5.

5 (F) Inventories
1 Introduction

The significance of inventories to the financial statements and the significance of the
accounting, auditing and reporting issues that may arise in this area frequently cause
us to devote a considerable proportion of the total audit time to the inventory and
related accounts. In planning the audit, we recognize that specialized accounting,
auditing and reporting considerations may apply to certain inventories (e.g., oil and
gas or precious metals). Accordingly, we refer to appropriate authoritative sources,
such as industry knowledge, available within the firm.

The principal objectives in auditing inventories are to determine whether:

· All inventories included on the balance sheet are held by the entity or by
others for the entity (Existence assertion);

· All inventories owned by the entity at the balance sheet date are included on
the balance sheet (Completeness assertion);

· Inventories are carried at the lower of cost and net realizable value (“NRV”)
and that the cost and NVR determinations are appropriate, including adequate
provisions for excess, slow-moving, obsolete and damaged goods, and for losses
on purchase and sales commitments (Valuation assertion);

· The entity owns, or has a legal right to, all the inventories on the balance
sheet. All inventories are free of liens, pledges or other security interests or, if
not, such liens, pledges or other security interests are identified (Rights and
Obligations assertion);

· Inventories are properly classified, described and disclosed in the financial

statements, including notes, in accordance with the applicable financial reporting
framework (Presentation and Disclosure assertion).

The nature, timing and extent of the substantive audit procedures for inventories
depends, 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 market and for
compiling the physical inventory, respectively). Other significant factors affecting the
nature, timing and extent of our inventory procedures include:
 · The accounting methods used (e.g., actual or standard costs; first-in, first-out
(“FIFO”); or average costs);

· The locations, types and condition of the inventory;

· The entity’s physical inventory procedures; and

· Economic conditions, especially those that affect the entity’s ability to sell the
inventory at a profit.

Because the audit approaches for inventories vary substantially, depending on the
particular circumstances of the individual engagement, the guidance set out below is
necessarily general.

2 Inherent Risk Factors

S08 Make Combined Risk Assessments of the EY Global Audit Methodology (“EY
GAM”) provides information on our inherent risk assessments. The following items are
examples of inherent risk factors that may increase the inherent risk for this account
or disclosure. When the opposite situations exist, that would decrease inherent risk
for the account or disclosure.

Nature of the item

· The size of the account or disclosure is significant;

· Our prior audit experience indicates that there have been frequent errors in
the account balance;

· The inventory valuation is subject to significant estimation;

· The results of our planning analytics do not coincide with our expectations;

· Complex or unusual transactions occurred at or near the end of the year;

· Significant inventory variances exist;

· Products are susceptible to loss or theft;

· Products or services are difficult to differentiate;

· The nature of products or services is such that the quantity is difficult to

visually inspect, weigh, measure or count, or is subject to significant estimation;

· There is little predictability to the types of product in inventory;

 · The product lines and inventory costs have undergone significant changes
throughout the year;

· There is inconsistency in the nature of the services rendered (e.g., the same
employee or group of employees perform different tasks at different wage rates
depending on the circumstances);

· Inventory consists of a large number of smaller-valued items;

· Payroll documentation is susceptible to manipulation by the entity staff.

Nature of the business/industry

· The volume of inventory transactions is high;

· The quantity of products held is high;

· Partial shipments and/or backorders occur frequently;

· Purchases are normally made or products are sold on a conditional basis (e.g.,
when goods/services are received on a trial basis, on a rental basis or on
consignment);

· The title to products sold normally passes before the product is shipped;

· The title to products purchased normally passes before or after the receipt of
the product;

· There is little consistency in the nature of the products or services received,

the suppliers from whom products or services are acquired, or the volume of
products or services purchased or sold;

· Warehouse receipts are used as collateral for loans;

· Liens, pledges or other security interests in inventories exist;

· Intra- and inter-company profits exist in inventories;

· Purchases are not usually made from large computerized suppliers (e.g., prices
are manually assigned and invoice extensions and totals manually calculated);

· The value assigned to purchases or services is subject to estimation;

· Payroll expenses are usually determined on a conditional basis (e.g., in the

case of piece work, compensation depends on the outcome of a future event such
as number of items produced that will not be rejected by customers’ quality
control system);

· There are numerous types of supporting evidence—e.g., various categories of

 workers with different payment bases (piece work, hours, weekly, etc.);

· Basic data to compute payroll expenses is subject to frequent changes (e.g.,

hourly rates);

· The method used for valuing payroll expenses is complex—e.g., different wage
rates, numerous deductions, different input data for quantity of work performed
(pieces, hours, days, etc.);

· There is inconsistency in the nature of services rendered (e.g., services

rendered which change due to seasonal nature of work);

· Various regulatory requirements are in effect in manufacturing process and in

payroll-related matters;

· The manufacturing of finished products is a complex process;

· Standard costs are changed frequently and/or inventory component costs are
volatile;

· There is a significant number of new products;

· Current plant operating levels are unusually high or low;

· The quality of the entity’s product is low;

· Significant changes in operations and/or production problems occurred during

the year;

· The business is in a rapidly growing industry and must respond to competitors’

technological innovations.

