This could be the result of intentional fraud or unintentional error, in which they both lead to an understatement of inventory. In the audit of inventory, completeness assertion tests whether all the inventory recorded in the balance sheet really belongs to the company. One important rule that always applies to the inventory valuation is that the value of the inventory is measured at the lower of cost and net realizable value.
As the auditors, we need to confirm that the client correctly follows the above rule or the misstatement might occur. More likely than not, the overstatement statement tends to happen in this case as the client sometimes determines the value by cost on all of the inventory including obsolete inventory which their net realizable value is usually lower than the cost.
One more important aspect of the inventory valuation is whether the overhead allocation made by the client is appropriate. All in all, inventory existence and valuation are primary concerns that we need to pay close attention to.
This is due to the overstatement of inventory at the end of the accounting period will lead to the understatement of the cost of goods sold which then makes the net profit higher than it actually is. Audit Inventory Introduction As auditors, we usually audit inventory by testing the various audit assertions including existence, completeness, rights and obligations, and valuation. Audit Assertions for Inventory In the audit of inventory, we usually test the audit assertions included in the table below: Audit assertions for inventory Existence Inventory balances reported on financial statements actually exist at the reporting date.
Precautions must first be taken to maintain social distancing, and local and jurisdictional rules related to personnel health and safety should be followed. The next best person would be a client employee who is not involved in the inventory accounting function and is not involved in the warehouse shipping and receiving function.
Nonetheless, if inventory is material and an auditor is not able to either roll forward or roll back the inventory or get comfortable with a video feed process, then the audit is likely to have a scope limitation, and if inventory is material, the audit opinion is likely to be qualified.
There are other audit procedures that are normally performed that might lend some audit evidence about the existence of inventory. For example, inventory price-testing is performed on almost every audit, and the primary objective of inventory price-testing is, of course, to address the valuation assertion. Obviously, if the client is selling product after year end, they likely would have had to have that in inventory at year end, depending of course on inventory turns, especially the closer you are to year end.
So with cutoff testing and price-testing, even in our traditional audits taking place before the pandemic, there have been other audit procedures that auditors perform that contribute to evidence about existence. The bottom line is that while these are challenging times with respect to observing inventory on-site, there are ways for auditors to get sufficient, appropriate evidence about inventory that will allow them to perform a successful, high-quality audit.
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However, while inventory is an asset on the balance sheet, too much inventory can become a practical liability. Real-world examples can make inventory models easier to understand. The following examples demonstrate how the different types of inventory work in retail and manufacturing businesses.
Finished Goods: A jewelry manufacturer makes charm necklaces. Staff attaches a necklace to a preprinted card and slips it into cellophane envelopes to create a finished good ready for sale. The cost of goods COGS of the finished good includes the packaging it comes in as well as the labor to make the item. Work In Progress: A cell phone consists of a case, a printed circuit board, and components.
The process of assembling the pieces at a dedicated workstation is WIP. MRO Goods: Maintenance, repair and operating supplies for a condominium community include copy paper, folders, printer toner, gloves, glass cleaner and brooms for sweeping up the grounds. Packing Materials: At a seed company, the primary packing material is the sealed bag that contains, for example, flax seeds. Placing the flax seed bags into a box for transportation and storage is the secondary packing.
Tertiary packing is the shrink wrap required to ship pallets of product cases. Safety Stock: A veterinarian in an isolated community stocks up on disinfectant and dog and cat treats in case the highway floods during spring thaw, delaying delivery trucks.
The veterinarian stocks up on these items to meet customer demand. Cycle Inventory: As a restaurant uses its last paper napkins, the new refill order arrives. The napkins fit easily in the dedicated storage space. Its service inventory, therefore, is meals per day. Book Inventory: The theoretical inventory of stock in the inventory record or system, which may differ from the actual inventory when you perform a count.
Transit Inventory: An art store orders and pays for 40 tins of a popular pencil set. The tins are en route from the supplier and, therefore, in transit. However, some people recognize only three types of inventory, leaving out MRO. Understanding the different types of inventory is essential for making sound financial and production planning choices. Raw Materials: Raw materials are the materials a company uses to create and finish products.
When the product is completed, the raw materials are typically unrecognizable from their original form, such as oil used to create shampoo. Components: Components are similar to raw materials in that they are the materials a company uses to create and finish products, except that they remain recognizable when the product is completed, such as a screw.
Work In Progress WIP : WIP inventory refers to items in production and includes raw materials or components, labor, overhead and even packing materials. Packing and Packaging Materials: There are three types of packing materials. Primary packing protects the product and makes it usable. Secondary packing is the packaging of the finished good and can include labels or SKU information. The tertiary type of packing is bulk packaging for transport.
Safety Stock and Anticipation Stock: Safety stock is the extra inventory a company buys and stores to cover unexpected events. In such cases one buys in bulk and holds inventories at the plant warehouse. Companies resort to buying in bulk and holding raw material inventories to take advantage of the quantity discounts offered by the supplier. In such cases the savings on account of the discount enjoyed would be substantially higher that of inventory carrying cost.
In case of raw materials being imported from a foreign country or from a far away vendor within the country, one can save a lot in terms of transportation cost buy buying in bulk and transporting as a container load or a full truck load.
Part shipments can be costlier. In terms of transit time too, transit time for full container shipment or a full truck load is direct and faster unlike part shipment load where the freight forwarder waits for other loads to fill the container which can take several weeks.
There could be a lot of factors resulting in shipping delays and transportation too, which can hamper the supply chain forcing companies to hold safety stock of raw material inventories.
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