Inventories are a significant component of a company’s assets and are often subject to frequent fluctuations. Thus, the proper recognition, measurement, and presentation of inventories are crucial for financial statement users to understand a company’s financial position and performance.
In this article, we will discuss the accounting treatment of inventories, audit risks, audit assertions, walkthrough testing, test of control, and substantive audit procedures for inventories.
The accounting treatment of inventories is governed by International Financial Reporting Standards (IFRS) and the International Accounting Standard (IAS) 2 “Inventories.”
According to these standards, inventories are recognized as assets when they meet the criteria of being owned by the entity, held for sale in the ordinary course of business, and in a condition that is ready for sale. The cost of inventories must also be determined and can be either the purchase price or the production cost, whichever is lower.
Inventories are reported on the balance sheet at the lower of cost or net realizable value. The cost of inventories includes all costs incurred to bring the inventory to its present location and condition, including the purchase price, direct costs, and indirect costs.
The net realizable value of inventories 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.
- Misrepresentation of inventory quantities: The misrepresentation of inventory quantities can cause overstatement or understatement of inventory values and affect the financial statements.
- Misrepresentation of inventory costs: Improper inventory costing methods can result in overstatement or understatement of inventory values and affect the financial statements.
- Lack of control over inventory transactions: Lack of control over inventory transactions can result in incorrect inventory values and affect the financial statements.
- Misclassification of inventory: Misclassification of inventory as an asset instead of a liability can result in incorrect inventory values and affect the financial statements.
- Improper recognition of obsolete or slow-moving inventory: Improper recognition of obsolete or slow-moving inventory can result in overstatement of inventory values and affect the financial statements.
- Inadequate cut-off procedures: Inadequate cut-off procedures can result in incorrect inventory values and affect the financial statements.
- Lack of physical inventory count: Lack of physical inventory count can result in incorrect inventory values and affect the financial statements.
- Unrecorded inventory transactions: Unrecorded inventory transactions can result in incorrect inventory values and affect the financial statements.
- Misrepresentation of inventory obsolescence: Misrepresentation of inventory obsolescence can result in incorrect inventory values and affect the financial statements.
- Inadequate review of inventory transactions: Inadequate review of inventory transactions can result in incorrect inventory values and affect the financial statements.
Audit assertions refer to the expectations that management has regarding the existence and completeness of inventory. These assertions are made by management as part of the financial reporting process and are based on their understanding of the inventory management system.
The following are the common audit assertions that are relevant to inventory:
- Existence: This assertion is concerned with the presence of inventory in the company’s physical possession. This means that the auditor must verify that the inventory items are actually present and available for use or sale.
- Completeness: This assertion is concerned with whether all inventory items are recorded in the company’s books. The auditor must verify that all inventory items, including slow-moving or obsolete inventory, have been properly recorded.
- Valuation: This assertion is concerned with the accuracy of the values assigned to inventory items. The auditor must verify that inventory has been valued correctly based on the principles of cost accounting.
- Rights and Obligations: This assertion is concerned with ensuring that the company has the right to use and sell the inventory items and that it has no obligations to third parties that may restrict their use or sale.
- Presentation and Disclosure: This assertion is concerned with the accuracy and completeness of the disclosure of inventory in the financial statements. The auditor must verify that the information provided in the financial statements is accurate and complete, including the manner in which inventory is presented, such as whether it is recorded at cost or market value.
In conducting their audit, auditors should consider the audit assertions relevant to inventory and perform audit procedures to test them. These procedures may include physical inspection of inventory, review of inventory records and documentation, and testing of inventory management processes and controls.
Walkthrough Testing is a type of audit procedure that focuses on the flow of transactions within an entity’s systems and processes. The objective of this testing is to understand how transactions are recorded, processed and reported to ensure that they are complete, accurate, and in compliance with accounting standards and regulations.
During a walkthrough test, the auditor will follow the flow of transactions from source documents to the financial statements. This may involve reviewing process flowcharts, interviewing employees, observing the process, and testing the controls in place.
