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(1)

OVERVIEW

Objective

¾

To identify and explain areas of risk.

¾

To apply procedures to obtain appropriate audit evidence.

RISKS

SOURCES OF EVIDENCE

IMPORTANCE INVENTORY SYSTEM

¾ Types of inventory

¾ Materiality ¾ Control objectives

¾ Internal control examples

C A P E R

IAS 2

¾ Measurement

¾ Cost formulas

¾ NRV

¾ Provisions

¾ “Ideas list”

“CUTOFF”

¾ Importance

¾ Audit procedures

PHYSICAL INVENTORY

COUNTING

¾ Purpose

¾ Types of stocktaking

¾ Perpetual inventory

¾ Physical counting

THIRD PARTY INVENTORY

¾ Inventory held by other parties

¾ Third party inventory

¾ Reservation of title

(2)

1

IMPORTANCE

1.1

Types of inventory

¾

Raw materials and consumables

¾

Work in progress

¾

Finished goods and goods for resale

¾

Long-term contracts.

1.2

Materiality

Balance sheet Income statement

Current assets

Inventory x Revenue Cost of sales * (x) x

___

Gross profit x

___ * = Opening inventory

+ Purchases (+ conversion costs) – Closing inventory

Inventory is frequently material to both BS & IS

2

SOURCES OF EVIDENCE

Example 1

Complete the following ideas list.

2.1

“Ideas list”

¾

Accounting systems ⇒

¾

Documentation ⇒

¾

Tangible assets ⇒

¾

Management and employees ⇒

¾

Customers and suppliers ⇒

¾

Other third parties (e.g. banks,
(3)

3

INVENTORY SYSTEM

3.1

Control objectives

Goods received

Stage 1 Goods despatched

Receipt recorded

Stage 2 Despatch recorded

Movement posted to general ledger and

inventory records Stage 3

Toensure that …

… damaged goods are not accepted.

… goods cannot be misappropriated.

… all movements are accurately recorded.

… management has accurate/timely info concerning inventory levels.

3.2

Internal control examples

3.2.1

Goods received

¾

Physical inspection

¾

Securely stored

3.2.2

Goods dispatched

¾

Two warehouse employees involved

¾

Maintain “open orders” file

¾

Notification of “stock-outs”

3.2.3

Receipt recorded

¾

Serially numbered goods received notes (GRNs) sequentially controlled

¾

Matched to purchase order

3.2.4

Dispatch recorded

¾

Serially numbered dispatch notes (DNs) sequentially controlled

¾

Customer signature (proof of delivery)

¾

Matched with customer order

¾

Serially numbered goods returned notes

3.2.5

Postings

¾

GRNs and DNs used to update inventory records

¾

GRNs and DNs evidenced as processed (e.g. stamped) and filed numerically

¾

Regular physical inventory counting, comparison book v actual and
(4)

4

RISKS

¾

Not all quantities of materials, goods etc may be recorded on stocksheets.

¾

Inventory may not be adequately safeguarded.

¾

Inventory may not be valued consistently and in accordance with IAS 2 Inventories.

¾

“Cutoff” for inventory movements may be inaccurate.

¾

Inventory belonging to third parties may not be excluded from physical count.

¾

Inventory with third parties belonging to the client may be omitted from count.

5

“CUTOFF”

A procedure for isolating the flow of inventory, cash and related documentation to ensure that all aspects of a transaction are dealt with in the same accounting period.

5.1

Importance

¾

Accurate “cutoff” may be crucial to inventory, purchases and sales. Cutoff determines where one accounting period ends and another one commences.

PURCHASES

receive inventory receive inventory

YEAR END

despatch inventory despatch inventory

INVENTORY

¾

Errors or inconsistencies in cutoff can create misleading measurements of profit.

Illustration 1

(5)

Illustration 2

If goods invoiced to a customer (worth $10,000 at cost) were erroneously included in the closing inventory, there would be an element of double counting and profits would be overstated by $10,000.

