What the auditor should do during the observation of the physical inventory count?
Timing and Extent of Inventory ObservationThe timing and extent of inventory observation are determined by the client's inventory system and the effectiveness of its inventory controls. If the client maintains perpetual inventory records and the inventory controls are effective, the auditor may limit the extent of his or her observation and may observe the physical count at various times during the year. Show
If the client has a periodic inventory system, a physical inventory should be taken at least once during the year. No matter how many times during the year the client takes a physical inventory, the auditor should observe the count that occurs at or near year-end. When quantities of inventory are determined solely by physical count and all counts are made as of the balance sheet date or within a reasonable time before or after the balance sheet date, the auditor should ordinarily be present when inventory is counted. If the records are well kept and checked by the client periodically by comparisons with physical counts, the auditor may observe inventory either during or after the end of the period under audit. Necessity to Observe Physical CountThe auditor should make or observe, some physical counts of the ending inventory. Tests of the accounting records alone are not sufficient for the auditor to become satisfied about inventory quantities at the balance sheet date. Sometimes the auditor may not have observed the beginning inventory of a period he or she is being asked to report on. Ordinarily, this occurs in new engagement. If the auditor is satisfied about the current year-end inventory, he or she may be able to satisfy himself or herself of prior period inventories by the following procedures :
The two major steps in the observation of a physical inventory are as follows :
Planning the physical inventory before conducting the physical count is essential. The auditor should review or prepare the client instructions and should work closely with the client in the planning stage. The inventory should be taken at a time when operations are suspended or minimal. The client has primary responsibility for planning and conducting the physical inventory. Because of the auditor's important role in the taking of the inventory, however, he or she should participate in the planning stage. Before taking the inventory, the client should submit a plan containing the following :
(Source : WILEY - Practitioner's Guide to GAAS 2010 - Steven M.Bragg) The process of cross-checking financial records with physical inventory and records What is Auditing Inventory?Auditing inventory is the process of cross-checking financial records with physical inventory and records. It can be completed by auditors and other parties. An inventory audit can be as simple as just taking a physical count of stock and inventory to verify a match to the accounting records. Auditing ExplainedAuditing is the process of verifying that the financial records of an entity are accurate and fairly represented. Transactions in financial records must fairly represent the entity’s financial positioning and actual operating activities. Since financial documentation and records are produced internally, there is a high risk that records can be manipulated by inside parties. Insiders can make mistakes or intentionally alter information while preparing financial records, which is considered fraudulent behavior. Auditing ensures that these mistakes are prevented. Audits also ensure that entities are complying with relevant accounting standards such as the International Financial Reporting Standards (IFRS), Generally Accepted Accounting Principles (GAAP), and other relevant accounting standards. Evidence in AuditingEvidence is needed to determine whether financial statements or records have been prepared in accordance with standards and free from material error. It is also required to promote the accuracy, transparency, and independence of audit reports. Evidence is required by auditors to verify the validity of financial records. It can either verify or provide support for the financial information that is presented. On the other hand, the evidence can contradict the financial information, which indicates errors or fraudulent behavior. Importance of Auditing InventoryObservation of inventory is a generally accepted auditing procedure, where an independent auditor issues an opinion on whether the financial records of inventory accurately represent the physical inventory being carried. Auditing inventory is an important aspect of gathering evidence, especially for manufacturing or retail-based businesses. It can represent a large balance of assets or capital. Auditing inventory must verify not only the amount of inventory but also its quality and condition to see whether the value of the inventory is fairly represented in financial records and statements. Inventory Audit ProceduresSome common inventory audit procedures are: 1. ABC analysisAn ABC analysis includes grouping different value and volume inventory. For example, high-value inventory, mid-value, and low-value products can be grouped separately. The items can be tracked and stored in their separate value groups as well. 2. Analytical proceduresAnalytical procedures include analyzing inventory based on financial metrics such as gross margins, days inventory on hand, inventory turnover ratio, and costs of inventory historically. 3. Cut-off analysisThe cut-off analysis includes pausing operations such as receiving and shipping of inventory while making a physical count to avoid mistakes. 4. Finished goods cost analysisFinished goods cost analysis applies to manufacturers and includes valuing finished inventory during an accounting period. 5. Freight cost analysisFreight cost analysis includes determining the shipping or freight costs for transporting inventory to different locations. Generally, freight costs are included in the value of inventory, so it is important to track the freight costs as well. 6. MatchingMatching involves matching the number of items and the cost of inventory shipped with financial records. Auditors may conduct matching to verify that the right amounts were charged at the right time. 7. Overhead analysisOverhead analysis includes analyzing the indirect costs of the business and overhead costs that may be included in the costs of inventory. Rent, utilities, and other costs can be recorded as part of inventory costs in some cases. 8. ReconciliationReconciliation includes solving discrepancies that are found in an inventory audit. Errors may be re-checked and reconciled on financial records. Related Readings Thank you for reading CFI’s guide to Auditing Inventory. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
What steps should the auditor perform when observing the inventory count?Some common inventory audit procedures are:. ABC analysis. An ABC analysis includes grouping different value and volume inventory. ... . Analytical procedures. ... . Cut-off analysis. ... . Finished goods cost analysis. ... . Freight cost analysis. ... . Matching. ... . Overhead analysis. ... . Reconciliation.. What is the responsibility of the auditor during an inventory count?The primary objective of an auditor's attendance at the inventory count of a limited liability company is to obtain sufficient appropriate evidence regarding the existence and condition of inventory. Auditors should not play any active part in the count as to do so would represent a self-review threat to the audit.
What are the purposes of the auditors observation of the taking of the physical inventory?-By observing the taking of the physical inventory, the auditors are seeking sufficient competent evidence as to the effectiveness of the methods of inventory taking and as to the measure of reliance that may be placed upon the client's inventory records and its representations as to inventory quantities.
What part should the auditors play in planning the physical inventory?The auditor must review management's instructions for the physical count to determine if the physical counting is well planned and addresses all the items relevant to the company's inventory.
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