Auditing Inventories and Fixed Assets

Inventory
Inventory is an area of major importance for the auditor and , historically, has been the balance
sheet item that creates most problems, because:

1. It significant to the determination of profit and a significant component of the balance sheet
2. Accounting for inventory is often not part of the double entry system
3. The determination of year-end quantities can be problematic
4. There are different approaches to valuation
5. It is often the subject of manipulation and fraud, both by management and others

In a merchandising entity inventory consists of goods acquired for resale. In a manufacturing

company inventory includes:
• Raw materials
• Partly manufactured items (wip)
• Finished goods

Smaller entities may not maintain inventory records. Large manufacturing entities maintain
comprehensive inventory records, with subsidiary inventory ledgers. In both case the prime
audit objective is to determine (a) the quantity and (b) the value of the inventory appearing
in the financial statements.

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 Auditing Inventories and Fixed Assets

Audit Objectives

The principal audit objectives for each assertion and audit controls are shown in Table 1.

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 Auditing Inventories and Fixed Assets

Recording Inventory Transactions

The use of computer information systems has made it much easier to maintain perpetual
inventory records. If the recording of sales and purchase is computerized, it is relatively
simple to exited the system to record the input and removal of goods from inventory.

Simpler systems maintain records of quantity only. More sophisticated maintain records by
quantity and value. In any case, the accounting function of inventory recording should be
segregated from the physical custody of the inventory.

The functions of inventory recording are:

1.Recording the movement of goods into inventory (entered through the purchasing system;
inventory keeper acknowledges receipt)
2.Recording the movement of goods from inventory (the dispatch note is the basis for
authorization of the release of the goods from inventory and for the entry in inventory
records, reducing the quantity on hand; in retail stores this is often done by scanned
barcodes)
3.Recording transfer of inventory (usually occurring in manufacturing; production move orders
control the movement of goods from raw materials, through work in process to finished
goods)
4.Physically comparing inventory with inventory records (perpetual inventory records need to
be compared with physical inventory at regular intervals; the funcitions involved are:
• Inventory count and
• Comparison with records

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 Auditing Inventories and Fixed Assets

Developing the audit plan

The selected approach to the audit of inventory depends on
1. The materiality of inventory
2. Risk factors
3. The availability and reliability of inventory records
4. Significant and high value items
5. The location of inventory

Materiality and risk factors

In a manufacturing entity, inventories and cost of goods sold are usually significant to both the
entity's financial position and the results of its operations. Moreover, numerous factors
contribute to the risk of misstatements in the assertions for these accounts, including those
described below:
 The volume of purchase, manufacturing and sale transactions that affect these accounts is
generally high, increasing the opportunities for misstatements to occur.
• There are often contentious valuation and measurement issues such as:
– the identification, measurement and allocation of indirect materials, labour and manufacturing
overhead;
– joint product costs;
– the disposition of cost variances;
– accounting for scrap and wastage.

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 Auditing Inventories and Fixed Assets

Materiality and risk factors (cont’d)

• Special procedures are sometimes required to determine inventory quantity or value, such as
geometric volume measurements of volume or weight of inventory using aerial photography,
and estimation of value by experts.
• Inventories are often stored at multiple sites, leading to difficulties in maintaining physical
control over theft and damage and in accounting for goods in transit between sites.
• Inventories are vulnerable to spoilage, obsolescence and general economic conditions that
may affect demand and saleability and thus their valuation.
• Inventories may be sold subject to right of return and repurchase agreements.
• Inventories may have been purchased subject to 'reservation of title' clauses.

Audit strategy
• In verifying the existence (and completeness) assertions, auditors have the choice of three
audit strategies depending on the entity's policy for determining inventory quantity. The
options are:
• Inventory quantity determined by perpetual inventory records where the entity does not
intend to count inventory at or close to the balance sheet date. This strategy requires that
control risk over inventory records be assessed as low.
• Inventory quantities determined by inventory count near the balance sheet date, adjusted to
balance sheet quantities by reference to perpetual inventory records. This strategy requires
that control risk over inventory records, or of purchases and sales cutoff, is not assessed as
high.
• Inventory quantities determined by inventory count at or within a few days of the balance
sheet date.
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 Auditing Purchases, Trade Payables and Payroll

• This is a predominantly substantive approach in which the auditors would not test control
over inventory records, which may not even exist.

An entity may use each of the three methods for different categories of inventory or for
inventory at different locations. For example, a manufacturing entity may determine the
quantity of raw materials and finished goods at a year-end inventory count, but rely on
perpetual records in determining the work-in-process inventory.

In developing the audit plan, auditors will need to discuss the approach that management
intends to take. If management intends to rely solely on inventory records, then more
extensive tests of control will be necessary to confirm the required assessment of control
risk. Moreover, this assessment must be completed before the balance sheet date in the
event that tests of control fail to confirm the assessment of control risk as being low, and
the auditors are required to advise management to count inventory at or near the balance
sheet date.

Specialized inventories may require the assistance of experts in determining either the quantity
(as in the case of aerial measurement of inventory volume or weight - such as piles of coal)
or value (as in the case of antiques or diamonds). Depending on the circumstances,
including such factors as the materiality of the inventory, the risk of material misstatement
and the degree of independence of the expert, the auditor may decide to rely on the work of
an expert engaged by management or may prefer to engage an independent expert for the
purpose of providing sufficient evidence to support the valuation assertion.

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 Auditing Inventories and Fixed Assets

For merchandise inventory, a predominantly substantive approach is usually more efficient in

verifying the valuation assertion. For manufacturing entities, it is usually necessary for the
auditors to have assessed control risk over the maintenance of costing records (used as the
basis for costing closing inventory) as being less than high. This is an area that frequently
receives insufficient audit attention owing to a reluctance to unravel the complexities of the
costing system.

Control risk over inventory records

• Table 2 contains a partial listing of potential misstatements, necessary controls, possible
tests of the operating effectiveness of those controls and the specific audit objective to which
each belongs. As explained above, auditors would assess control risk over perpetual
inventory records only where they are used in determining inventory at the balance sheet
date. If the preliminary assessment, based on the design effectiveness of controls, is that
control risk is likely to be high, then the auditors would advise management not to rely on
the records in determining inventory at the balance sheet date.
• If the preliminary assessment supports management's intended reliance on inventory
records, then the auditors would proceed to draw up an audit programme incorporating
possible tests of the operating effectiveness of controls such as those identified in Table 2.

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Auditing Inventories and Fixed Assets
Table 2: Control Risks Assessment-Inventory Records

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 Auditing Inventories and Fixed Assets
Tangible Fixed Assets
Tangible noncurrent assets are tangible assets intended to be retained for use in the entity's
operations. This category, on the balance sheet, includes land and buildings, plant and
equipment and the related accumulated depreciation. Land and buildings may be freehold or
leasehold and plant and equipment may include assets held under finance leases. The
principal related profit and loss accounts are depreciation expense, repairs expense, finance
charges on finance leases and rent on operating leases.

The principal transaction class relating to noncurrent asset balances is that of purchases.
The relevant objectives are listed in Table 3.

Table 3: Audit Objectives for Fixed Assets

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Auditing Inventories and Fixed Assets
Table 4: Substantive Procedures for Fixed Assets Audit

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