Efficient Tests of Balances Series—No. 14: Balancing Risk and Audit Standards for Inventories

Feb 27th 2012
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 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 owners).
  • 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 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.
Learning how to audit inventories centers on inventory observations, pricing and clerical tests and learning to “what extent” auditing procedures should be applied. Somewhat different than 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 prevent the financial statement assertions for inventories from being misstated.
As RMM (the combination of inherent and control risk) increases, more and better evidence is needed to verify financial statement assertions. Possible effects of high and low risk on inventories observation, pricing and clerical audit procedures are outlined in the following table.
Level of Risk of Material Misstatement
Illustrative Procedures Based on Risk
High risk—physical inventory method, no count instructions prepared and count performed by untrained employees. Inventory pricing and compilation performed internally without review
Observation test counts, pricing and clerical tests will be extensive. The LL of ISIs will be low as a result of the high risk. Physical control of the inventory count, count sheets or tags placement and collection and the inventory compilation procedures may be necessary.
Moderate risk—physical inventory method, good count instructions prepared and followed and trained employees or professionals used to perform the count. Inventory pricing and compilation performed internally but reviewed and checked by a responsible person (controller, CFO, etc.)
Good count instructions and trained employees reduce the RMM during the physical count, pricing and compilation of the inventory. Observation test counts, pricing tests and clerical tests will be fewer. The auditor’s objective will be to determine that employees are complying with client instructions, policies and procedures.
Low risk—perpetual inventory method, cycle counts performed, tests counts made by trained employees or professionals with written instructions and results indicate records are accurate. Inventory pricing and cost buildups reviewed and approved by top finance department authority or other responsible person.
The auditor’s objective when risk is low is to determine that the client’s internal control, accounting systems and policies and procedures over inventories are designed and operating properly. Observation of cycle counts must be representative of all items and locations. Inventory cost buildups must be tested through representative sample selections.
Live and on-demand webcasts in my Basic Staff Training Series include detailed guidance on how to balance risk and the audit standards for inventories and other audit areas. You can obtain syllabuses and register by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com.

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