CHAPTER 11

The audit of inventory

EXAM FOCUS
Examination questions on inventory are popular at this level. Inventory is often the m ost
significant asset on the balance sheet and the balance sheet value may involve some subjective
judgements. A small variation in balance sheet value can be magnified w hen measuring
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apparent incompetence in verifying this item.

A good student w ill always try to answer questions w ith the relevant level of detail so make
sure that you absorb the various issues on controls and audit procedures. A question on
inventory is a source of easy marks if you adopt a structured approach in your answer.

SYLLABUS AND STUDY GUIDE COVERAGE

This chapter covers the following elements of the ACCA study guide:

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¨ Describe, illustrate and analyse how internal control systems over the inventory
transaction cycle operate in both large and small entities.

¨ Describe and illustrate the use by auditors of internal control checklists for the
inventory transaction cycle.

¨ Describe and tabulate tests of control of inventory for inclusion in a work program.

¨ Explain and illustrate how structural and operational weaknesses in inventory

systems should be reported to management and how recommendations should be
made.

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¨ Explain the importance of inventory, describe inventory counting procedures and

explain cut-off.

¨ Describe and tabulate for inclusion in a w ork program the substantive procedures
used in obtaining evidence in relation to inventory.

¨ Explain the purpose of substantive procedures in relation to financial statement

assertions concerning inventory.

In order to cover these elements the follow ing topics are included:

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1 Introduction
1.1 Audit duty
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(a) management are competent to physically ascertain the inventory;

(b) management are competent to judge its condition;

(c) inventory is valued objectively using generally accepted accounting principles and
presented in the financial statements in such a manner as to give a true and fair view
and to com ply with current legislative requirements.

1.2 Financial statement assertions

It is important that you should focus on the financial statement assertions that are relevant to
inventory. They are as follow s:

¨ All items of inventory are owned by the entity. (This is an important assertion w hen
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also the section on reservation of title clauses.)
¨ The inventories are valued using bases that are relevant to the business of the entity.
¨ The inventory valuation policy complies with law and GAA P and this policy has been
followed consistently from year to year.
¨ The goods are valued according to the principles of historical cost accounting ie, they are
valued at the lower of cost and net realisable value. They w ill, if sold, realise at least their
balance sheet value.
¨ The goods physically existed at the balance sheet date.
¨ The presentation of the item in the financial statements is consistent with the stated
accounting policy.

1.3 Reporting to management

As inventory is often the largest asset on the balance sheet, it may carry a considerable level of
inherent risk. Ultimately, management are the people w hose exercise of judgement and
expertise are of considerable relevance to arriving at a fair valuation of inventory. The auditor
must be diligent in his audit approach and should be sensitive to any issues that m ight cast
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letter (ISA 260) should therefore highlight any organisational or structural weaknesses that
come to light in the audit of inventory. Typical issues that require audit attention are:

¨ Identifying any control weaknesses in the inventory keeping system which could expose
the entity to significant loss eg, poor custodial controls over goods that could lead to theft
or damage.
¨ Reporting any weaknesses in accounting records which w ould indicate that control
systems were poor.
¨ Reporting on any breakdow ns in system s of supervision (large amounts of surplus goods
do not arise from any other cause).
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designed to cosmetically improve the results.
¨ Obtaining reassurance on any changes in accounting treatment (eg, classifying obsolete
goods as saleable or vice versa) by means of a suitably w orded letter of representation
(ISA 580).

2 Audit procedures
2.1 Methods of ascertainment of inventory
(a) Year-end inventory counts ² 7KLV LV D YHU\ FRP PRQ PHWKRG E\ ZKLFK PDQDJHPHQW
ascertain the amount of inventory for inclusion in the financial statements. The
enterprise may well have a system of mem orandum inventory records, but these are

160
 Chapter 11 The audit of inventory

not relied upon for the calculation of the closing inventory. The inventory records,
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reassurance to support the physical quantities recorded during the inventory count.
This is particularly relevant to smaller undertakings.

(b) Continuous inventory counting ² ,Q PDQ\ PDQXIDFWXULQJ EXVLQHVVHV HVSHFLDOO\ WKRVH
engaged in continuous processes) the enterprise can ascertain its inventories from a
system of continuous inventory w here:

(i) the cost accounts for w ork in progress and finished goods are integrated with
the financial ledger;

(ii) the amounts of inventory counted agree with mem orandum records of
quantity;

(iii) the evaluated quantities of inventory agree w ith the balance in the nominal
ledger; in such a system the physical ascertainment of inventory is carried out
by a process of cyclical counts using specialist teams of inventory checkers.