Organization of the Entity

· The purchases, disbursements and payroll functions are decentralized (e.g.,

products or services are acquired from various locations);

· Purchases are normally negotiated by several parties (e.g., by officers,

shareholders or affiliated entities);

· There are significant inventories held or processed by third parties (e.g., public
warehouse);

· There is inventory held in foreign countries and valued using foreign

currencies;

· There is dependence by or on employees or agents for a group of employees,

including related parties;
 · There is economic dependence on or by one or more suppliers, including
related parties;

· The transactions or events leading to purchase recognition are not controlled

by the entity (e.g., shipments are made to public warehouses or directly to
customers from suppliers);

· The entity has a large number of plant locations;

· Personnel responsible for this account and/or the physical inventory count
have a lower level of competence or experience;

· The entity has inadequate IT systems for the volume of activity, size and/or
complexity of the account.

3 Primary Substantive Procedures Applicable to

Inventories
EY GAM S11 Design Substantive Audit Procedures requires that we perform Primary
Substantive Procedures (“PSPs”) on all audit engagements for all significant accounts,
regardless of the combined risk assessments. The PSPs for Inventories are set out in
EY GAM S11_Exhibit 1 Appendix A: Primary Substantive Procedures (PSP) by
Account. Each of the PSPs is discussed further below.

PSPs describe the nature of the procedures to be performed. As part of the

development of our audit plan, we also include the timing and extent of the PSPs.

PSPs on their own will not necessarily provide all of the audit evidence we need on a
particular assertion for a significant account. Therefore, our audit plan also includes
analytical procedures, general audit procedures and other procedures necessary to
respond to our combined risk assessment. Refer to Appendix 1 Illustrative
Procedures for Inventories Regardless of Combined Risk Assessment and Appendix 2
Illustrative Procedures for Inventories Responsive to Combined Risk Assessment.

3.1 PSP F1: Observation of Physical Inventories

PSP F1: Observe the taking of physical inventories. Verify that client count instructions are
followed and that inventories owned by others are separated. Perform appropriate test counts
and trace test counts to the inventory compilation.

Attendance at the inventory count is the principal procedure that helps us to satisfy
ourselves of the existence of inventory. Attendance at the inventory count can also
enhance our 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:

· Completeness and valuation of inventories;

· Cutoff for recording inventories inwards and outwards and the resultant impact
on the measurement of revenues and costs; and

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

International Standard on Auditing (“ISA”) 501 Audit Evidence – Additional

Consideration for Specific items, Part A: Attendance at Physical Inventory Counting
requires us to attend the physical inventory count when it is practicable and
reasonable to do so and inventory is material to the financial statements. ISA 501
Part A is reproduced in EY GAM E05 Exhibit 3 Attendance at Physical Inventory
Counting.

Our approach to auditing inventories is influenced by the entity’s process for

determining the inventory quantities, for example, whether the entity:

· Takes a complete physical inventory at the balance sheet date;

· Takes a complete physical inventory at an interim date that is reasonably close

to the balance sheet date; or

· Makes cycle counts (i.e., whether the entity counts different items at different
times during the year and compares the quantities to the perpetual records, and
the records are properly adjusted).

If we judge that we cannot observe the counting of physical inventories, we prepare a

memorandum substantiating the impracticality and unreasonableness of observing
the count and select alternative procedures for supporting (or refuting) the existence
and completeness assertions. These alternative procedures might include test
counting the inventory after the count date. However, when designing alternative
procedures, we bear in mind that tests of accounting records alone are not sufficient
evidence of inventory quantities and that it is often difficult to satisfy ourselves
regarding inventory quantities if we do not attend a physical inventory count.
If the entity decides not to perform a physical inventory count, and we are unable to
satisfy ourselves regarding inventory quantities, we consider the effect of this scope
limitation on our audit report.

