Since the AICPA's Financial Reporting Framework for Small- to Medium-sized Entities (FRF for SMEs) and some other financial reporting frameworks use the accrual basis of accounting, matching costs of goods sold with sales revenues in the period of sale is a basic principle. Determining inventory quantities and values is, therefore, an important management responsibility for most frameworks, including the FRF for SMEs. As described in the following paragraphs there is, however, a difference from U.S. GAAP when applying the lower of cost or market principle to inventory valuations.
U.S. GAAP Requirements
Inventories are valued under FIFO, LIFO, average cost, specific identification, or retail methods at the lower of cost or market. Inventory costs are not permitted to exceed the ceiling of net realizable value (selling price less costs of completion and disposal) or be less than the floor of net realizable value (ceiling of net realizable value less a normal profit margin).
FRF for SMEs Requirements
Inventories are valued at the lower of cost or the ceiling of net realizable value determined under the FIFO, LIFO, average cost, specific identification, or retail methods (selling price less estimated costs of completion and disposal). General disclosures are:
- Accounting policies and costing method.
- Carrying amounts of inventories in total and by appropriate classifications, e.g., raw materials, work-in-progress, finished goods, merchandise, supplies.
- Costs of goods sold for periods presented.
- Unusual or material losses resulting from costing methods.
- Material purchase commitments and any expected loss when the purchase price exceeds market value.
- Any interest costs capitalized in inventories.
Learning how to audit inventories for any framework centers on inventory observations, pricing and clerical tests, and learning to "what extent" auditing procedures should be applied. Somewhat different than with other major audit areas, entities that account for inventories using either the physical or perpetual inventory methods experience most of their risks of material misstatement in counting, pricing, and compiling the inventory components.
Similar to other audit areas, the amount of audit work for inventories depends on the risk of material misstatement (RMM) evaluations at both the financial statement and classification (assertion) levels. Based on an understanding of a client's industry and its business (particularly its operations), the nature of its inventories, and its inventory accounting method (physical or perpetual), the auditor identifies the risks of material misstatement and designs auditing procedures to gather evidence to evaluate the financial statement assertions for inventories.
The Relevant Auditing Standards
Specific Auditing Standards for inventory are published in the AICPA Professional Standards, AU Section 331. Some of the key issues in this section include:
- Inventory observation is a generally accepted auditing procedure (before the McKesson Robbins case inventories could be confirmed by auditors).
- For physical counts of inventory, the auditor must usually be present at the time of the count to observe count procedures, make test counts, and inquire about potential risks of material misstatement.
- For accurate perpetual inventory records, the auditor's observation procedures may be performed at periods during or after the year being audited.
- For statistical methods of sampling inventory, the auditor must be satisfied that the client's methods produce reliable results that are substantially the same as a count of all items. The auditor must be present for representative counts and must evaluate the sampling plan and its application to determine that results are reasonable and statistically valid.
- For inventories held in public warehouses, quantities may be confirmed, but additional procedures are usually necessary. Examples of such additional procedures are obtaining an audit report on the warehouseman's internal control or applying appropriate procedures at the warehouse to determine confirmed information is reliable. Other procedures such as observing physical counts of the goods and testing the owner's procedures for investigating and evaluating the warehouseman's performance may be necessary in some cases if practical and reasonable.
In Part 2 of this article, the impact of risk of material misstatement on inventories auditing procedures will be discussed. For live and on-demand webcasts on this and other subjects, click on the applicable box on the left side of my home page, www.cpafirmsupport.com. Be sure to register on my website to receive a 20 percent discount on all webcast products purchased through the site portal.