The closing inventory valuation is based upon a year-end valuation of the existing,
continuous inventory records, as opposed to a year-end count and evaluation exercise.
Only large com panies with good controls can operate these systems satisfactorily.

2.2 Attendance at physical inventory counting

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auditing standards. Students of auditing are often referred to the affair of M cKesson and
Robins. This celebrated case referred to an investigation by the United States Securities and
Exchange Comm ission (SEC) in 1941 into a fraud perpetrated by members of the M usica
family, w ho fabricated a totally fictitious crude drug business for fraudulent purposes.

The auditors (in comm on w ith audit practice of that tim e) relied on the inventory records and
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The IAASB have issued ISA 501, of which Part A deals with attendance at the inventory count.
Attendance at the counting of inventory can now be regarded as a primary source of evidence
for the existence of all inventories.

2.3 Internal controls over inventories

It is a useful discipline to consider the internal controls maintained by the enterprise over
inventories.

(a) Custodial controls

(i) Goods are properly racked, shelved and stored so as to safeguard their
existence and prevent wastage or spoilage.

(ii) Goods are properly insured.

(iii) Goods are held in a secure location and supervised by persons rem ote from the
recording or authorisation functions associated with procurement and material
handling.

(b) Recording controls

(i) There are memorandum records to evidence the existence of inventories.

(ii) There are records to evidence the usage of inventories and the inputs from
purchases or production.

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(iii) Accurate amounts of inventory can be obtained from the accounting records.

(c) Authorisation controls

(i) All replenishments of inventory are suitably authorised by persons rem ote
from custodial or recording functions.

(ii) All usage of inventory is authorised sim ilarly.

(d) Managerial supervision

(i) There are regular reviews of the am ounts of inventory in hand to guard
against over- or under-stocking.

(ii) Slow-m oving and obsolete lines are identified for suitable managerial action.

(iii) Regular counting takes place on a cyclical basis and all differences or shortages
are followed up.

Not every enterprise is capable of dem onstrating that it possesses an ideal system of internal
controls; such internal controls that do exist provide additional reassurance that management
can competently physically ascertain and judge the condition of inventories.

2.4 Substantive tests on inventories

Substantive tests on ownership and existence include the following.

(a) Examination of inventory sheets and comparison with summaries. Noting that the
sequence of inventory sheets is complete.

(b) Vouching authorised prices (the audit work on valuation is dealt with later in this
chapter).

(c) Testing casts and extensions.

(d) Examining slow-moving item s and testing for reduction to net realisable value where
appropriate.

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and that all uninvoiced sales are eliminated from inventories of finished goods.

(f) Comparison with previous year inventory sheets, noting:

(i) significant changes in quantities;

(ii) SURSRUWLRQV RI ´PL[µ RI LQYHQWRU\ EHWZHHQ UDZ PDWHULDOV FRPSRQHQWV Z RUN
in progress and finished goods.

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(the special problems of work in progress are dealt with separately).

(h) Obtaining certificates for inventories held by third parties.

(i) Establishing by discussion w ith management the extent of any lien that can be
exercised by any supplier over inventories purchased on credit.

2.5 Inventories at branches

The method of accounting for inventory should afford good controls over branch inventories
and this is, of course, one of the main reasons for charging inventories to branches at selling
price.

Audit checks will include:

(a) scrutiny of branch returns;

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 Chapter 11 The audit of inventory

(b) physical checks at branches in co-ordination with internal audit checks (if any);

(c) discussion with internal auditor of the results of their branch audits;

(d) overall checks on branch profitability;

(e) obtaining an inventory certificate from the branch manager;

(f) verification that item s m oved from head office to branch or between branches are not
included in the year-end inventories at both locations.

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2.6 2YHUDOOWHVWV±DQDO\WLFDOUHYLHZ
W hen all possible direct audit w ork has been performed, it is still necessary to confirm that the
figures for inventory (including w ork in progress) are consistent with other figures in the
accounts and with corresponding figures for earlier years.

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(a) Reconciliation of changes in inventory quantities as betw een the beginning and end of
the financial year w ith the records of purchases, production and sales.