If the manner of carrying out the inventory count or the results of the test counts is
not satisfactory, the audit professional attending the count discusses the matter with
the senior members of the engagement team. We may need to draw this matter to
the attention of management who may request a recount of all or part of the
inventories.

Taking a complete physical inventory at the balance sheet date

If the entity’s primary method of determining the inventory quantities is to take a

complete physical inventory at or near the balance sheet date, we ordinarily place
more emphasis on auditing the priced-out compilation of the physical inventory rather
than on the inventory and cost of sales application. Conversely, if the entity relies
principally on its inventory and cost of sales application for determining the inventory
quantities and/or the inventory and cost of sales amounts, we place more emphasis
on testing the effectiveness of controls over the application. Thus, the effectiveness of
controls is of greater importance to us when an entity takes a complete physical
inventory at an interim date or when it relies on cycle counts and the perpetual
records than when the entity takes a complete year end physical inventory.

Taking a complete inventory count at an interim date

When a complete physical inventory is taken at an interim date or when the entity
relies on cycle counts and the perpetual records, there is the potential that errors in
the inventory quantities will arise during the period from the count date to the
balance sheet date. In such a case, the effectiveness of controls over the inventory
and cost of sales, sales and accounts receivable and purchases and accounts payable
applications will significantly affect the entity’s ability to produce an accurate
inventory balance at the balance sheet date. Because, even with effective controls,
the chances for error increase as the period between the count date and the balance
sheet date increases, we encourage the entity to count inventories reasonably near
the year end.

For practical reasons, the physical inventory count may be conducted at a date other
than year end. This will ordinarily be adequate for audit purposes only when the
entity has designed and implemented controls over changes in inventory.

If inventories are taken at an interim date, we review the rollforward of the inventory
and cost of sales accounts to satisfy ourselves that the activity in these accounts from
the date of the physical inventory to the date of the balance sheet is reasonable.
Effective controls that are tested may allow us to confine our rollforward procedures
to a review of the entries in the general ledger, a comparison of the gross profit
margins during the intervening period with those in prior months, and a year end
cutoff.

If there are effective controls that are not tested, we need to test the support for the
entries made by the entity. However, if the entity has ineffective controls over the
inventory and cost of sales accounts, the physical inventory will have to be performed
at year end or we will need to perform extensive tests of the support for the entries.

Making cycle counts

When an entity relies heavily on the perpetual records to determine the inventory
quantities and checks the accuracy of the records by partial counts on a continuous or
cycle basis, we observe the counting process to the extent necessary to confirm our
preliminary evaluation of the effectiveness of the count procedures. When we plan
our approach to the audit of physical quantities in these circumstances, we recognize
that it will differ from our approach when all the inventory is counted at once. Refer
to Appendix 3 Cycle counts for guidance on auditing inventories when the entity uses
cycle counts to confirm the accuracy of its perpetual inventory records, rather than
performing a complete annual inventory account at an interim date or at year end.

3.1.1 Our Responsibilities when Attending the Physical

Inventory Count

Counting the inventory items is management’s task and not ours. Our purpose is not
to perform the inventory count but to observe the entity’s methods, check count
selected items and test the reliability of the entity’s counting records and procedures.

We expect that management will ordinarily establish procedures under which

inventory is physically counted at least once a year to serve as a basis for the
preparation of the financial statements or to ascertain the reliability of the perpetual
inventory system.

We attend the physical inventory count to enable us to inspect the inventory to

determine its existence and to provide audit evidence as to the reliability of
management's procedures. Our attendance may serve as a test of controls or as a
substantive procedure, or both, depending on our combined risk assessment and
planned approach.

We observe the taking of physical inventories to establish that:

· The entity’s personnel are complying with the instructions for taking the
 inventories;

· Items belonging to the entity are accurately counted and recorded;

· Items to be excluded from inventory (no-value items, non-inventory items,

items belonging to others) 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;

· Proper cutoff has been established. We inspect shipping, receiving and

transfer documents and the related inventory items, when appropriate, to
establish the numbers of the last documents used and other information needed
for subsequently verifying cutoffs in the accounting records; and

· Count tags, sheets or cards are properly controlled. We record sufficient

information to be able to trace the test counts into the inventory compilation at a
later date, and we record selected information concerning the count tags, sheets
or cards that are used, partially used, unused and voided.

We also perform tests of the entity’s counts (from the floor to recorded counts and
from recorded counts to the floor)to determine that the quantities counted are
accurate.

