist

Notes

PURPOSE:

Inventory counts are carried out by business either:

1. To corroborate information contained in their books and records which is the product of a
continuous accounting and control system, or

2. To provide an inventory figure for inclusion in financial statement and to use in calculating profit
where there is no system of continuous inventory accounting.

Attendance at inventory counts by the auditor is a standard verification test which serves to confirm
the physical existence of inventories, to corroborate the method of quantification and to ascertain
their physical condition.

OUR JOB:

The staff member is required to:

(1) Observe procedures and complete the following checklist.

(2) Carry out test counts randomly and record the results on the sheets attached to the
checklist.

INVENTORY COUNT STAGES:

An inventory count has three stages:

 Organisation

 Conduct

 Follow-up

(Following checklist is divided as per inventory count stages.)

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Checklist

Question Yes No Alternative procedure

Organisation

(1) Were written instruction prepared, issued in advance

of the count and used?

(2) Was there adequate physical preparation for the

count including:

 Tidying up

 Stopping work or production

 Sorting goods out

 Identifying and marking goods

(3) Were stock sheets prepared before the count?

(4) Was cut-off properly organized by:

 Closing receiving and despatch

 Recording the last numbers of documents controlling

the flow of goods prior to the count

 Marking the last goods received and issued prior to

the count.

Conduct

(1) Was the count carried out by personnel:

 Not usually involved in the custody of inventories.

 Able to identify the inventories being counted.

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Question Yes No Alternative procedure

(2) Was a system of double check carried out by

accounts or supervisory personnel?

(3) Were inventories marked as counted to avoid

omission or duplication in the count?

(4) Were damaged or obsolete items specifically noted?

(5) Were the contents of sealed packages checked by

opening and weighed to see that contents conformed
to labels?

(6) Was there an adequate procedure to identify goods

not belonging to the company?

(7) Where amendments to inventory sheets were made,

were these initialled by a supervisor?

Follow-up

(1) Were all the inventory sheets accounted for?

(2) Were rough inventory sheet retained?

(3) Is there a proper procedure for authorised

amendment of inventory record to agree to the
results of the count?

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Chartered Accountants
Conclusions
Give below your overall conclusions on the count referring specifically to:

(1) The adequacy of procedures laid down.

(2) Whether these procedures were complied with, and

(3) Whether the results of the counts can be relied upon that they properly reflect quantities on hand
as of that date and to form the basis of the valuation of inventories.

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Chartered Accountants
Client ___________________________

Date of count _____________________

RECORD OF TEST COUNTS

Reference (stock sheet Description of item Quantity EXCESS/ SHORT

number etc) counted

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Chartered Accountants
Client ___________________________

Date of count _____________________

DETAILS OF OLD, OBSOLETE, DAMAGED INVENTORY

Reference (stock sheet Description of item Quantity Condition (i.e. note any
number etc) counted damage or obsolescence)

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Chartered Accountants

Client_____________________________________________________ Prepared by______________

Period of Account____________________________________________ Date____________________

Reviewed by_______________

Dated_____________________

PHYSICAL CASH ACCOUNT

RUPEE NO RUPEES REMARKS

5,000 × =

1,000 × =

500 × =

100 × =

50 × =

20 × =

10 × =

5 × =

2 × =

1 × =

Total:

Rupees in words:

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