(b) Comparison of the quantities and amounts of inventories in the various categories with
those included at the previous balance sheet date and with current sales and
purchases.

(c) Consideration of the gross profit ratio shown by the accounts and its comparison with
the ratio shown in previous years.

(d) Consideration of the rate of turnover of inventories and its com parison with previous
years.

(e) Consideration of the relationship of the quantities ready for sale and in course of
production w ith the quantities shown in operating and sales budgets.

(f) W here applicable, examination of standard costing records and consideration of the
variances show n thereby and their treatment in the accounts.

3 Some practical aspects of inventory counting

3.1 Necessary instructions
An important part of good inventory counting is the provision of clear instructions. These
should be sent to the auditor for review prior to attendance and should deal with the
following:

(a) Name of person with overall responsibility for the count.

(b) Date and time of the count.

(c) Cut-off procedures and time when they take effect.

(d) Division of factory/warehouse into areas to facilitate counting.

The instructions should specify that the premises are to be properly arranged and
organised prior to the count in order to facilitate the counting process. Obsolete and
slow-moving item s and goods owned by third parties should be identified before the
counting wherever possible.

(e) Named teams of checkers/counters.

The instructions must be clear. By this we mean that the personnel involved should be
properly identified, the method that they adopt for conducting the count should be
spelled out and there should be a briefing session for all personnel prior to the count.

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 Chapter 11 The audit of inventory

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The method by which the count is to be carried out should be satisfactory. A method
frequently adopted is to perform the count using pre-numbered tags. These tags
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The teams of counters (two in a team) go round w ith a set of tags. They count the
goods and attach a tag, noting the quantity dow n on a pre-printed list of part numbers.
W hen a tagging and preliminary counting have been completed a check of part
numbers and job numbers is done to ensure that no parts have been missed and that all
have been correctly identified.

The checkers can then move into action, tearing off the bottom half of the tag and
recounting the goods. This time, quantities are entered on the tag. These tags are then
returned to the counting control centre w here the details on the tags are written dow n
on the pre-printed part lists which were completed in Stage 1. After the checker teams
have returned, all the tags are accounted for (against issue control lists) to ensure that
none has been m issed. Any differences between the count and the check can now be
reconciled and re-counts performed where necessary.

(g) Segregation of items received aftHU ´FXWRIIµ WLPH DQG PHWKRG RI GHDOLQJ ZLWK
movements outwards to avoid double counting.

(h) Identification of third party goods.

(i) M ethod of identifying slow-m oving/obsolete item s.

(j) Comparison of book to physical amounts, and notification of differences.

Other aspects

(a) Division of duties ² 7KH FRXQW VKRXOG QRW EH FRQGXFWHG E\ WKRVH UHVSRQVLEOH IRU WKH
custody of inventory or the maintenance of inventory records. (As a practical point,
however, these persons will generally be on hand to lend their expert guidance over
the location of items and the identification of particular lines.)
(b) Use of independent experts ² ,W PD\ EH GHVLUDEOH IRU WKH DXGLWRU WR HPSOR\ DQ
independent expert to assist him in his task of attendance at the count. In certain
businesses, such as scrap metal dealers or jewellers, the use of the independent expert
is growing as there is a need to obtain unbiased reassurance on the condition and value
of certain item s.
(c) Specialist counters ² )DUP LQJ HQWHUSULVHV ERRNVHOOHUV DQG KRWHOV DUH WKUHH H[DPSOHV RI
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(d) Inventories held by third parties ² ,W LV RIWHQ FRP PRQ WR ILQG WKDW JRRGV KDYH EHHQ
consigned to third parties, either on a sale or return basis, or because the third party is
carrying out some specialist processing function. Auditors usually require certificates
from such third parties to confirm the existence of these inventories.
(e) Inventories held by the client belonging to third parties²7KHVHDUHVLWXDWLRQVZKHUH
(i) items are held for repair, or
(ii) items are held on a sale or return basis because of an agency agreement.
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for evaluation purposes.
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manner in w hich they are complied with. Obviously the auditor must record all the
work done during the observation exercise as these records w ill be used to obtain
reassurance that the test item s counted by him were included in the final inventory
records used for evaluation purposes.

