SUBSTANTIVE TESTING – INVENTORY

A. INTRODUCTION

No statement of the financial position audit area creates more potential problems for the
auditors than that of inventory.

Closing inventory (stock) does not normally form an integrated part of the double entry
bookkeeping system and hence a misstatement may not be detected from tests in other
audit areas. The following is a summary of why inventories are often the most difficult and
time-consuming part of the audit:

a) Inventory often represent a significant asset on the statement of financial position.

b) The value of closing inventory has a direct impact on profit.
c) Inventory is often made up of many diverse items with different unit values.
d) The valuation of W.I.P. is often a subjective process as the decision as to the stage
which W.I.P. has reached and the costs to be included is often subjective. This also
applies to the allocation of overheads to inventory.
e) Verification of the existence of inventory and W.I.P. involves attendance at the
inventory count and extensive follow-up procedures.
f) The provision for slow moving and obsolete inventory is another subjective area.
g) The physical control of inventory is often difficult because of multiple locations,
inventory held by third parties e.t.c.
h) Different valuation methods are allowed under IAS 2 INVENTORIES although they
must be applied consistently.

The four main elements of the audit of inventories (completeness, existence, rights and
obligations and valuation) require careful consideration.

B. REGULATORY ASPECTS OF INVENTORY

The valuation and disclosure rules for inventory are laid down in IAS 2 INVENTORIES
 Cost is defined by IAS 2 as comprising all costs of purchase and other costs
incurred in bringing inventories to their present location and condition.
 Net realizable 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.
 Production costs (costs of conversion) include:
a) Costs specifically attributed to units of production,
b) Production overheads and
c) Other overheads attributable to bringing the product or service to its
present location and condition.

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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 about the quantities and conditions of inventories
and W.I.P.

RESPONSIBILITIES IN RELATION TO INVENTORIES

Management

1. Ensure that inventory figure in the accounts:

 Represents inventory that exists.
 Includes all inventory owned.
2. Ensure that accounting records include statements of physical inventory count.

Auditors

1. Ensure that they obtain sufficient audit evidence about inventory figure from:
 Inventory records,
 Inventory control systems,
 Results of physical inventory counts
 Test counts by auditors.
2. Attend physical inventory count if inventory is material and evidence of existence is
provided by management inventory counts.

C. METHODS OF INVENTORY COUNTS

1. Physical Inventory Counts at Year-End.

2. Physical Inventory Counts Before or After the Year-End.

3. Perpetual Inventory –where management has a programme of inventory counting

throughout the year.

AUDIT PROGRAMME/PLAN: PERPETUAL INVENTORY COUNT

 Attend One of the Inventory Counts

- The objective of the auditor is to observe and confirm that instructions are being
adhered to.
 Follow Up the Inventory Counts
- To compare quantities counted by the auditors with the inventory records, obtaining
and verifying explanation for any differences, and checking that the client has
reconciled count records with book inventory records.
 Review the Year’s Inventory Counts

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 - To confirm the extent of counting, the treatment of discrepancies and the overall
accuracy of records. Note that if matters are not satisfactory, auditors will only be
able to gain sufficient assurance by a full count at year-end.

 Assuming A Full Count Is Not Necessary At Year-End

- Compare the listing of inventory with the detailed inventory records, and carry out
other procedures i.e. cut-off, analytical review to gain further comfort.

An attendance at an inventory count, gives evidence of the Existence and apparent

Ownership of inventory. It also gives evidence of the Completeness of inventory, as do the
follow up tests to ensure that all inventory sheets were included in the final count.

PLANNING ATTENDANCE AT INVENTORY COUNT

Before the physical inventory count, the auditors should ensure that audit coverage of the
count is appropriate and that the client’s instructions have been reviewed.

