Inventory

1 Introduction

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Inventory is one of the more involved audit areas. It will usually be material for any business that manufactures or sells goods. Remember also that inventory directly affects both the statement of financial position (as a current asset) and reported profit (as closing inventory is deducted in calculating cost of sales). In particular, the auditor has to check:

• The quantity of the inventory and must make sure that it is properly described. If it’s not properly described it is going to be difficult to decide what its value should be as its condition has to be assessed. This includes not only its physical condition, but also whether the inventory is old and therefore not as saleable, or perhaps there is too much inventory so that it will have to written down to net realisable value.
  

• The value of the inventory. Cost can usually be ascertained by looking at purchase invoices/cost records, but there can be considerable disagreement over whether or not the costs are lower or higher than the inventory’s net realisable value, and indeed what the net realisable value should be.
  

• Ownership. Just because an item of inventory is in a client’s warehouse doesn’t mean that it is owned by the client. It may be third party inventory which is being held there, or the items may have been sold but have not been despatched yet.
  

2 Year-end physical inventory counts ('stocktake')

The main aspects of the stocktake include the following:

• Instructions. Remember, many stocktakes will take place only once a year and the procedures are therefore not that well-known or practised by many staff members. It’s very important that there is careful advance planning. Instructions have to be given out. Staff members have to be briefed. There may be training sessions.
  

• Preparation of the count area. The inventory area has to be prepared by tidying and sorting items. It’s important that slow-moving, damaged, old and third-party inventories can be identified.
  

• Pre-number each inventory location. All the shelves or inventory locations should be pre-numbered, ideally sequentially. Labels are often attached and the labels will have a number. They will describe the inventory location. They may have space in which the type and quantity of inventory can be recorded and there should be one or two spaces on the label which are signed off once the items have been counted and checked.
  

• Sequentially pre-numbered inventory sheets. The inventory is going to be listed on inventory sheets and it’s essential that these are sequentially pre-numbered in order to check that all inventory sheets have been returned and that the inventory is therefore likely to be complete.

• Count teams. Inventory counters or stocktakers will often work in pairs. Staff who work in the warehouse should not count or record inventories for which they are responsible, but staff who do not work in the warehouse may be unfamiliar with what they are seeing and counting. Probably the best solution is to have a mixed team. One person from the warehouse who knows about the inventory and one who is independent and who is less likely to alter inventory counts to cover up errors. They go round together, one will count, one will check. They sign off and mark each location as it is counted so that that inventory wouldn’t be counted twice. They mark the inventory location number on the stock sheets and the stock sheet numbers on the location label so that items can be later checked.
  

Note that it is not the responsibility of auditors to carry out the stocktake: it is their job to decide if the stocktake can be relied upon. What the auditors should do is:

• Look at the instructions that are issued in advance and identify any shortcomings for discussion with management.
  

• On the stocktaking day , to observe and evaluate the conduct of the count.
  

• The auditor will make some counts himself, noting down the description of the items, the quantity, and the location. They will also note down the number of the stock sheet in which that inventory item should be recorded.
  

• At some stage the auditor will have to make test checks on the accuracy of the count. The auditor will count some inventory quantities on the shelves and trace this to the inventory sheets and will then pick some items on the inventory sheets and go back to the inventory location and count the amount which is actually there to make sure that it agrees. Testing from 'physical to book' quantities relates to the completeness assertion; from 'book to physical' relates to the existence assertion.
  

• Make a note of the last few goods received notes and dispatch notes of the year. This will be used later in cut-off tests.
  

• At the end of the count it is essential for the auditor to check that all inventory sheets are recovered to make sure that no inventory is left out of a count.

3 Inventory valuation

Inventory sheets show the physical quantity and perhaps description of the inventories only. There is no value there yet. After the stocktake it is important to value inventory. You should know from your earlier studies of financial reporting that cost may include:

• Purchase price - agreed to suppliers’ invoices
  

• Conversion costs (including production overheads) - agreed to costing records. There could be many calculations to do here.
  

Value = Cost/unit x Quantity

The values of the individual items will be added up to form a grand total of the inventory. It’s very important that these calculations are checked, including the addition of the final column. Remember any value you like can be put in for closing inventory and the accounts will always balance, but for every dollar added to the value of closing inventory there is a dollar added to the reported profit.

Management must now consider whether inventory identified as slow-moving, damaged or obsolete needs to be written down below cost. For retail goods, management would consider, for example, the selling prices of inventory after the year end. For inventory of a specialised nature, management and/or the auditor may require the assistance of an expert (see Chapter 23).

4 Cut-off: purchases

Cut-off is the assertion that classes of transactions (and events) have been recorded in the correct accounting period. If a goods received note is dated shortly before year end then, assuming those items have not been sold already, we would expect them to be found in inventory and if they are recorded in inventory, they should also be recorded in purchases and payables.

If they were counted in inventory but not in purchases and not in payables, the calculation of profit would be incorrect. The purpose of the closing inventory adjustment is to adjust the purchases figure to give a cost of sales figure.

If a goods received note, however, is dated after year end, the likely assumption should be that the goods were not in inventory at the year end date and therefore were not counted. If they are not in inventory they shouldn’t be in purchases and they shouldn’t be in payables.

We are looking here at consistency. At one level that doesn’t really matter whether goods are included in inventory or have not yet been received. But we must be consistent: if they are in closing inventory we have to recognise that we have purchased them; if they are not in closing inventory because they haven’t arrived yet, we mustn’t recognise that we have purchased them.

Part of what the auditor is likely to do when attending a physical stocktake at year end is to note down the numbers of good received notes issued in the last few days of the year so that later the auditor can check that the company has properly accounted for those items being purchased and being in payables.

5 Cut-off: sales

Checking cut-off in sales is also important. If an item is recorded as having been sold, in other words it has been debited to receivables and credited to sales, it should not also appear in inventories. To verify this, at the stocktake the auditor would normally note down details of the last goods dispatched notes issued at the end of the year and perhaps the numbers of the first few issued after the year end.

If a goods dispatched note has been issued before year end then, generally speaking, we would say that those goods been sold and the items should be in sales and receivables. Those goods should not be included in inventories (even if physically still on the client’s premises because they haven’t yet been delivered).

If a goods dispatched note was issued after year end then the normal assumption is that the goods have not been sold at year end. The item should not be in sales, should not be in receivables but if it hasn’t been sold, it should be counted in closing inventories.

Although shifting the saleable item from one financial year to another will alter the profits in those two years, what’s really important in cutoff is consistency. If something is regarded as having been sold at the year end it should not be counted in closing inventory; if it is not regarded as having been sold at the year end, it should be in closing inventory.