3.2 Cut-off procedures

The determination of the cut-off is a crucial factor in measuring inventories, purchases and
sales. By cut-off is meant the method to determine where one accounting period ends and
another one commences. Errors or inconsistencies in determining the cut-off can create
misleading measurements of profit. For example, if a purchase invoice for 5,000 tons of metal
worth $1m was received on 5 April for goods received on 31 M arch, and the company has a
31 M arch year-end, obviously the metal must be included in the figure for inventories and
trade payables. If, due to an error, the invoice was not entered in the records until the new
period had com menced, then profits in the preceding period w ould be overstated by $1m.

Similarly, if goods invoiced to a customer (w orth $10,000 at cost) were erroneously included in
the closing inventories, there w ould be an element of double counting and the profits would be
overstated by $10,000 as a result.

In order to avoid such double counting it is essential that purchase and sales invoices are
checked against the inventory records to ensure that:

(a) all goods received into inventory at the year-end and included in the balance sheet
inventory figure have the corresponding invoice entered in the purchase day book and
included in trade payables;

(b) all goods despatched at the year-end and excluded from the balance sheet inventory
figure have the corresponding sales invoice raised, entered in the sales day book and
included in accounts receivable;

(c) similarly, all purchase or sales invoices entered in the books before the year-end must
have the corresponding inventory movement reflected in the balance sheet inventory
figure.

A typical cut-off procedure for purchases would be as follows:

(a) Determine the time w hen all physical movement of inventory ceases eg, 5.00 pm on
31 M arch.

(b) Set up a quarantine bay for goods that arrive after that time.

(c) Determine the number of the last goods received note (GRN s should be sequentially
pre-numbered) that relates to goods received before the cut-off.

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 Chapter 11 The audit of inventory

(d) The auditor m ust then scrutinise the purchase invoices entered in the records at the
end of the period and trace them to the GRNs to ensure that the goods were in
inventory.

(e) The auditor m ust scrutinise the purchase invoices entered at the start of the new
period and trace them to the GRN s to ensure that they were not included in inventory
at the year-end.

3.3 2ZQHUVKLSRILQYHQWRULHV±UHVHUYDWLRQRIWLWOH clauses

A problem encountered by auditors in recent years has been the effect of reservation of title
clauses imposed by suppliers in their conditions of sale.

This right gives the supplier of the goods the ability to reclaim goods supplied to an insolvent
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The Romalpa case

The ability to recover the goods or to trace for the monies was enunciated in the UK Court of
Appeal in Aluminium Industrial Vaasen (AIV) BV vs Romalpa Aluminium Ltd. In this particular
case AIV consigned alum inium to Romalpa w ith certain conditions of supply w hich specified
inter alia that:

(a) the goods were to be separately marked and identified;

(b) the goods were to be separately stored;
(c) ow nership of the goods was transferred to the seller when the indebtedness was
discharged.

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Romalpa was clearly the agent for the supplier. The Romalpa case caused the accountancy
profession to consider the problem s of similar clauses being used and most accountants adopt
a pragmatic solution to such matters ie, they regard reservation of title clauses purely as a
safeguard for suppliers if a customer defaults. One of the earliest statements on professional
guidance was produced by the ICAEW who recom mended that the strict legal form of the
transaction for accounting purposes should be ignored, and the commercial substance of the
transaction should be recognised. This recom mendation was made subject to the proviso that
both the parties to the transaction were going concerns. W here the am ounts of sales or
purchases were material, the accounting treatment should be disclosed.

An alternative accounting treatment would be to exclude the item entirely from the accounts of
the recipient, treating it purely as a transfer of goods on a consignment basis.

It is generally believed that in order to have a reasonable chance of being upheld if challenged
in court, a reservation of title clause must:

(a) define the goods involved;

(b) specify the products manufactured from the goods supplied;
(c) require the purchaser to isolate his goods from the goods supplied;
(d) make it clear that full legal title remains w ith the supplier until the goods are paid for
in full;
(e) make it clear that if the purchaser sells the goods or products manufactured from
them, he does so as the agent of the supplier until the goods are paid for in full.

It would appear that a reservation of title clause has little chance of success if the goods
concerned have lost their identity by being manufactured into another product. Only time and

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further case law will tell whether this will also apply to components w hich, although used in
the manufacture of other products, are still clearly identifiable (eg, car batteries).

3.4 Implications for auditors

(a) Purchases

(i) The auditor should review the conditions of sale of selected significant
suppliers. He should also enquire from the directors whether purchases are
made subject to reservation of title clauses and obtain their confirmation in
writing.