5.2

Audit procedures

¾

To avoid double counting it is essential that purchase and sales invoices are checked against inventory records to ensure that:

‰ all goods received into inventory by the end of the reporting period and included in the statement of financial position have the corresponding invoice entered in the purchase day book and included in trade payables

‰ all goods despatched at the end of the reporting period and excluded from the

statement of financial position have a corresponding sales invoice raised, entered in the sales day book and included in trade receivables.

¾

To avoid omissions, all purchase or sales invoices entered in the books before the end of the reporting period must have the corresponding inventory movement reflected in the statement of financial position inventory.

6

VALUATION AND IAS 2

Lower of cost and net realisable value for separate items of inventory.

6.1

Measurement methods

6.1.1

Standard cost

¾

It must approximate to actual. Price variance accounts will highlight obvious differences between standard and actual price.

6.1.2

Retail method

¾

Selling price less standard gross profit %.

¾

% may be average for each “department”.
(6)

6.2

Cost formulas

¾

Specific identification of individual costs. Need to confirm:

‰ material costs to suppliers’ invoices

‰ labour to payroll and time summaries

‰ the basis of unit cost calculations for allocating overheads.

¾

Otherwise (for interchangeable items):

‰ First-in, first-out (FIFO)

‰ Weighted average

6.3

Net realisable value

¾

NRV is affected by

‰ obsolescence

‰ condition/damage etc

‰ market price fluctuations.

¾

In computerised inventory systems, an exception report may identify items which have not moved in a specified period.

¾

A review of selling prices after the end of the reporting period may confirm NRV.

6.4

“Allowances”

¾

An example of an “accounting estimate” which is an allowance

¾

Determination may be

‰ simple (e.g. a % of inventory value); or

‰ complex (e.g. by analysing current data and sales forecasts to estimate slow-moving or surplus inventory).

¾

Any formulae used (e.g. different %s applied to inventory ageing) need to be reviewed regularly by management to assess their appropriateness.

¾

Audit approaches

‰ Review and test management’s process used to develop the estimate ‰ Use an independent estimate for comparison with management’s

(7)

7

ATTENDANCE AT PHYSICAL INVENTORY COUNTING

[ISA 501]

When inventory is material … the auditor should obtain sufficient appropriate audit evidence regarding its existence and condition (⇒ valuation) by attendance at physical inventory counting unless impracticable.

7.1

Purpose

¾

To inspect inventory.

¾

To observe compliance with the operation of management’s procedures for recording and controlling the results of the count.

¾

To provide evidence as to the reliability of management’s procedures.

7.2

Types of stocktaking

Full physical

count Perpetual system

Before/after

y/e At y/e

Example 2

Suggest advantages and disadvantages of a full physical count at the end of the reporting period.

Solution

Advantages

Disadvantages

9

8

9

8

(8)

Example 3

Suggest advantages and disadvantages of a full physical count shortly before the end of the reporting period.

Solution

Advantages

Disadvantages

9

8

9

8

9

8

7.3

Perpetual inventory system

¾

Inventory is counted on a regular basis and just not once (at the end of the reporting period). Acts as a check on the accuracy of the book records (usually computerised incorporating purchases and movements between raw materials, work-in-progress and finished goods).

¾

Counts should be programmed so all inventory (eg each product line) counted at least ONCE a year (i.e “continuous stocktaking”). High value items/product lines are usually counted more often, eg every month or in some cases (eg high value jewellery) every day.

¾

All material differences between book inventory and physical counts must be investigated and corrected at the time of each count.

¾

Auditors should attend at least one of the physical counts (preferably more than one if inventory is homogeneous and each product line is counted only once).

¾

Movements throughout the year into book records (eg from goods received records) and out (eg transfers to next production stage/goods out as sales) must be audited to establish occurrence and measurement assertions.

¾

This is necessary to support the assertion that quantity records are reliable (existence and completeness) as a basis for the determination of the year-end valuation.

Example 4

(9)

Solution

Advantages

Disadvantages

9

8

9

8

9

8

7.4

Attendance at physical inventory counting

¾

Applies equally to end of the reporting period counts and perpetual inventory counts.

Before =

Planning Attendance During = Follow-up After =

¾

review prior year

working papers

¾

discuss instructions with management

¾

familiarisation; nature, value, location(s) etc

¾

arrange third party certificates

¾

consider need for expert(s)

¾

assess accounting and internal control system

¾

consider role of internal audit

¾

extract representative sample.

