What is an Inventory Audit?

In an inventory audit, the auditor uses several analytical procedures to

check the company’s inventory methods and confirm that the financial
records and actual physical count of goods match. An inventory audit is
considered a generally accepted auditing procedure.

Inventory is a key asset in a company’s financial statements, as it can be

used as collateral for bank loans and also can be misappropriated for
fraudulent reporting purposes. Companies typically put in place internal
controls, such as a custodian of inventory or a segregation of duties
between the custodian of inventory and the individual with access to the
perpetual records, to reduce risks of inventory fraud or misappropriation.

Recall the four assertions related to account balances in an audit. Inventory

is a balance sheet account, and so the relevant assertions are existence,
rights, completeness, and valuation. Existence refers to whether the
inventory is actually present. Rights refers to whether the company
undergoing the audit actually owns the rights to the
goods. Valuation refers to pricing, as well as any impairment issues.
Completeness addresses whether all the goods that should be recorded are
fully recorded.

Inventory Audit Procedures

There are two types of substantive procedures related to auditing

inventory. Substantive procedures are methods of verifying the actual
numbers on financial statements. This is different from testing of controls,
which are procedures that test the systems/policies that give rise to the
numbers.

• Analytical Procedures
A) Procedures with inventory typically include:
1. Comparing gross margin numbers with previous years
2. A comparison of the inventory turnover ratio with previous
years
3. A comparison of the unit costs of inventory with previous years

• Tests of Details of Balances

The practice of having auditor observation at the inventory count

The Inventory Count – Before

Before the client performs their inventory count, the auditor typically
reviews the client’s proposed policies/procedures pertaining to the
inventory count. “Best practices” typically include:

• Two-person count teams

• Pre-numbered tags and proper sequencing
• Halting the shipping and receiving of goods during the inventory
count
• Segregation of goods that are held on consignment
• A master count sheet that is controlled only by the supervisor of the
inventory
The auditor also selects, in advance, a sample of items to test on the day of
the count. They will use both representative and specific item (stratification)
testing when possible.

The Inventory Count – During

• The auditor observes whether the client complies with the proposed
policies/procedures for the count – Are these procedures being
performed correctly and efficiently?
• Observe the quality and the condition of the goods – is there any
sign of impairment/obsolescence?
• The auditor runs their own tests and makes note of the results. Any
necessary adjustments must be followed up to ensure that the
inventory records and general ledger reflect the adjustments.
• Obtain important cut-off information to make sure that the inventory
is counting goods that need to be counted and not counting goods
that shouldn’t be counted. For example, examine the last five
shipping documents and receiving reports.

The Inventory Count – After

• Match the quantities brought forward from the count to the recorded
amounts on the ledger and book any adjustments that need to be
made
• Inventory must be valued at the lower of either cost or market value
(also known as net realizable value)
1. Cost: Calculate the unit cost of inventory again to make sure
pricing is accurately determined
2. Market Value: Examine subsequent sales of inventory to see if it
was sold for more/less than cost, or look at the gross profit
margins.

Other Inventory Audit Issues

Another issue that may arise and be of concern to an auditor is the timing
of the inventory observation. The observations usually take place at the end
of October or the end of December. Typically, due to year-end holidays
and/or weather issues, inventory observations are held in October.
However, if the client is more prone to fraud/manipulation and is notorious
for that, auditors may show up at the end of December to obtain more
reliable data.

Another issue is whether the auditor needs to bring in a specialist or run

some off-site testing to make sure that the inventory in the warehouse is
genuine. For example, for some goods such as jewelry or high-tech
products, it is uncommon for a regular auditor to be able to differentiate
between real and fake goods. Auditors may want to bring in a specialist for
a thorough examination or send some samples to a lab for testing.