(ii) The auditor should consider if the transactions are significant enough to
warrant disclosure by way of a note in the financial statements.

(iii) W here suppliers consign goods and an equitable charge is created, the
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The auditor should note that the am ount of the liability in respect of such
transactions is fairly quantified and disclosed as a secured item.

(b) Sales

W hen dealing w ith the accounts of a supplier with reservation of title clauses, there
should of course be disclosure as above. The point to note here is that the valuation of
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and thus investigate their loss.

4 Valuation of inventories
4.1 Introduction
IAS 2 requires inventories to be valued at the lower of cost and net realisable value (N RV).
Several points arise from this basic requirement:

(a) Cost is defined as all expenditure w hich has been incurred in bringing the product or
service to its present location and condition. This expenditure will include all related
production overheads in addition to the costs of the purchases. In other w ords, we can
sum marise this as being cost of acquisition plus conversion costs (including overheads)
incurred in bringing the goods to their present location and condition.

(b) Net realisable value is defined as the estimated sales proceeds less the estimated costs
of completion and the estimated costs necessary to make the sale.

The comparison between cost and net realisable value m ust be made for each item or group of
similar items in inventory and not for the total of all the inventory in aggregate.

4.2 Methods of arriving at costs

It is necessary to arrive at the cost of inventory by the consistent use of one of the methods
accepted in IAS 2.

(a) Acceptable methods

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required for inventories of items that are not interchangeable.

(ii) $YHUDJHFRVW²WKHLQYHQWRU\YDOXHGDWWKHZHLJKWHGDYHUDJHFRVWprice during

the trading period.

(iii) First in, first out (FIFO) ² JRRGV DFTXLUHG HDUOLHVW DUH DVVXPHG WR EH XVHG
earliest, so that inventory at the balance sheet date is valued at the price at
which the latest batch has been obtained.

168
 Chapter 11 The audit of inventory

(iv) Last in, first out (LIFO ²LQZ KLFK LVVXHVIURPLQYHQWRU\DUH SULFHG RXW DW WKH
latest price, thus tending to undervalue inventory at the balance sheet date
because it will be valued at prices ruling some time previously.

For items that are interchangeable, methods (ii) and (iii) (AVCO and FIFO) are the
benchmark treatments of IAS 2, while method (iv) (LIFO) is an allowed alternative
treatment.

Other methods such as the standard cost method (valuing inventories at a fixed
standard cost per item) or the retail method (valuing inventories at their sales value
less an estimated gross margin) may be acceptable if their results approximate to the
actual cost of the items in inventory.

(b) Unacceptable methods

Under IAS 2 the following m ethods are usually unacceptable:

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valued at a fixed price which may remain static for several years. Like LIFO,
the base cost method also tends to undervalue inventory in time of inflation.

(ii) &XUUHQW FRVW RU DQ\ DOWHUQDWLYH WR KLVWRULFDO FRVW ² ,$6  RQO\ UHFRJQLVHV WKH
historical cost convention.

These methods are unacceptable since they are unlikely to produce an inventory
valuation close to the actual cost of the items held in inventory.

4.3 Work in progress±SUDFWLFDOSUREOHPV

In some undertakings, work in progress can be physically ascertained (eg, in a process
industry). In other undertakings, however, there is often little point in physically verifying
work in progress. For example, in jobbing industries audit reliance is often placed on costing
records which are integrated w ith the financial books ie, the balance on the work in progress
control account in the financial ledger is capable of being supported by detailed costing records
which show a breakdown into the elements of cost of materials, labour and overheads. If such
an integrated system is supported by a system of standard costing, then there is the added
reassurance provided by the managerial supervision that this system demands. W ork-in-
progress balances at the year-end can then be validated by:

(a) vouching the standard journal entries for transfers of materials, labour and overheads
to w ork in progress;

(b) vouching the transfers from w ork in progress account to finished goods;

(c) reviewing production variances to ensure that standards are broadly comparable w ith
actual costs.

4.4 Auditing the valuation of inventories

The procedures suggested in order to validate the basis of valuation can be divided into the
following steps:

(a) Ascertain the accounting policy for inventories (including work in progress):

Does it comply w ith IAS 2?

(b) Review the costing system:

Is it appropriate to the needs of the business (eg, continuous, uniform units of

production are accounted for by process costing systems; discrete units of production
might be accounted for using job or batch costing system s)?