PLANNING INVENTORY COUNT

1. Gain Knowledge by:

- Reviewing of previous year’s stock take arrangements.
- Discussing with management inventory count arrangements and significant changes.
2. Assess Key Factors: i.e.
- The nature and volume of the inventory.
- Risks relating to inventory.
- The identification of high value items.
- Method of accounting for inventory.
- Location of inventory and how it affects inventory control and recording.
- Internal control and accounting systems to identify potential areas of difficulty.

3. PLAN PROCEDURES
- Ensure a representative selection of locations, inventory and procedures are
covered.
- Ensure that sufficient attention is given to high value items.
- Arrange to obtain from third parties confirmation of inventory they hold.
- Consider the need for expert help.

REVIEW OF INVENTORY COUNT INSTRUCTIONS

Organization of the Count

1) Supervision by senior staff including senior staff not normally involved with
inventory.

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 2) Tidying and marking inventory to help counting.
3) Restriction and control of the production process and inventory movements during
the count.
4) Identification of damaged, obsolete, slow moving, third party and returnable
inventory.

Counting

1) Systematic counting to ensure that all inventories are counted.

2) Teams of two counters, with one counting and the other checking or two
independent counts.

Recording

1) Serial numbering, control and return of all inventory sheets.

2) Inventory sheets being completed in ink and signed.
3) Information to be recorded on the count records include (location and identity,
count units, quantity counted, condition of items, stage reached in production
process e.t.c.).
4) Recording of quantity, conditions and stage of production of W.I.P.
5) Recording of last numbers of goods inwards and outwards records and of internal
transfer records.
6) Reconciliation with inventory records and investigation and correction on any
differences.
D. AUDIT PROGRAMME/PLAN: ATTENDANCE AT INVENTORY COUNT
 Check that client’s staff is following instructions.
 Make test counts to ensure that procedures and internal controls are working properly.
 Ensure that the procedures for identifying damaged, obsolete and slow-moving
inventory operate properly; the auditors should obtain information about the
inventories’ condition, age, usage and in the case of W.I.P., its stage of completion.
 Confirm that inventory held on behalf of third parties is separately identified and
accounted for.
 Conclude whether the count has been properly carried out and is sufficiently reliable as
a basis for determining the existence of inventories.
 Consider whether any amendment is necessary to subsequent audit procedures.
 Gain an overall impression of the levels and values of inventories held so that the
auditors may, in due course, judge whether the figure for inventories in the financial
statements is reasonable.

When carrying out test counts, the auditors should select items from the count
records and from the physical inventories and check one to another, to confirm
accuracy of the count records. The auditors should concentrate on high value
inventory.

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 AFTER THE INVENTORY COUNT

After the count, the matters recorded in the auditors’ working papers at the time of
the count should be followed up. Key audit tests include the following:

AUDIT PROCEDURES/PLAN: FOR MAKING A FOLLOW-UP AFTER THE INVENTORY COUNT

 Trace items that were test counted to final inventory sheets.

 Check that all count records have been included in the final inventory sheets.
 Ensure that continuous inventory records have been adjusted to the amounts
physically counted or measured, and the differences have been investigated.
 Confirm cut-off by using details of the last serial number of goods inwards and
outwards notes; and of movements during the count.
 Check replies from third parties about inventories held by or for them.
 Confirm that the client’s final valuation of inventory has been calculated
correctly.
 Follow up on queries and notifying problems to management.

CUT – OFF

Importance of Cut- Off

Cut-off is most critical to the accurate recording of transactions in a manufacturing

enterprise at particular points in the accounting cycle as follows:

 The point of purchase and receipt of goods and services.

 The requisitioning of raw materials for production.
 The transfer of completed W.I.P. to finished goods.
 The sale and dispatch of finished goods.

Audit Procedures

The auditors should consider whether management has instituted adequate cut-off
procedures intended to ensure that movements into, within and out of inventories are
properly identified and reflected in the accounting records.

Sales Cut-Off

Invoices for goods dispatched after the count should not appear in the Statement of
Comprehensive Income for the period.

Prior to the physical inventory count, management should make arrangements for cut-off to
be properly applied.

