Efficient Tests of Balances Series—No. 16: Obtaining Substantive Evidence from Analytical Procedures for Inventories

For all levels of risk of material misstatement, analytical procedures normally performed for inventories would include:
 
  • Compare account balances in purchases, inventories and costs of good sold accounts with the preceding year or years. Investigate significant changes in amounts or deviations from trends.
  • Consider computing the following ratios and comparing to the prior year or years to evaluate the reasonableness of all assertions:
    • Inventory classifications (raw materials, work-in-process, finished goods) as a percent of total inventory.
    • Gross margin at the financial statement level and by product line.
    • Inventory turnover at the financial statement level and by product line.
 
Significant variations from analytical procedures require additional procedures to determine their effects are not causing the financial statements to be materially misstated. Significant variations are generally those that comprise dollar amounts over the lower limit for individually significant items at the financial statement classification level or, in the case of ratio analysis, percentage variations that are significant in relation to the auditor’s expectations.
 
Acceptable results from analytical procedures and/or additional procedures produce substantive evidence that may result in opportunities to reduce the tests of balances sample sizes. Once the auditor has investigated variations and determined either they aren’t the result of error or fraud, or proposed a journal entry to correct significant misstatements, the results of analytical procedures can be considered to have produced acceptable results. In other words, the analytical procedures with acceptable results provide substantive evidence that decreases the risk of material misstatement in the inventories financial statement classification. In such cases, less substantive evidence will be required from the detailed tests of balances.
 
Considering Fraud and Inherent Risk
 
Inventory items have a high risk of misappropriation, especially when inventories are not store securely and few key controls are being performed by management personnel. For perpetual inventory systems, complex accounting and pricing systems also increase the risk of misstatement. These factors may increase the inherent and control risk for inventories and raise the risk of fraud occurring and going undetected. High levels of professional skepticism should be used when performing inventories procedures. High levels of professional skepticism include:
 
  • Making inquiries for all unusual matters. Even a small variance in expectations revealed in analytical procedures or a small unidentified entry in purchases, costs of goods sold or inventories accounts, for example, could lead to a material error or fraud.
  • Evaluating and clarifying management’s responses to inquiries and communicating the responses to an engagement supervisor when such responses may indicate error or fraud (or when the staff assistant doesn’t know if it indicates error or fraud!).
  • Carefully evaluating client data and records, particularly inventory physical count records, for the possibility they could be erroneous or fraudulent.
  • Paying attention to discussions and activities of client personnel during the inventory observation and at other times that may raise suspicion about error or fraud.
 
These and other inventory auditing procedures are discussed in my live and on-demand webcasts in my Basic Staff Training Series. You can download syllabuses and register by clicking on the applicable box on the left side of my home page, www.cpafirmsupport.com.
 

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by Larry Perry, CPA, CPA Firm Support Services, LLC - Larry has over 40 years experience as a CPA practitioner, author of accounting and auditing manuals, author and presenter of live staff training seminars and author of webcast and self-study CPE programs.  He is co-founder of CPA Firm Support Services, LLC (www.cpafirmsupport.com), an organization providing resources, training and consulting to smaller CPA firms.  Larry writes a weekly blog on AccountingWEB.com focusing on small audits, reviews and compilations.  He is currently developing documentation manuals and handbooks for small audits, reviews and compilations and related electronic practice aids.

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