(c) Obtain authorised prices used for valuation of purchased goods and:

169
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(i) test with invoices to validate FIFO or average cost;

(ii) test the allocation of handling costs (carriage, freight, insurance) to confirm
that the basis is consistent and accurate;

(iii) test extensions for arithmetical accuracy.

(d) Obtain costings for manufactured items and compare with budgets for labour,
materials and overheads.

(e) In respect of the overhead budget, establish the basis of identifying manufacturing
overheads and test that absorption is in accordance with the normal activity level.

(f) Review any variance reports on prices and production to ensure that actual historic
cost is used for evaluation.

4.5 Reductions to net realisable value

Net realisable value (NRV) is used as an alternative to cost in the following circumstances:

(a) to value by-products;

(b) where goods are slow-m oving, damaged or obsolete;
(c) where there is a glut in production;
(d) where goods are sold as a loss leader.

In such cases the auditor may validate the valuation by:

(a) reviewing the basis of calculation to ensure that it is consistent with previous years;

(b) examining post balance sheet realisation in order to confirm the basis of calculation;

(c) obtaining written confirmation from the directors as to the reasonableness of the basis
of valuation in respect of unsold items.

4.6 :RUNLQSURJUHVV±FRQVWUXFWLRQFRQWUDFWV
Certain classes of enterprise such as civil engineering companies enter into long-term
construction contracts. IAS 11 explains that a long-term construction contract is a contract
entered into for the design, manufacture or construction of a single substantial asset where the
time taken to complete the contract is such that the contract activity falls into different
accounting periods.

Normally a long-term construction contract will take more than a year to complete. Special
considerations in auditing long-term contracts include the follow ing:

(a) The formula used for calculation of recognised profits is generally:

Attributable profit to date = ´ Total estimated profit

Total costs to date
Total costs to date plus costs to completion

(b) The skill of the management in making forecasts and the recognition of foreseeable
losses.

(c) The reasonableness of any policy for profit recognition and in particular the avoidance
RI ´IURQW ORDGLQJµ WKH FRQWUDFW LH DQWLFLSDWLRQ RI KLJKHU SURILWV LQ HDUOLHU \HDUV Z KHUH
there is uncertainty about ultimate contract profits. This is obviously imprudent.

(d) The terms of the contract covering such matters as cost escalation clauses, calculation
of overhead, mark-up on costs.

(e) The evidence of post-balance sheet events on foreseeable losses, penalties or other
contingencies.

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(f) The evidence of valuation obtained from professional sources, such as quantity
surveyors and architects.

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5 Attendance at physical inventory counting

5.1 Introduction
ISA 501 3DUW $  ´$WWHQGDQFH DW SK\VLFDO LQYHQWRU\ FRXQWLQJµ LV FRQVLVWHQW ZLWK WKH VSLULW RI
ISA 500 on audit evidence, with its requirement to obtain sufficient appropriate audit evidence
of the existence and condition of inventory.

W e have included it at the end of our study of the audit of inventories because it provides a
sum mary of everything that has been covered.

ISA 501 reflects possible methods of inventory counting:

(a) physical verification by a full count or by sampling with extrapolation;

(b) cyclical inventory counting supported by a system of perpetual inventory;

(c) counting inventories either before or after a year-end; this is acceptable as audit
evidence provided that there are satisfactory records which can be used to substantiate
the quantities at the balance sheet date.

The work of the auditor can be divided into three phases:

(a) before the count;

(b) during the count;
(c) after the count.

5.2 Before the inventory count

The auditor should attend to the follow ing:

(a) UHYLHZSUHYLRXV\HDUV·Z RUNLQJSDSHUV

(b) discuss the counting arrangements;

(c) consider the location of inventory and assess the implications of this for inventory
control and recording;

(d) consider the nature, volume and probable value of the inventories;

(e) review systems of control and internal audit arrangements;

(f) ensure that all locations are covered;

(g) arrange to verify inventories held by third parties;

(h) establish if expert help is needed to substantiate quantities and identify condition.

