Introduction

Inventories are one of the significant portions of entities current assets, especially for those entities in
the manufacturing, servicing and trading industry. For some entities, special audit consideration, should
be applied for those companies with certain specialized nature inventories (e.g., oil and gas or precious
metals). The audit of inventories presents the auditors with significant risk because:

1. they often represents a very substantial portion of currents assets;

2. numerous valuation methods are used for inventories;
3. the valuation of inventories directly affects cost of goods sold; and
4. the determination of inventory quality, condition, and value is inherently complex.

The nature timing and extent of the substantive audit producers for inventories depend, to a great
extent, on the sophistication of the entity’s inventory and cost of sales application, the effectiveness of
controls over the application and the reasonableness of the applicable accounting estimation and non-
routine data processes (e.g., the processes for determining any write-downs to net realizable value and
for compiling the physical inventory, respectively). Other significant factors affecting the nature, timing
and extent of our inventory procedures include:

1. The accounting methods used ( e.g., actual or standard costs; first-in, first-out (“FIFO”); or
average costs);
2. The locations types and condition of the inventory;
3. The entity’s physical inventory procedures; and
4. Economic conditions, especially those that affect the entity’s ability to sell the inventory at a
profit.

Because of the close relationship between inventory and cost of sales, the two can best be with the
test of inventory and cost of sales.

Audit Objectives

When auditing inventories and cost of sales, the principal objective for the substantive tests is so
determine the following:

Audit Procedures for Inventories and Cost of Sales

The auditor’s primary substantive procedures for inventory balances and cost of sales /cost of goods
sold typically include the following:

1. Observing inventory count and performing test counts;

2. Confirming inventories held by others;
3. Reconciling inventory summary sheet with general ledger;
4. Performing purchases and inventory cut-off;
5. Checking appropriate valuation in accordance with accounting policies;
6. Performing lower of cost or net realizable value test;
 7. Determining whether any inventories have been pledged and reviewing purchase
commitment; and
8. Performing analytical procedrues.

Audit procedures presented in this textbook merely illustrate typical audit procedures (i.e., primary
substantive procedures) for audits of merchandising and manufacturing entities. It is also primarily
designed for audits of corporation; however, some discussions are made for partnership and sole
proprietorship businesses. In actual practice, audit programs must be tailored to each client’s risk and
internal control. The audit procedures comprising audit programs may substantially vary from
engagement to the next.

Assertions mentioned in this textbook relate to primary assertion addressed by the audit procedures
discussed. However, some other assertions may also be addressed.

Observations during inventory count and test counts

In the audit of inventories, auditors are primarily concerned about the existence assertion, that is, the
possibility of overstatement of year-end balances. One of the substantive procedures to verify the
existence of inventory is by observation of inventory count as required by PSA 501 (Redrafted) Audit
Evidence – specific Considerations for Selected Items. Attendance at the inventory count can also
enhance the auditor’s understanding of the entity’s business by providing an opportunity to observe the
production process and/ or business locations at first hand and provide evidence in relation to:

1. Design and operation of the entity’s accounting and control systems;

2. Completeness and valuation of inventories; and
3. Cutoff for recording inventories inwards and outwards and the resultant impact on the
measurement of revenues and costs.

Management’s responsibility - inventory count

Whether the company is using perpetual of periodic inventory system, inventory count is an essential
internal control. Inventory count is normally conducted at year-end but the company may decide to
conduct count before year-end. To have an efficient and effective inventory count, management is
responsible for careful advance planning, conducting and supervising the inventory count.

Auditor’s responsibility – inventory count

The auditor’s responsibility is to observe the inventory count, perform test counts and test the reliability
of the entity’s counting records and producers. Observation may include ensuring whether:

1. Client’s employees are complying with the written inventory count instruction;
2. Items belonging to the audit client are accurately counted and recorded;
3. Items belonging to others are accurately counted and recorded, including a clear description of
their non-inventory status;
4. Items to be excluded from inventory (obsolete items, non-inventory items, items owned by
other) are either subject to satisfactory control and excluded from the counting process or are
accurately counted and recorded, including a clear description of their non-inventory status;
5. Proper cutoff has been established; and
6. Counts tags, sheets or cards are properly controlled.