Inventory obsolescence refers to a situation where the inventory items held by a company have become outdated, unmarketable, or otherwise unusable.
This can lead to a decrease in the value of the company’s assets and negatively impact its financial statements. To mitigate these risks, auditors must perform a thorough review of the company’s inventory valuation and obsolescence procedures.
Accounting Under IFRS
The International Financial Reporting Standards (IFRS) provides guidance on the recognition, measurement, and disclosure of inventory obsolescence. IFRS requires companies to value their inventory at the lower of cost or net realizable value, which 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.
If an item of inventory is no longer expected to be sold, its carrying amount should be written down to its net realizable value.
The following are ten common audit risks associated with inventory obsolescence:
- Misclassification of inventory items as obsolete
- Inadequate provisions for obsolescence
- Inaccurate determination of net realizable value
- Inadequate procedures for identifying and evaluating obsolescence
- Lack of timely write-downs for obsolete inventory
- Inaccurate calculation of inventory reserves
- Inadequate control over the recording of obsolescence provisions
- Inadequate documentation supporting the obsolescence calculations
- Reliance on outdated or inaccurate data
- Inadequate segregation of duties over the inventory obsolescence process
In the context of inventory obsolescence, auditors should focus on the following audit assertions:
- Existence: The inventory items are recorded in the books and exist physically.
- Valuation: The inventory items are valued at the lower of cost or net realizable value.
- Rights and Obligations: The company has the right to sell the inventory items and the obligation to transfer them to the buyer.
- Completeness: All inventory items are recorded in the books and no items are missing.
- Accuracy: The inventory items are recorded at the correct cost and quantity.
Walkthrough testing is a type of substantive audit procedure used to test the accuracy of the financial statements and the internal control system. In the context of inventory obsolescence, walkthrough testing may include the following steps:
- Observing the physical inventory counting process
- Tracing the inventory items from the purchase order to the general ledger
- Testing the accuracy of the inventory balances in the general ledger
- Evaluating the inventory write-down process and determining if the write-downs are appropriate and timely
- Reviewing the supporting documentation for inventory obsolescence provisions
Test of Control
The test of control is an audit procedure used to assess the effectiveness of the company’s internal control system. In the context of inventory obsolescence, the following control activities should be tested:
- The process for identifying inventory items that are potentially obsolete
- The process for calculating net realizable value
- The process for recording inventory write-downs
- The segregation of duties over the inventory obsolescence process
- The accuracy of the inventory balances in the general ledger
Substantive Audit Procedures for Inventory Obsolescence
Substantive audit procedures refer to the steps auditors take to gather evidence and test the financial statements of a company. When auditing inventory obsolescence, the following are the key substantive audit procedures that auditors should consider:
- Review of Aging Report: An aging report helps auditors to understand the aging of inventory items, including how long each item has been in stock and when it may become obsolete.
- Assessment of Slow-Moving Inventory: Slow-moving inventory is a key indicator of obsolescence and auditors should perform an assessment to identify such items.
- Evaluation of Sales Trends: Auditors should evaluate sales trends to determine if there are any changes in sales patterns that may indicate obsolescence.
- Evaluation of Economic Indicators: Economic indicators such as changes in consumer preferences, market demand, and competition can impact inventory obsolescence and auditors should evaluate them.
- Physical Inventory Count: Physical inventory counts can help auditors verify that the company’s inventory balances are accurate and up-to-date.
- Testing of Inventory Valuation Methods: Auditors should test the methods used by the company to value its inventory, including first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost.
- Evaluation of Write-Offs and Provisions: Write-offs and provisions are a common way to account for inventory obsolescence and auditors should evaluate them to ensure they are appropriate.
- Review of Management Adjustments: Auditors should review any adjustments made by management to the company’s inventory balances, such as write-downs or write-offs, to ensure they are appropriate.
- Assessment of Internal Control: Auditors should assess the company’s internal control over inventory management to ensure that proper procedures are in place to prevent obsolescence.
- Discussion with Management: Auditors should discuss the findings of their audit procedures with management to ensure that any issues identified have been addressed.
In conclusion, substantive audit procedures play a critical role in verifying the accuracy of the company’s financial statements, and the steps outlined above will help auditors to effectively audit inventory obsolescence.