5.3 During the inventory count

The auditor should attend to the follow ing:

(a) REVHUYHFRXQWVIRUFRPSOLDQFHZ LWKWKHFOLHQW·VLQVWUXFWLRQV

(b) test the procedures and controls for com pliance;

(c) test the counts;

(d) examine both the physical inventories and the count records, checking one to the other
in order to gain assurance as to the completeness and accuracy of inventory records;

(e) collect evidence by photocopying inventory sheets and noting the detail of the
sequence;

(f) test the procedures to identify slow-moving and obsolete items;

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 Chapter 11 The audit of inventory

(g) the auditor should pay particular attention to the cut-off arrangements; where,
however, there is an interim inventory valuation based on a physical count which is
updated for year-end and evaluation purposes, the auditor must test the cut-off at that
interim date as well as the year-end.

5.4 After the inventory count

(a) The auditor should follow up matters recorded in the w orking papers at the time of the
count.

(b) The photocopies taken earlier should be used to validate the final inventory sheets.

(c) Test that continuous inventory records have been adjusted to amounts physically
counted and measured. M anagement should have instituted procedures to deal with
transactions between the date of the count and the year-end.

(d) Discuss w ith management any weakness or difficulties discovered during the count.

Practice question 1 (The answer is in the final chapter of this book)

Silverhill

Your firm is the auditor of Silverhill Potteries Lim ited, which is a w holesaler of pottery
products (eg, cups, saucers, plates, mugs etc), and you are carrying out the audit for the year
ended 30 April 20X4. You have been asked by the senior in charge of the audit to identify
inventory which may be worth less than cost and to check that it has been valued correctly. The
company has a com puterised inventory control system w hich records receipts and despatches
of goods, current inventory quantities and the age of the inventory. You attended a count of all
the inventory at the year end.

Required

(a) Define in detail the basis for valuing inventories in accordance with IAS 2 Inventories
(see note below). (4 marks)

(b) State the types of inventory w hich may be w orth less than cost, and describe the
investigations you will carry out to identify this inventory. (8 marks)

(c) Describe the audit work you will carry out to determine the net realisable value of the
inventory you have found from your investigations in part (b) above. (8 marks)

Note:

You should assume that:

¨ inventory quantities are correct.

¨ the inventories should be valued in accordance with IAS 2.
¨ there is no long-term contract work in progress.
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Approach to the question

This is an example of a question w hich starts off in quite general term s and becomes m ore
detailed as it progresses.

In this particular case the general section of the question requires you to know certain technical
information laid dow n in IAS 2. The opportunity for gaining a significant am ount of marks for
simply regurgitating factual knowledge will be lim ited, but it w ill happen. This is one of those
situations and you must exploit it. They are likely to be easier marks to gain and, if you

173
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perform well in this part of the question, there is less pressure when it comes to the trickier
´DSSOLFDWLRQEDVHGµDUHDV

Part (a) of the question carries four marks. It is therefore not enough just to state that
´LQYHQWRU\LVYDOXHGDWWKHORZHURIFRVWDQGQHWUHDOLVDEOHYDOXHµ7KLVZLOORQO\JDLQ\RXRQH
mark at the m ost, w hich is not even a pass.

Always include any relevant definitions or explanations such as the definition of cost and net
realisable value.

For w ork in progress and finished goods of a manufacturer, the costs of direct labour and
production overheads, based on a normal level of activity, are included in the value of
inventory.

1HYHUOHDYHVRPHWKLQJRXWEHFDXVH\RX·UHXQVXUHRILWVUHOHYDQFHVRLQFOXGHDSRLQWWRGLVFXVV
the various valuation bases as well. N ormally, a FIFO (first in, first out) basis is used. Other
com mon acceptable bases include weighted average cost and standard cost (provided they are
similar to actual cost). H owever, IAS 2 states that the LIFO (last in, first out) basis is only an
allowed alternative treatment for valuing interchangeable items of inventory, so it is less
com monly seen in practice.

W e can then move on and answer parts (b) and (c). Part (b) begins to concentrate on specific
areas ie, that of inventory that may be worth less than cost. Part (c) goes into more detail and is
concerned w ith determining NRV.

This is a practical application paper. It w ould be possible to answer this question (and others
set by this examiner) theoretically. In other w ords, you might talk in general terms about types
of inventory worth less than cost and a general approach to determining net realisable value.

This is not what the examiner wants.

If he wanted a general discussion, then the question would not include the case study scenario.
Your answer m ust relate specifically to the facts given about Silverhill Potteries and must use
examples that specifically relate to this company.

As far as part (c) is concerned, there are eight marks available for describing audit w ork to
determine net realisable value. Purely describing an NRV test will not be enough.

