Inventories are a crucial part of most businesses and play a significant role in the financial statements. It is crucial to ensure that the inventory is valued correctly, as overvaluation or undervaluation can lead to significant financial misstatements. In this article, we will discuss the audit procedures for inventory valuation and the inherent risks involved.
Accounting Under IFRS
International Financial Reporting Standards (IFRS) requires inventories to be measured at the lower of cost and net realizable value. Cost is determined using one of the following methods:
- First-In, First-Out (FIFO)
- Weighted Average Cost
- Specific Identification
Disclosure requirements include:
- Nature of inventories
- Measurement basis used
- Methods and significant assumptions used in estimating the amount of inventory
- Any provisions made for slow-moving, obsolete, or damaged inventory
Audit Risks
- Inaccurate Inventory Counts: Improper or incomplete inventory counts can result in over or under valuation of inventory.
- Improper Costing Methods: If an incorrect costing method is used, it can lead to over or under valuation of inventory.
- Inadequate Physical Controls: A lack of physical controls can lead to theft, damage, or loss of inventory, which can result in incorrect valuation.
- Inaccurate Record Keeping: Poor record-keeping can result in incorrect valuation of inventory.
- Misclassification of Inventory: Improper classification of inventory can result in incorrect valuation.
- Unauthorized Adjustments: Unauthorized adjustments to inventory records can result in incorrect valuation.
- Obsolescence: Inventory can become obsolete due to changes in consumer demand or technological advancements, leading to incorrect valuation.
- LIFO Reserve: If a LIFO reserve is established, it can result in incorrect valuation of inventory.
- Slow-Moving Inventory: Provisions for slow-moving inventory can result in incorrect valuation of inventory.
- Overvaluation of Work-in-Progress: Overvaluation of work-in-progress can result in incorrect valuation of inventory.
Walkthrough Testing:
Walkthrough testing is an important step in the audit procedure of inventory valuation. It is a process where the auditor reviews the documentation and procedures that are related to the valuation of inventory to understand the systems and controls that have been put in place by the entity to ensure the accuracy of the inventory balances.
During walkthrough testing, the auditor will examine the following aspects of the entity’s inventory processes:
- Receiving of goods: the auditor will check if there are adequate procedures in place for the receiving, documenting and inspecting of goods that have been received.
- Physical counts: the auditor will examine the process of performing physical counts of inventory, including the frequency and procedures for counting, to ensure the accuracy of the inventory balance.
- Recording of transactions: the auditor will review the procedures for recording transactions related to inventory, including purchase orders, sales orders, and other transactions, to ensure that all transactions are recorded accurately and timely.
- Valuation of inventory: the auditor will assess the methods used by the entity for valuing its inventory, including cost methods, to ensure that the inventory is valued correctly in accordance with IFRS.
- Cutoff procedures: the auditor will evaluate the procedures for determining the cutoff date for inventory transactions, which is the date up to which transactions are included in the financial statements.
By conducting walkthrough testing, the auditor can obtain a good understanding of the entity’s inventory processes, the systems and controls that are in place, and the risks of material misstatement related to inventory valuation. This information can be used to plan the audit procedures and assess the risks of material misstatement.
Test of Control:
Test of control refers to a set of procedures performed by auditors to assess the operating effectiveness of a company’s internal control over its inventory valuation. The objective of these procedures is to determine the extent to which the company’s controls mitigate the risks of material misstatement in the financial statements.
In the context of inventory valuation, the test of control can be performed through several methods such as:
- Observation: This involves observing the physical inventory count process to ensure it is performed in accordance with the company’s policies and procedures.
- Inquiry: This involves asking questions of the company’s employees involved in the inventory count process to obtain an understanding of their roles and responsibilities.
- Inspection: This involves reviewing documentation such as inventory count sheets, inventory reports, and other relevant records to assess the accuracy and completeness of the company’s inventory information.
- Reperformance: This involves recalculating the inventory balances based on the data obtained from the company’s records, to determine the accuracy of the company’s inventory valuation.
The results of the test of control procedures should be documented, and any significant deficiencies in the company’s internal control over inventory valuation should be reported to management.
Substantive Audit Procedures
Substantive audit procedures are performed by auditors to obtain sufficient appropriate evidence to support their audit conclusions regarding the accuracy and completeness of a company’s financial statements. In the context of inventory valuation, the following substantive audit procedures can be performed:
- Analytical procedures: This involves comparing the current year’s inventory balances to the previous year’s balances and analyzing any significant fluctuations.
- Confirmation: This involves sending inquiries to external parties such as suppliers or customers to verify the existence and accuracy of inventory held by the company.
- Observation: This involves observing the physical inventory count process to assess the accuracy and completeness of the inventory information.
- Recalculation: This involves recalculating the inventory balances based on the data obtained from the company’s records, to determine the accuracy of the company’s inventory valuation.
- Reperformance: This involves tracing the calculation of inventory cost from the raw materials stage to the finished goods stage to assess the accuracy of the company’s inventory valuation.
- Sampling: This involves selecting a sample of items from the company’s inventory and performing substantive procedures on that sample to assess the accuracy and completeness of the inventory information.
- Inquiry: This involves asking questions of the company’s employees involved in the inventory count process to obtain an understanding of their roles and responsibilities.
- Inspection: This involves reviewing documentation such as inventory count sheets, inventory reports, and other relevant records to assess the accuracy and completeness of the company’s inventory information.
- Comparison: This involves comparing the company’s inventory balances to industry benchmarks to assess the reasonableness of the company’s inventory valuation.
- Reconciliation: This involves reconciling the company’s inventory balances to the amounts reported in its general ledger, to assess the accuracy and completeness of the company’s inventory information.