The audit is defined as one of the most cumbersome tasks during a financial year-end. It includes a wide variety of tasks that need to be included in terms of ensuring that proper auditing inventories are duly maintained. As a matter of fact, it can be seen that auditing inventory is referred to as the process of cross-checking financial records along with physical inventory and records whether inventories are correctly recognized, measure, and disclosed in accordance with the applicable accounting standards. This is also involve directed towards reconciliation of physical inventory with the amount that is declared by the company in the financial statements.
Definition of Inventory Audit
Auditing Inventory is considered to be one of the most important steps in a typical auditing process. This is because unlike other transactions, which can be backed by proof of payment or invoices, inventory audit needs to be physically reconciled. However, it is often impractical to conduct an end-to-end physical inventory audit in order to reconcile the actual inventory on hand with the declared inventory. Therefore, it calls for some audit procedures to be followed that can possibly streamline this and ensure that the best possible results are derived as a result.
Another aspect that needs to be taken into consideration here is the fact that inventory in itself tends to be one of the riskier features within an organization. This is because it can be tweaked by the organization as an act of fraud, or it might be misstated in order to give an incorrect impression to other stakeholders of the company. Hence, it is rudimentary for organizations, as well as auditors to ensure that proper controls are in place so that the overall inherent risk pertaining to fraud as a result of inventory is reduced to a minimum extent.
Therefore, auditing inventory is not solely about physical verification, it includes a variety of other procedures that are used by the auditors in order to make sure that there are no material misstatements in the financial statements.
Risks associated with Inventory and Inventory Audit
Inventory Audit is considered to be an essential step in the accounting process, predominantly because of the fact that it helps the company safeguard itself from potential losses. There are certain risks that are inherent in the audit process, and these risks need to be minimized to the utmost extent. Auditors need to make sure that both, the risk of material misstatement and the detection risk are minimized during the inventory audit.
Further description of the risk involved in the audit process are as follows:
- In order to safeguard the majority stakeholder interest, it is important for organizations to conduct a proper inventory audit. There should be no material misstatements pertaining to inventory because this can potentially tamper with the actual financial position of the company.
- In the case where inventory is misstated, or it is not accounted for properly, it is indicative of possible fraud or embezzlement within the company. This is a significant red flag, which might result in severe financial losses to the company in the longer run.
- For items in transit, or for high-value items, the auditors cannot be entirely sure about the existence of these particular items. Therefore, if they are declared as such by the organization, auditors need to ensure that their existence is actually validated.
For Audit Inventory, the following audit assertions are tested:
- Existence: This audit assertion states that there is a need to ensure that inventory balances actually exist with the company on the reporting date.
- Completeness: Inventory that is reported on the Balance Sheet should be complete, and should fully be representative of the amount of inventory that the company has.
- Rights and Obligations: All the inventory that is mentioned on the financial statements of the company should be under the possession of the company. The company should have a legal entitlement towards these inventory-related items.
- Valuation: All the inventory that is mentioned on the financial statement should be in accordance with the true economic value of the inventory. This means that all accounting principles should be properly followed, and therefore, they should be declared at their correct value in the financial statements.
- Presentation and Disclosure: Any disclaimers pertaining to inventory should be properly disclosed in the financial statements. All proper presentation-related clauses should be accounted for in the financial statements.
Inventory Audit is a highly subjective aspect of auditing, and therefore, it varies from organization to organization. For larger organizations that have several pieces of inventory, it is often harder to physically count all the different units within the company. In this regard, there are several different procedures that can be inculcated by companies. These procedures include the following:
The description of some of the most commonly used audit procedures are as follows:
- Cut-Off Analysis: This is basically the act of auditors examining if inventory additions have been properly accounted for in the respective analysis. This implies that for every respective month-end or weekend, any further incoming inventory would not be counted for in the previous week. The main rationale here is to ensure that there is no extraneous inventory mentioned on the financial statements at the year-end.
- Observation and extrapolation: Since larger inventory options are often harder to physically count for, auditors often observe the processes, or internal controls, that are present within the company to ensure that proper observation has been carried out. In this regard, it is important for auditors to observe the relevant procedures, to inspect the internal reconciliations of the company. Followed by this, they can collect data points based on which they can easily identify the relevant inventory protocols and if the inventory mentioned on the financial statement is actually accurate.
- Testing high volume items: Materiality tends to be an increasingly important component within the audit process. Therefore, some auditors tend to focus on high volume items in order to make sure that they are properly accounted for in the financial statements. This is often implemented using a
- Testing error-prone items: There are a lot of ‘high-risk’ inventory items that an organization might possess. In this regard, it is important for auditors to ensure that auditors are able to test these high-error items, in order to mitigate the overall risk involved.
- Testing Inventory in Transit: Inventory in transit is also checked upon by auditors in order to account for various differences between inventory controls
- Finished goods cost analysis: This applies to manufacturers – who need to ensure that all finished goods are accounted for in the inventory and there are no miscalculations or overstatements.
Challenges Associated with an Inventory Audit
Given the fact that inventory audit is considered to be a very important step, yet it is not as simple as it is perceived to be. There are a couple of challenges from the perspective of the auditor when conducting an inventory audit. These challenges are enlisted below:
- Inventory Audits are generally time-consuming: Inventory Audits take a significant amount of time because auditors need to test inventory against all assertions. Particularly in the case of manufacturing concerns, there are several inventories maintained and hence, this tends to be a relatively time-consuming task.
- Difficult to scale and extrapolate: Since it is practically impossible for auditors to ensure all inventory items are physically verified, it is difficult for auditors to scale and extrapolate. There is a thin line between extrapolating and over-generalizing.
- It hinders other parts of the audit: Since inventory in itself is an integral part of both financial statements (Income Statement and Balance Sheet), it needs to be fully completed before auditors can move on to the next part of the audit.