The best approach is to state what you do ideally and then, through a series of logical steps,
what you w ould do as the next best alternative.

Remember to relate the points specifically to Silverhill Potteries. For example, if you have
identified various slow moving or obsolete lines of pottery, then a review of after-date sales
invoices is going to be of little use as nothing w ill have been sold.

W e are not saying that an after-date sales invoice review is not a valid point to make but it
must be related to the question circumstances. So, make the point and then criticise (evaluate)
it.

Using the definitions stated in part (a) will help you to stay relevant and produce a better
answer. Do not forget that part of an NRV test will include work on the estimated costs to
FRPSOHWLRQ LH PDUNHWLQJ DQG GLVWULEXWLRQ ² D IDFW WKDW \RX UHPHPEHU WR LQFOXGH if you have
included a reasonable definition of N RV in part (a).

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 Chapter 11 The audit of inventory

Practice question 2 (The answer is in the final chapter of this book)

Textile W holesalers

Your firm is the auditor of Textile W holesalers Limited, w hich buys textile products (eg,
clothing) from manufacturers and sells them to retailers. You attended the inventory count at
WKH FRPSDQ\·V \HDU HQG RI  2FWREHU ; 7KH FRPSDQ\ GRHV QRW PDLQWDLQ ERRN LQYHQWRU\
UHFRUGVDQGSUHYLRXV\HDUV·DXGLWVKDYHUHYHDOHGSUREOHPVZ LWKSXUFKDVHVFXWRII

Your audit tests on purchases cut-off, which started from the goods received note (GRN), have
revealed the following results.

No Date of GRN No 6XSSOLHU·V Invoice value On purchase ledger In purchase

GRN invoice No $ before year end? accruals at
year end?
1 28.10.X8 1324 6254 4,642 Yes No
2 29.10.X8 1327 1372 5,164 Yes Yes
3 30.10.X8 1331 9515 7,893 No Yes
4 31.10.X8 1335 4763 9,624 No No
5 1.11.X8 1340 5264 8,243 Yes No
6 4.11.X8 1345 9695 6,389 No Yes
7 5.11.X8 1350 2865 7,124 No No

Assume that goods received before the year end are in inventory at the year end, and goods
received after the year end are not in inventory at the year end.

A purchase accrual is included in payables at the year end for goods received before the year
end when the purchase invoice has not been posted to the purchase ledger before the year end.

Required

(a) At the inventory count:

(i) describe tKH SURFHGXUHV WKH FRPSDQ\·V VWDII VKRXOG FDUU\ RXW WR HQVXUH WKDW
inventory is counted accurately and cut-off details are recorded; and

(ii) describe the tests you would carry out and the matters you w ould record in
your w orking papers. (11 marks)

(b) From the results of your purchases cut-off test, described in the question:

(i) identify the cut-off errors and produce a schedule of the adjustments which
should be made to the reported profit, purchases and payables in the financial
statements to correct the errors; (5 marks)

(ii) com ment on the results of your test, and state w hat further action you would
take. (4 marks)

Ignore sales taxes.

7RWDO²PDUNV

Approach to the question

Students tend to shy away from questions that involve numbers because this is predominantly
a discursive paper. The two things to remember are:

¨ the numbers and calculations will not be complex.

175
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¨ the numbers and calculations will only account for a relatively small percentage of the
mark allocation.

Notice in this question that parts (a)(i) and (a)(ii) may be answered without reference to the
QXPEHUV (YHQ WKRXJK WKH TXHVWLRQ GRHV QRW DFWXDOO\ GR VR LW·V DGYLVDEOH WR VSOLW SDUW D ·V
mark allocation, say 6/5. You may not be absolutely accurate but it will provide you with m ore
structure w ith which to approach your answer.

6 Summary
The audit of inventory is a particularly important topic because inventory can be a large
number on the balance sheet, for w hich management must use their judgement to derive the
correct number. The tw o aspects are in determining:

¨ The quantity RI LQYHQWRULHV  7KH DXGLWRU VKRXOG DWWHQG WKH FOLHQW·V LQYHQWRU\ FRXQW WR
ensure that this is carried out effectively.

¨ The valuation of inventories. IAS 2 requires inventories to be valued at the lower of cost
and net realisable value.

W here the auditor discovers weaknesses in the inventory system he should report those
weaknesses to management in accordance with ISA 260.

176