3.1.2 Planning Attendance at the Physical Inventory Count

When planning our attendance at the physical inventory count, we consider:

· The risks of material misstatement related to inventory;

· The nature of the controls related to inventory;

· Whether adequate procedures have been established and proper instructions

issued for the physical inventory count;

· The timing of the count;

· The locations at which inventory is held; and

· Whether an expert's assistance is needed.

We also obtain an understanding of the individual items in the inventories, which

helps us when observing the physical inventory count. We gain an understanding of:
 · The main categories of inventory (e.g. raw materials, work-in-progress
(“WIP”), finished goods, etc.) and the approximate value of each category;

· Items to be excluded from inventory;

· Whether there are any particularly high value items or lines; and

· Whether there are significant quantities of obsolete or slow-moving inventory

and, if so, whether provision has been made in respect of it.

Inspection of bills of materials, perpetual inventory records, blueprints, and

engineering and production documents prior to starting the observation and during
the observation as is necessary, helps us acquire the desired information.

Some entities use computer-assisted techniques to perform inventory counts; for

example hand-held scanners can be used to record inventory items which update
computerized records. In some situations there are no inventory-sheets, no physical
count records and no paper records available at the time of the count. In these
circumstances we consider the IT environment surrounding the inventory count and
consider the need for TSRS assistance when evaluating the techniques used and the
controls over them. Relevant issues include system interfaces and controls over
ensuring that the computerized inventory records are properly updated for the
inventory count information.

If the entity has inventory in multiple locations, we determine all locations where
inventory is held (including goods on consignment). If inventory is held at a number
of different locations, we attend an inventory count at a selection of locations each
year, with an emphasis on those which are more material or significant (e.g., subject
to an accounting estimation process); those where there have been inventory count
problems in past years; and those where there have been inventory discrepancies or
deficiencies.

If some sections are not being counted at the date of attendance, we determine what
the counting arrangements are (e.g. continuous inventory checks) and from what
records the inventory figures will be taken.

We review and determine the adequacy of the instructions and other written
materials concerning the counting of inventories and the recording of inventory
transactions near the count date. We discuss the inventory count procedures with
entity officials to determine that instructions are adequate and that reasonable
precautions are taken to ensure count accuracy.

In particular, we consider the instructions regarding:

· The application of procedures to control the count, for example, collection of

 used stock sheets, accounting for unused stock sheets and count and recount
procedures. These include:

o Provision for having second counts performed by a separate group of

employees, and for recounts when discrepancies with perpetual records are
found;

o Procedures to ensure that all goods are counted, no goods are counted
twice and fictitious items are not added to the inventory listings at a later
date; and

o Procedures guarding against errors in totaling quantities, converting from

one measure to another, costing, extensions, additions and summarization.

· Accurate identification of the stage of completion of WIP, of slow-moving,

obsolete or damaged items and of inventory owned by a third party, for example,
on consignment; and

· Whether appropriate arrangements are made regarding the movement of

inventory between areas and the shipping and receipt of inventory before and
after the cutoff date.

Based on the aforementioned information concerning the inventory count, we

determine if our procedures can be restricted to observation and limited inventory
counts or whether it is necessary for us to perform extensive inventory counts.

If the entity count procedures (i.e., the instructions) are adequate, we may restrict
our count procedures to a few items and devote the majority of our time to
observation of the entity’s inventory count activities.

If the entity count procedures in the instructions are inadequate, we discuss any
actual or apparent defects or omissions in inventory count instructions prior to the
date of physical inventory count and attempt to get management to improve them. If
this proves impractical, then we plan to count sufficient quantities of inventory to
determine that a material error will not arise.

3.1.3 Establish that Entity Personnel are Complying with

Inventory Count Instructions

We observe that the instructions for the physical inventory count are being followed
by the entity’s count teams and that the inventory that is purported to be on site is,
in fact, on site. The Illustrative Inventory Count Observation Checklist may be used
to highlight the audit procedures and considerations usually employed during the
physical inventory count.
If we have evaluated the entity’s count instructions to be adequate to achieve an
accurate count and proper cutoff, we observe whether these count instructions are
being followed during the count to determine the nature and the extent of our count
procedures. We consider whether:

· The employees counting the inventories appear competent;

· The inventory is arranged to facilitate counting;

· There is adequate checking of counts and descriptions by a group of second

counters;

· There is a review at the end of the count to check that all items have been
counted and none have been double-counted;

· The stage of WIP is adequately described and inter-departmental movements

are controlled during the count;

· The entity is checking the inventory counts to inventory status records (e.g.,
perpetual inventory records) and differences noted are being followed up;

· Consigned goods or goods belonging to third parties are segregated from the
rest of the inventory and excluded from the count; and

· Receiving and shipping of inventory during the count is controlled and cutoff
information is documented.