The main focus of a walkthrough test is to identify any areas where transactions may be recorded inaccurately or omitted, and to assess the controls that are in place to prevent these errors. The auditor will also look for any areas where fraud may be taking place, or where the risk of fraud is high.
It is important to note that walkthrough testing is not the same as substantive testing, although the two procedures are often performed in conjunction with each other.
Substantive testing focuses on the accuracy of the financial information, while walkthrough testing focuses on the process and controls that ensure that the financial information is accurate.
Walkthrough testing is an important component of the audit process, as it helps auditors to gain a comprehensive understanding of the entity’s systems and processes.
This information is then used to inform the development of the audit plan, including the selection of other audit procedures, such as substantive testing and test of control procedures.
Test of Control:
Test of Control refers to the procedures that auditors perform to evaluate the effectiveness of the controls in place to mitigate risks to the financial statements.
The purpose of the test of control is to provide the auditor with sufficient evidence to support the auditor’s opinion that the financial statements are free from material misstatement due to fraud or error.
During the audit of inventory, the auditor should perform the following tests of control to assess the reliability of the inventory management process:
- Physical inventory counts: The auditor should observe or participate in the physical count of inventory to verify that the process is properly designed and followed.
- Documentation review: The auditor should review inventory documentation, such as purchase orders, receiving reports, and bills of lading, to determine whether the process is adequately documented and properly supported.
- Segregation of duties: The auditor should assess the segregation of duties in the inventory management process to ensure that there is an adequate level of control over the movement of inventory.
- Authorization and approval procedures: The auditor should review the procedures for authorizing and approving inventory transactions to determine whether they are appropriate and properly followed.
- Cutoff procedures: The auditor should test the cutoff procedures for inventory transactions to ensure that inventory transactions are recorded in the correct period.
- Valuation procedures: The auditor should test the valuation procedures used to determine the cost of inventory to ensure that the amounts are accurate and reliable.
- Observation of the annual physical inventory count: The auditor should observe or participate in the annual physical inventory count to verify the accuracy of the inventory balances.
- Testing of the IT system: The auditor should test the IT system used to manage inventory to ensure that it is functioning properly and effectively mitigating risks to the financial statements.
Overall, the test of control is an important part of the audit process and helps the auditor to determine the reliability of the inventory management process.
It provides the auditor with the necessary evidence to support their opinion that the financial statements are free from material misstatement due to fraud or error.
Substantive Audit Procedures
Substantive audit procedures refer to the specific audit steps taken by auditors to obtain sufficient and appropriate evidence to support their opinions on the financial statements of a company.
In the context of an audit of inventory, the substantive audit procedures are performed to provide assurance on the existence, ownership, accuracy, and completeness of inventory.
The substantive audit procedures that auditors may perform include, but are not limited to:
- Physical observation: Physical observation of the inventory provides evidence of its existence and the control over it. This includes observing the physical inventory counting process and comparing the results to the inventory records.
- Analytical procedures: Analytical procedures are performed to identify unusual trends and patterns in the inventory data. This helps auditors identify potential misstatements and areas that need further investigation.
- Confirmations: Auditors may send confirmations to suppliers or customers to confirm the existence of inventory items, especially for items that are difficult to physically observe.
- Cut-off testing: Cut-off testing is performed to ensure that inventory transactions are recorded in the correct period. This involves reviewing transactions near the end of the period to ensure that they were recorded in the correct financial statement period.
- Recalculation: Auditors may recalculate the inventory quantities and values to verify the accuracy of the records. This includes comparing the results to the inventory records to identify any discrepancies.
- Tests of detail: Tests of detail are performed to provide evidence to support the inventory amounts on the financial statements. This may include reviewing a sample of transactions or detailed tests of specific items in the inventory.
- Agreed-upon procedures: Agreed-upon procedures refer to procedures agreed upon between the auditor and the client in advance to obtain specific audit evidence. This may include procedures specific to the inventory, such as a count of a specific item or location.
The substantive audit procedures performed by auditors are designed to provide reasonable assurance that the financial statements are free from material misstatements.
The nature, timing, and extent of substantive audit procedures depend on the auditor’s assessment of the risks of material misstatement, and their overall audit strategy.