The process of cross-checking financial records with physical inventory and records Show
Auditing inventory is the process of cross-checking financial records with physical inventory and records. It can be completed by auditors and other parties.  An inventory audit can be as simple as just taking a physical count of stock and inventory to verify a match to the accounting records. Auditing ExplainedAuditing is the process of verifying that the financial records of an entity are accurate and fairly represented. Transactions in financial records must fairly represent the entity’s financial positioning and actual operating activities. Since financial documentation and records are produced internally, there is a high risk that records can be manipulated by inside parties. Insiders can make mistakes or intentionally alter information while preparing financial records, which is considered fraudulent behavior. Auditing ensures that these mistakes are prevented. Audits also ensure that entities are complying with relevant accounting standards such as the International Financial Reporting Standards (IFRS), Generally Accepted Accounting Principles (GAAP), and other relevant accounting standards. Evidence in AuditingEvidence is needed to determine whether financial statements or records have been prepared in accordance with standards and free from material error. It is also required to promote the accuracy, transparency, and independence of audit reports. Evidence is required by auditors to verify the validity of financial records. It can either verify or provide support for the financial information that is presented. On the other hand, the evidence can contradict the financial information, which indicates errors or fraudulent behavior. Importance of Auditing InventoryObservation of inventory is a generally accepted auditing procedure, where an independent auditor issues an opinion on whether the financial records of inventory accurately represent the physical inventory being carried. Auditing inventory is an important aspect of gathering evidence, especially for manufacturing or retail-based businesses. It can represent a large balance of assets or capital. Auditing inventory must verify not only the amount of inventory but also its quality and condition to see whether the value of the inventory is fairly represented in financial records and statements. Inventory Audit ProceduresSome common inventory audit procedures are: 1. ABC analysisAn ABC analysis includes grouping different value and volume inventory. For example, high-value inventory, mid-value, and low-value products can be grouped separately. The items can be tracked and stored in their separate value groups as well. 2. Analytical proceduresAnalytical procedures include analyzing inventory based on financial metrics such as gross margins, days inventory on hand, inventory turnover ratio, and costs of inventory historically. 3. Cut-off analysisThe cut-off analysis includes pausing operations such as receiving and shipping of inventory while making a physical count to avoid mistakes. 4. Finished goods cost analysisFinished goods cost analysis applies to manufacturers and includes valuing finished inventory during an accounting period. 5. Freight cost analysisFreight cost analysis includes determining the shipping or freight costs for transporting inventory to different locations. Generally, freight costs are included in the value of inventory, so it is important to track the freight costs as well. 6. MatchingMatching involves matching the number of items and the cost of inventory shipped with financial records. Auditors may conduct matching to verify that the right amounts were charged at the right time. 7. Overhead analysisOverhead analysis includes analyzing the indirect costs of the business and overhead costs that may be included in the costs of inventory. Rent, utilities, and other costs can be recorded as part of inventory costs in some cases. 8. ReconciliationReconciliation includes solving discrepancies that are found in an inventory audit. Errors may be re-checked and reconciled on financial records. Related Readings Thank you for reading CFI’s guide to Auditing Inventory. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
If the company uses cycle counts instead of a physical count, the auditors can still use the procedures related to a physical count. They simply do so during one or more cycle counts, and can do so at any time; there is no need to only observe a cycle count that occurs at the end of the reporting period. Their tests may also evaluate the frequency of cycle counts, as well as the quality of the investigations conducted by counters into any variances found. Reconcile the Inventory Count to the General LedgerThey will trace the valuation compiled from the physical inventory count to the company's general ledger, to verify that the counted balance was carried forward into the company's accounting records. Test High-Value ItemsIf there are items in the inventory that are of unusually high value, the auditors will likely spend extra time counting them in inventory, ensuring that they are valued correctly, and tracing them into the valuation report that carries forward into the inventory balance in the general ledger. Test Error-Prone ItemsIf the auditors have noticed an error trend in prior years for specific inventory items, they will be more likely to test these items again. Test Inventory in TransitThere is a risk that you have inventory in transit from one storage location to another at the time of the physical count. Auditors test for this by reviewing your transfer documentation. Test Item CostsThe auditors need to know where purchased costs in your accounting records come from, so they will compare the amounts in recent supplier invoices to the costs listed in your inventory valuation. Review Freight CostsYou can either include freight costs in inventory or charge it to expense in the period incurred, but you need to be consistent in your treatment - so the auditors will trace a selection of freight invoices through your accounting system to see how they are handled. Test for Lower of Cost or MarketThe auditors must follow the lower of cost or market rule, and will do so by comparing a selection of market prices to their recorded costs. Analyze Finished Goods CostsIf a significant proportion of the inventory valuation is comprised of finished goods, then the auditors will want to review the bill of materials for a selection of finished goods items, and test them to see if they show an accurate compilation of the components in the finished goods items, as well as correct costs. Analyze Direct LaborIf direct labor is included in the cost of inventory, then the auditors will want to trace the labor charged during production on time cards or labor routings to the cost of the inventory. They will also investigate whether the labor costs listed in the valuation are supported by payroll records. Analyze OverheadIf you apply overhead costs to the inventory valuation, then the auditors will verify that you are consistently using the same general ledger accounts as the source for your overhead costs, whether overhead includes any abnormal costs (which should be charged to expense as incurred), and test the validity and consistency of the method used to apply overhead costs to inventory. Test Work-in-ProcessIf you have a significant amount of work-in-process (WIP) inventory, the auditors will test how you determine the percentage of completion for WIP items. Review Inventory AllowancesThe auditors will determine whether the amounts you have recorded as allowances for obsolete inventory or scrap are adequate, based on your procedures for doing so, historical patterns, "where used" reports, and reports of inventory usage (as well as by physical observation during the physical count). If you do not have such allowances, they may require you to create them. Review Inventory OwnershipThe auditors will review purchase records to ensure that the inventory in your warehouse is actually owned by the company (as opposed to customer-owned inventory or inventory on consignment from suppliers). Review Inventory LayersIf you are using a FIFO or LIFO inventory valuation system, the auditors will test the inventory layers that you have recorded to verify that they are valid.
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Textbook solutions Auditing & Assurance Services - 7th Edition |
What is the audit procedure that is least likely to be performed in the inventory cycle of a merchandising company?
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