If the instructions are not being followed during the count, we count sufficient
quantities of the inventory to satisfy ourselves that there are no material count errors
rather than restricting our tests to a few items and devoting the majority of our time
to observation of entity activities (see subsection 3.1.4 Perform Tests of the Entity’s
Counts, below, for guidance).

We establish that count tags, sheets or cards are properly controlled. The controlling
of count tags, sheets or cards allows the entity to ensure all count information is
collected and that no items/areas are double-counted. Once the entity has accounted
for all the count tags, sheets or cards, we perform procedures to check that the entity
has in fact collected all count data. Our procedures depend on the method used for
the count, for example, if serially numbered count tags or cards or tags are used, we
account for the numerical continuity of used and unused count documents at the end
of the inventory count.

3.1.4 Perform Tests of the Entity’s Counts

The principal objectives of the entity’s counts are to confirm the quantities of
inventory on hand and to determine whether the entity’s procedures in the count are
working effectively.

We concentrate our efforts on the locations or categories that represent the bulk of
the values and on the individual items of greatest value. At the same time, we make
limited tests in other areas and of other items so our tests provide representative
information about the inventories. Particular attention is given to areas where
counting is unpleasant or difficult. To achieve good coverage of the inventories, we
consider selecting items we will test-count from each of:

· The perpetual inventory records (if any);

· The count tags, sheets or cards; and

· The inventory itself.

We make as many test counts of the inventory items as we need to be satisfied with
the diligence and accuracy of the count teams and to test the entity’s compilation of
the physical counts. The extent of our observations and tests of the physical
inventory count depend on many factors, including:

· The adequacy of the inventory instructions;

· Whether these instructions are followed during the counts;

· The skills, attitudes and independence of the employees assigned to count the
inventories;

· The entity’s supervision of the counting process;

· The materiality of the inventories; and

· The problems anticipated.

To perform test counts we:

· Select a few items in advance of the count as being of significant value, based
on our knowledge of the entity’s products, a review of the inventory listing for
high-value items and/or a tour of the plant/warehouse. For each of the items
selected, we:

o Count the item;

 o Verify the item description;

o Reconcile, on the spot, our count to the entity’s count as recorded on the
count records, and to the inventory status records (if we plan to rely on such
records in determining the inventory quantities). If we cannot reconcile our
count to that of the entity or the status records, we determine the correct
quantity, obtain the entity’s agreement and request correction of the entity
count and/or status records; and

o Record the product description (in sufficient detail to enable us to

subsequently trace it into the final inventory listing), the quantity counted by
us and by the entity, and whether the entity has agreed to correct their count
to match ours.

· Select an additional few items of significant value observed during the count
and:

o Verify the item description; and

o Record the description and quantity in our workpapers for subsequent

checking to the final inventory listing; and

· Carry out our counts together with entity representatives and agree the results
with them at the time of the count.

If we encounter any errors in the entity’s counts, we expand the above test-counts.

When we have evaluated the entity’s count procedures as inadequate or have

observed that the count procedures are not being followed during the count, or when
a substantial portion of the inventory count is not observed by us, we perform
sufficient test-counts to determine that there are no material count errors.

We obtain inventory cutoff information at the inventory count date to determine that
the accounting records are cutoff at the same point as the movement of the physical
inventory (i.e., that the book-to-physical correction does not include gains or losses
caused by documents posted in the incorrect period).

At the inventory count, we either note details or take copies of the documents
indicating the following inventory movements, if applicable:

· Last receipts;

· Last shipments;

· Last inter/intradepartmental transfers;

 · Last inter/intracompany transfers;

· Last raw material requisitions; and

· Last production reports.

If the entity ships/transfers inventory between branches and/or other group entities
at or around the count date, we note the details of any transactions to check that no
inventory is missed or double-counted as a result of inventory movements.

If the entity uses statistical sampling to estimate the inventory quantities, we satisfy
ourselves that the sampling plan is reasonable and statistically valid, that it has been
applied properly, and that the results are reasonable in the circumstances. We may
wish to consult a person with expertise in sampling for assistance in gaining the
necessary satisfaction.

If the entity uses procedures to estimate the physical quantity of inventory, such as
estimating a coal pile, we satisfy ourselves regarding the reasonableness of those
procedures. When inventory is weighed, we check that scales are properly calibrated
before the start of the count.

In audits of larger entities, internal auditors often participate with us in observing and
testing the physical inventory count. Generally, this co-operative approach is taken to
maximize the verification of the inventory counting, and to reduce our required effort.

