Auditor should anticipate certain potential problems in auditing inventory, accounts payable, and related accounts. Inventory may include damaged or obsolete items so that recorded value must be reduced to net realizable value. This possibility relates to valuation assertion. Inventory might be miscounted either accidentally or intentionally. Overcounting inflates currently reported earnings; undercounting reduces reported income. If overcounted, problem is with existence assertion. If undercounted, problem is with completeness assertion. End-of-year cutoff could be recorded incorrectly in connection with receipt and shipment of inventory. Again, possible overstatement relates to existence assertion whereas understatement affects completeness assertion. End-of-year liabilities may have been omitted because invoice has not been received or because company wants to improve its reported debt position. Problem relates to completeness assertion. Inventory being held by client is on consignment or inventory owned by client is out on consignment.
Through this post, I am going to overview basic of inventory audit. Enjoy!
Internal Control System for Inventory Purchase
Company should have a system in place to record purchase of inventory (or fixed assets) and the related liability as well as subsequent payment. For example, assume that a department or individual within company needs an item. A requisition (sometimes referred to as a material requisition) is completed. A person with appropriate authority reviews and authorizes requisition. Whenever any document is created, it should be reviewed, authorized, recorded, and a copy to be kept.
- Copy of approved requisition goes to warehouse (or store room).
- If item is available, order is filled. If not, purchase requisition is created and sent to purchasing department.
- Purchasing department verifies request by checking against budget. Should also check that all documents have been properly authorized. A purchase order should be created after going through a set of prescribed steps such as getting bids (for expensive items) or checking with a number of vendors (for cheaper items). Should only buy from vendors listed on a preapproved vendor list.
- Copy of purchase order goes to receiving room to alert that a shipment is to be expected. On this copy, quantity is blanked out to ensure that goods will be counted.
- Goods are received by receiving room and compared to copy of purchase order to verify make, model, description of item, and condition. If there is a discrepancy or if goods are damaged, they are not accepted. If accepted, a receiving report is prepared giving all information about goods. Copy is sent to inventory accounting department to update perpetual inventory records. Receiving room is separate from warehouse in order to ensure adequate documentation of goods that are received.
- Goods are transferred to warehouse. Warehouse employees verify quantity, description, and condition and then return a signed copy of the receiving report so that the receiving room has a receipt to verify transfer of goods.
- Purchase invoice is eventually received from vendor. The price charged, terms of payment, and math need to be verified.
- Copies of all documents (requisition, purchase requisition, purchase order, receiving report, and purchase invoice) are forwarded to accounts payable department (also referred to as “vouchers payable department“). Agreement and authorization of all documents is verified.
- A voucher is prepared by accounts payable to indicate approval to make payment. It is reviewed and authorized. Liability and purchase are recorded in voucher register. Summary of voucher register is forwarded periodically to general accounting to record in general ledger.
- Voucher and back-up documentation (sometimes referred to as a voucher package) are sent to cash disbursements department and filed by due date.
- On due date, voucher is reviewed for reasonableness and compared one final time to documentation. Check is written.
- Second party compares check and voucher and signs check. Amount is recorded in cash disbursements journal as a reduction in cash and liability. Again, a summary will be made and forwarded to general accounting for recording. Voucher is defaced in some manner to avoid repayment. Check is mailed to vendor.
Substantive Testing Procedures For Inventory Audit
A number of substantive testing procedures should be performed to verify the assertions made by client about inventory, accounts payable, and any related balances. Analytical procedures are performed, both at beginning and end of audit. Auditor expectations are compared to client figures such as the age of inventory, gross profit percentage, balance of year-end inventory and liabilities, cost per unit, percentage of inventory that is recorded below cost, etc.
- Trace one or more transactions through the entire system to see if recording is appropriate at each step. Start with requisition and check all steps until liability is recorded and paid. Whenever auditor starts with initiation of a transaction and follows it through system, the completeness assertion is being tested.
- Vouch one or more entries in the T-account back through system to see if there is adequate support. Whenever auditor starts with a reported balance and seeks support, the existence assertion is being tested.
- Check math as well as client work where applicable. Re-add voucher register and cash disbursements journal and compare totals to the general ledger account. Application of LIFO/FIFO should be checked. For manufacturing company, inventory cost figures should be verified.
- For the three to four days before and three to four days after the end of the year, verify client cut-off procedures to ensure that transactions were recorded in correct period. Use receiving report and purchase invoice to determine when inventory and payable should be recorded. Need to know FOB point and location of inventory on last day of year. Cash disbursements journal provides date for removal of payable.
- Auditor reviews any evidence generated in subsequent period (the time from the balance sheet date until the end of fieldwork). For example: auditor investigates the following: (a) Inventory that does not sell in subsequent period should be examined for obsolescence or damage, (b) Cash payments in subsequent period are reviewed to see if they indicate an unrecorded year-end liability, (c) Invoices received should be reviewed to see if an unrecorded liability existed at year’s-end, (d) Accounts payable can be confirmed but that is not usually done since invoice is received from vendor.
- Representation letter should ask about presence of obsolete inventory.
- Auditor looks for evidence that inventory might be out on consignment or that goods are being held on consignment; (a) Contract file should be examined for evidence of consignment transactions, (b) Preparation of a bill of lading without a subsequent sales invoice may indicate consignment-out transactions, (c) Receipt of goods without a subsequent purchase invoice may indicate consignment-in transactions, (d) Collections and payments made at irregular intervals may indicate that cash is transferred whenever a sale is made, (e) Confirmations may expose inventory out on consignment that has been recorded by company as a receivable, (f) Auditor should confirm consignment-out balances and may want to make a test count.
- Auditor should observe client’s taking of a physical inventory. If company uses a periodic system, count will be at year’s-end. If it has a perpetual system, count can be any time during year unless risk levels are high. Auditor performs a number of tasks; (a) Makes sure that counters know what they are doing, (b) Looks for damaged or obsolete items, (c) Makes and records a number of test counts, (d) If tag system is used, records last tag number so no additional inventory can be added at a later time.
- Client adds cost to ending list of inventory items and arrives at a final total of the inventory cost. Auditor must verify this listing; (a) Makes sure that quantity listed for the items that were test counted agrees with recorded amounts, (b) Verify that last tag number is the same, (c) Checks a sample of cost figures, (d) Checks a sample of extensions and footings.