¾

observe compliance with instructions

¾

perform test counts (from physical to recorded and vice versa)

¾

take copies of stocksheets

¾

obtain more details of damaged inventory

¾

note cutoff details.

¾

follow up cut-off tests

¾

check “in bulk” copies

of stocksheets and check sequence

¾

ensure perpetual inventory records adjusted

¾

follow up third party certificates

¾

conclude on reliability of quantities used as a basis for computing inventory.
(10)

8

THIRD PARTY INVENTORY

8.1

Inventory held by other parties

¾

Client’s inventory may be held by third parties when

‰ third party warehousing/storage is being used

‰ goods are on consignment

‰ goods are in transit.

¾

If the inventory held by third parties is material, it must be inspected by the auditor or alternative evidence sought for goods that cannot be inspected (eg in transit on board a boat – inspect shipping documentation, insurance arrangements, subsequent arrival and offloading, confirmation letter from agents, management representations).

¾

If the inventory is not material, a confirmation letter should be obtained from the third party.

8.2

Third party inventory held by client

¾

Where inventory is received from a third party, eg for processing ( electroplating) or repair (under warranty) the auditor must consider the controls in place to ensure such inventory is not included within the inventory of the entity (eg identified and

segregated at the time of a physical inventory count).

8.3

Reservation of title

¾

Suppliers may include a “reservation of title” clause in their contracts of sale (usually on the purchase invoice). This states that title (i.e. ownership) of the goods does not pass to the customer until paid for, even if the goods are used within the

manufacturing process before payment.

¾

Considering substance over form:

‰ Legal form – goods belong to supplier until fully paid for. No liability or asset is recognised.

‰ Commercial substance – goods are treated as property of purchaser, who recognises the liability and includes such goods held at the end of the reporting period on their statement of financial position.

(11)

FOCUS

You should now be able to:

¾

explain the importance of inventory;

¾

describe physical inventory counting procedures;

¾

explain “cutoff”;

¾

value inventory;

¾

select appropriate audit procedures for inclusion in a work program (see also Appendix 3) relating to financial statement assertions concerning inventory.

EXAMPLE SOLUTION

Solution 1 — Sources “Ideas list”

¾

Accounting systems ⇒ Perpetual inventory records

¾

Documentation ⇒ Inventory cards, purchase invoices (cost) (also payroll for manufactured products), sales invoices (NRV)

¾

Tangible assets ⇒ Raw materials, WIP, finished goods

¾

Management and employees ⇒ Buyer, storekeeper

¾

Customers and suppliers ⇒ Major (raw material) suppliers, customer complaints (NRV < cost?)

¾

Other third parties (e.g. banks,

solicitors) ⇒ Bank (floating charge?), warehousing agents

(12)

Solution 2 — Full count

Advantages

Disadvantages

¾

Evidence most

effective/inventory physically in BS

¾

Potential disruption and cost of full count (e.g. if production halted or outlets closed)

¾

“Cutoff” ascertained at just one (end of the reporting period) date. Movements to be confirmed are minimised

¾

Number of locations to be attended at one time (by client and audit staff)

¾

Inventory records are not

required.

¾

Heavy demand on audit staff at popular end of reporting periods (e.g. 31 December).

Solution 3 — Before end of the reporting period

Advantages

Disadvantages

¾

Time can be made more

convenient (e.g. holiday closure)

¾

Movements to be substantiated therefore need records and ICs (to confirm “roll forward”)

¾

Still time to do full count at the end of the reporting period if significant problems found

¾

“Cutoff” needs to be examined at count date and the end of the reporting period also

¾

Facilitates a tighter audit

reporting deadline

¾

Reliable inventory records required

Solution 4 — Continuous stock-checking

Advantages

Disadvantages

¾

A method of internal control –

operates throughout year

¾

Requires adequate inventory records be kept up-to-date (⇒ clerical cost)

¾

Material and risk prone items can

be confirmed at any time

¾

No full counts

¾

The end of the reporting period

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