We are aware that we cannot regard the work of the internal auditors as our own.
However, by using the work of the internal auditors, we may be able to reduce our
efforts to minimum tests of the inventories. Refer to section 2.7 Considering the
Work of the Internal Audit Function in this manual for guidance on using the work of
internal auditors.

Some entities use outside firms that specialize in taking physical inventories. In such
cases, we still observe and test the physical inventory count because such specialized
firms take their instructions from the entity and are not, therefore, fully independent.
We may reduce (but not eliminate) the extent of our tests when we are satisfied with
the competence and independence of the outside firm.

If other offices of the firm participate in the physical inventory count, we provide
them with the entity’s instructions, information regarding any problems that might be
encountered, and if appropriate, a detailed audit plan that includes the approximate
extent of the test counts to be recorded and a description of the information to be
recorded (e.g., the cutoff information and the identifying information for the items
that are test counted).
In the case of entities that hold specialized inventories (e.g. oil, diamonds, precious
metals) we should consider whether we need to use an expert to substantiate
quantities or identify the nature and condition of the inventory. Use of an expert is
addressed in section 2.9 Using the Work of an Expert in this manual.

3.1.5 Procedures for Unobserved Locations

For those locations at which we choose not to observe the inventory count, we:

· Obtain a copy of the physical inventory compilation and review it for

reasonableness (large and/or unusual items);

· Obtain entity records of the physical count and review the results and
disposition of any exceptions/problems noted;

· Review the activity in the inventory account since the physical count for
reasonableness (large and/or unusual items);

· Vouch activity in the inventory account since the physical count to supporting
documents; and

· Perform analytical review procedures such as comparing current year balance

to prior year and to the budget.

3.1.6 Trace Test Counts to the Inventory Compilation

The tracing of the physical counts into the inventory compilation can, in many cases,
be confined to tracing in our test counts, if we are satisfied with the effectiveness of
the entity’s non-routine data process for compiling the inventory and if we do not
encounter errors when tracing in the test counts. If we believe that more physical
counts need to be traced into the compilation, we trace in a sample of the entity’s
count records. We also perform the opposite procedure of tracing items in the
compilation to the supporting count records. We confirm that the unit of measure
used in the physical inventory compilation is consistent with the unit of measure used
during the physical count.

We compare the inventory compilation with the information obtained during the
physical observation regarding the count tags, sheets or cards that were used,
partially used, unused and voided. We reconcile the total number of count tags,
sheets or cards recorded in the compilation to the information obtained at the count
and reviewed ruled-off count-sheets for additions to determine that the count tags,
sheets or cards used are included in the compilation and that voided count tags,
sheets or cards were not subsequently completed and included in the compilation.
To determine that the count information is accurately summarized in the inventory
compilation (e.g., a priced listing of all the items in inventory, referred to by most
entities as the final inventory listing, or represented by the perpetual records after
they are corrected for any differences from the physical counts), we trace into the
compilation the descriptions and quantities of:

· Our test-counts;

· Additional inventory items documented or contained in photocopies of count

tags, sheets or cards obtained during the inventory count. If we took photocopies
of count-sheets, we need only to trace a sample of items to the compilation; and

· Confirmations received (or verified via alternative verification) for inventory

held by others.

3.2 PSP F2: Confirmation of Inventories Held by Others

PSP F2: If significant, confirm inventories held by others at the physical inventory date and
trace confirmed quantities to the inventory compilation; consider observing these physical
inventories as well.

Inventory owned by the entity that is held by third parties includes:

· Inventory held in public warehouses;

· Consigned goods held by customers; and

· Inventory held by suppliers (i.e., title to the inventory has passed to the entity
prior to delivery).

We confirm inventories held by others and inventories held by the entity for others at
the physical inventory date. We consider observing the physical counts of inventories
held by others if those inventories are material.

If the inventory held by third parties is significant and the confirmation can be relied
upon, our confirmation letter sent to the custodian requests:
 · Details of inventory on hand at the count date (product descriptions,
quantities, damaged stock); and

· Details of the last receipt/shipment as at the count date and for several days
prior to and after count date.

Since the reply to our confirmation request is sent directly to us (i.e., not sent to us
via the entity), the confirmation request is signed by the entity as authorization for
the addressee to provide us with the information.

When confirmation replies are not received, we mail second/third requests and
contact the custodian by telephone in an attempt to obtain the written replies. If
confirmation is still not received or cannot be relied upon, we perform alternative
verification of the existence of such inventory. These procedures include:

· Inspection of:

o Shipping documents;

o Public warehouse receipts;

o Reports of and payments for subsequent consignment sales; and

o Correspondence with the third party.

