SCRAP INVENTORY

It would be helpful to have some context to be sure what you mean. Let’s assume you mean any inventory, generally, which has a “scrap” value – i.e. a value that is usually low, relatively to cost, for disposing of inventory (whether it is damaged, technically obsolete, out of fashion or perishable).

Assuming that quantities are verifiable (e.g. by physical count) the main financial statement at risk is valuation. Audit procedures should confirm that the inventory is measured at net realisable value. This would involve, for example, examining sales invoices after the reporting date and verifying the costs of disposal.

If the business has an alternative use for the scrap items (e.g. they could be “reworked” into different products) it would be necessary to consider the costs of reworking and the likelihood, if only planned rather than carried out.

For example, a clothes manufacturer has 1,000 pairs of trousers which cost $10 each. Due to a faulty production run they cannot be sold at the usual selling price of $25 each. The company has 2 options:
(1) To sell them all to a customer for $500 for which it would incur a packing and delivery cost of $100.
(2) To rework them into shorts for a total cost of $4,000 and and sell them at $10 each.

If (1) was the only option the net realisable value would be $400.
However, the realisable value of option (2) is $6,000 ($10,000 – $4,000), assuming no selling costs.

If when conducting the final audit the rework has been carried out, the auditor would examine production cost records to verify the $4,000 and sales invoices to see that the shorts are selling at $10.
If the reword hadn’t yet been carried out, the auditor would need evidence that it would happen – considering the time that has elapsed since the fault was found, whether similar faults have been rectified in the past, planned production scheduling (perhaps the reworking is scheduled for the introduction of a “summer” catalogue) and management representation.

The audit risk is that inventory (and hence profit) is overstated unless management writes it down to net realisable value (which may be nil). The answer published by ACCA for substantive procedures is:
– Obtain a schedule of the $1 million damaged cola products and cast.
– During the inventory count identify the quantity of the damaged goods and agree to the schedule.
– Discuss with management their plans for disposing of these goods, whether they believe these goods have a net realisable value (NRV) at all or if they will need to be scrapped.
– If any of the goods have been sold post year end, agree to the sales invoice to assess NRV.
– Agree the cost of the inventory to supporting documentation to confirm the raw material cost, labour cost and any overheads attributed to the cost.
– Quantify the level of adjustment required to value inventory at the lower of cost and NRV and discuss with management.