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 Appropriate systems of recording of receipts and dispatches of goods are in place
and also a system for documenting materials requisitions, Goods Received Notes
(GRNs) and Goods Dispatched Notes (GDNs) should be sequentially pre-numbered.
 Final GRN and GDN and materials requisition numbers are noted. These numbers can
then be used to check subsequently that purchases and sales have been recorded in
the current period.
 Arrangements should be made to ensure that cut-off arrangements for inventories
held by third parties are satisfactory.

Ideally there should be no movement of inventories during the count. Preferably,

receipts and dispatches should be suspended for the full period of the count. It may not
be practicable to suspend all deliveries, in which case any deliveries which are received
during the count should be segregated from other inventory and carefully documented.

AUDIT PLAN: CUT-OFF

INVENTORY COUNT  Record all movement notes relating to the
period, including:
- All interdepartmental requisition numbers.
- The last goods received note(s) and dispatch
note(s) prior to the count.
- The first goods received note(s) and dispatch
note(s) after the count.

 Observe whether correct cut-off procedures

are being followed in the dispatch and
receiving areas.
 Discuss with company staff performing the
count to ensure that they are understood.
 Ensure that no goods finished on the day
of the count are transferred to the
warehouse.

FINAL AUDIT  Match up the goods received notes with

purchase invoices and ensure that the liability
has been recorded in the correct period (only
goods received before year-end should be
recorded as purchases).
 Match up the goods dispatched notes to sales
invoices and ensure that the income has been
recorded in the correct period (only goods
dispatched before the year-end should be
recorded as sales).
 Match up the requisition notes to the W.I.P.
figures for the receiving department to ensure

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 that they are correctly recorded.

INVENTORY VALUATION

Audit Procedures

The audit procedures will depend on the methods used by the client to value W.I.P. and
finished goods, and on the adequacy of the system of internal control.

The auditors should consider what tests they can carry out to check the
reasonableness of the valuation of finished goods and W.I.P. Analytical procedures
may assist comparisons

being made with items and categories from the previous year’s summaries. A
reasonableness check will also provide the auditors with assurance regarding
completeness.

COST

AUDIT PLAN: INVENTORY PRODUCTION COSTS

FOR MATERIALS  Check the valuation of raw materials to invoices and
price lists.
 Confirm appropriate basis of valuation (e.g. FIFO) is
being used.
 Confirm correct quantities are being used when
calculating raw material value in W.I.P. and finished
goods.
FOR LABOUR COSTS  Check labour costs to wage records.
 Review standard labour costs in the light of actual
costs and production.
 Check labour hours to time summaries.

The auditor should ensure that the client includes a proportion of overheads
appropriate to bringing the inventory to its present location and condition. The basis of
overhead allocation should be:

i. Consistent with prior years.

ii. Calculated on the normal level of production activity. Thus, overheads arising
from reduced levels of activity, idle time or inefficient production should be
written off to the Statement of Comprehensive Income, rather than being
included in inventory.

AUDIT PLAN: ALLOCATION OF OVERHEADS

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a) All abnormal conversion costs (such as idle capacity) must be excluded.
b) Where firm sales contracts have been entered into for the provision of goods and
services to customer’s specification; design, marketing and selling costs incurred
before manufacture may be included.
c) Overheads are classified by a function when being allocated (e.g. whether they are a
function of production, marketing or administration).
d) The costs of general management, as distinct from functional management, are not
directly related to current production and are therefore excluded.
e) The allocation of costs of central service departments should be depend on the
function or functions that the department is serving. Only those costs that can
reasonably be allocated to the production function should be included.
f) In determining what constitutes ‘normal activity’ the following factors need to be
considered:
i. The volume of production which the production facilities are designed to
achieve.
ii. The budgeted level of activity for the year under review and for the ensuing
year.
iii. The level of activity achieved both in the year under review and in the
previous years. Although temporary changes in the load of activity may be
ignored, persistent variation should lead to revision of the previous norm.

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