· Consideration of whether a physical inspection of the inventory is required;

and

· Reporting non-replies to the entity as these indicate potential problems in the

records of the third party.

In addition to confirming or verifying inventory held by third parties, we also

determine that the entity owns the inventory. To do this, we:

· Review the terms and conditions of agreements with warehouses/suppliers

holding inventory on behalf of the entity or customers having consignment
inventory;

· Check that title remains with the entity; and

· Check that copies of such agreements are filed in the permanent file.
Depending on materiality of this inventory we also consider the following:

· The integrity and independence of the third party;

· Observing, or arranging for another auditor to observe, the physical inventory

count;

· Obtaining another auditor's report on the adequacy of the third party's controls
for ensuring that inventory is correctly counted and adequately safeguarded; and

· Inspecting documentation regarding inventory held by third parties, for

example, warehouse receipts, or obtaining confirmation from other parties when
such inventory has been pledged as collateral.

3.3 PSP F3: Reconciliation of Inventory Compilation with

General Ledger

PSP F3: Review the reconciliation of the valued physical inventory compilation with the
general ledger account balances and the perpetual inventory records. Investigate large and
unusual reconciling items.

Once physical inventories are counted and valued, the entity adjusts their accounting
records to reflect actual inventories held. Differences between accounting records
and the physical amount are applied to income. Therefore, if items are included in
the physical amount but not in the general ledger (as with goods received, sold or
transferred, not yet processed in the accounting records), or visa versa, the book-to-
physical adjustment is incorrect. This results in an over/understatement of income.

The same error occurs when the entity uses a periodic inventory system (i.e., when
inventory is recorded in the accounts only at the year end based on an actual physical
count). In this case, if there is an inconsistency between the physical count and the
recording of purchases or sales in the general ledger, there is an error in the recorded
net income.

Some examples of the ways book and physical amounts can become inconsistent with
each other are:

· Goods received and counted but not set up in accounts payable or accrued
 liabilities at count date;

· Goods not counted but received and recorded in accounts payable or accrued
liabilities at count date;

· Goods physically counted but also recorded as sales at count date; and

· Inventory in transit either missed or double-counted at count date.

Our review of the reconciliation of the physical inventory compilation with the general
ledger generally consists of:

· Agreeing the book and physical inventory figures to the compilation and
uncorrected general ledger, respectively;

· Adding the reconciliation;

· Reviewing the nature of reconciling items and verifying them against the cutoff
information obtained at the count (when applicable);

· Investigating significant differences between book and physical inventories.

Large inventory differences may indicate count or cutoff errors (in which case a
recount is considered), poor physical safeguards or inadequate controls over
shipping/billing and costing. We obtain explanations by inquiry of entity
personnel and support such explanations by corroborating evidence;

· Agreeing reconciling items to the supporting workpapers, adjusting journal

entries and the general ledger; and

· Verifying that the uncorrected general ledger includes an accrual for inventory
received prior to the count date, but not billed (i.e., the general ledger inventory
balance includes all inventory received). If the entity has not accrued this
amount, there should be an item for unbilled receipts in the book to physical
inventory reconciliation. If the reconciling item contains any inventory receipts
from major suppliers, we trace the amount in the inventory reconciliation to the
supplier reconciliation.

When inventories are counted prior to year end, and the perpetual records are used
to rollforward the inventory balance from the date of the count to the year end
(rather than the general ledger), the entity adjusts quantities in the perpetual records
to agree with the physical counts. Accordingly, we test-check the compilation to the
perpetual records (quantities and descriptions). To determine that the general ledger
is adjusted to the correct amount at year end, we:

· Obtain and verify the reconciliation of the perpetual records to the general
ledger; and
 · Check that the entries in the general ledger are cutoff consistently with the
entries in the perpetual records.

3.4 PSP F4: Rollforward Procedures

PSP F4: If inventories are taken at an interim date, review the rollforward documentation in a
manner responsive to our combined risk assessment and investigate unusual items.

If inventories are counted at an interim date, we carry out procedures on inventory

purchases and cost of sales either in the general ledger or perpetual records during
the period from the count date to year end (called the rollforward) to satisfy
ourselves that activity in the account, during the rollforward period, is reasonable.
The extent of substantive procedures performed depends on our combined risk
assessment.

For example, if our combined risk assessment is minimal, we may confine our
rollforward procedures to a review of the entries in the general ledger or perpetual
records, a comparison of the gross profit margins during the intervening period with
those in prior months, and review of year end inventory cutoff. Alternatively, if our
combined risk assessment is high, we test the support for the entries in the general
ledger or perpetual records or insist on a year end inventory count.

When relying on general ledger figures during the rollforward period, our tests may
include:

· Obtaining a listing of the movements on the inventory control account in the

general ledger between the physical inventory count/confirmation date(s) and the
year end;

· Investigating significant unusual entries and corroborating explanations

obtained with appropriate supporting evidence or through inquiry with other
independent entity officials;

· Checking that all postings to the inventory control account are recorded
(inventory purchases / production / costings);

· Obtaining explanations for significant fluctuations in inventory in months

before and after the observation date(s) in light of the year end inventory, and
 assessing the impact of any errors on net income; and

· If the above procedures are not sufficient, and inventory backup details are
available, performing a few year end test-counts.

When relying on the perpetual inventory records during the rollforward period, as a
minimum, we:

· Scrutinize the perpetual inventory records for the rollforward period;

· Investigate and obtain explanations for any unusual items. It is appropriate to

perform a few inventory test-counts during the year end audit and roll them back
to the year end;

· Analyze gross profit statistics separately, both for the year and the rollforward
period to identify and verify abnormal fluctuations; and

· Consider observing, at balance sheet date, significant new items and those
with significant increases or decreases between the physical inventory date and
the balance sheet date.

3.5 PSP F5: Inventory Cutoff

PSP F5: Trace the cutoff information obtained during the physical observation to the
accounting records of sales and purchases.

We perform cutoff procedures on the cutoff information obtained at the inventory

count to:

· Check that the inventory transactions are recorded in the general ledger or
perpetual records in the correct period; and

· To determine that inventories are not double-counted or missed due to

movements within the plant/warehouse or movement between entity branches,
related entities etc.
Cutoff procedures may consist of:

· Examining a sample of receiving reports for inventory receipts immediately

prior to and subsequent to the inventory count including the last and first receipts
respectively to confirm recording in the correct period;

· Examining support documents for a sample of inter/intradepartmental receipts

a few days on either side of the cutoff point, as determined by the cutoff
information obtained at the inventory count, and checking that all such receipts
included in inventory are excluded from the shipping location’s inventory;

· Examining a sample of shipping documents for shipments immediately prior to

and subsequent to the count date including the last and first shipments
respectively to confirm recording in the correct period;

· For inter/intradepartmental shipments, examining supporting documents for a

sample of inventory shipments a few days on either side of the cutoff point
checking that all shipments excluded from inventory have been included in the
receiving location’s inventory;

· Following up any unused documents noted at the cutoff date to check that
other transactions have been recorded in the correct period; and

· For unusual items documented as not included in the count (e.g.; inventory
received during the count, etc.), tracing these transactions to the accounting
records to confirm that they are recorded in the correct period.

If the entity is a manufacturing entity, we perform the following procedures in

addition to the ones noted above:

· Agree details of the last raw materials requisitions to production reports,

physical count-sheets, inventory status and general ledger postings (when
practical) to determine that raw materials relieved from stores are included in WIP
(i.e., have not been missed or double counted);

· Agree details of production reports to physical count-sheets, inventory status

and general ledger postings to determine that inventory transferred out of WIP is
recorded in finished goods (i.e., has not been missed or double-counted);

· Confirm that production reports include labor time incurred up to cutoff and
exclude labor time incurred subsequent to cutoff;

· Review general ledger entries in the inventory accounts before and after the
physical inventory cutoff to verify all entries such as labor accruals, overhead
absorptions or variance adjustments, were made in the correct period; and

· Review the entity’s procedures for determining the cutoff point for establishing
the degree of completion of WIP and satisfy ourselves that these procedures were
 properly carried out.

Where our work is performed at an interim date, cutoff procedures should be

performed at both the interim and year end dates.

3.6 PSP F6: Valuation in Accordance with Accounting

Policies

PSP F6: Test the valuation of inventory to verify that it is performed in accordance with the
client’s accounting policies or applicable financial reporting framework.

We determine that inventory prices comprise all costs reasonably attributed to the
purchase and manufacture of goods in accordance with the applicable financial
reporting framework.

We discuss with management whether there has been any change in accounting
policy in the year with respect to inventory valuation.

The entity’s method of valuing its inventories (e.g., FIFO) and the nature of its
inventories (e.g., raw materials, purchased parts, WIP, finished goods) influences our
procedures for verifying the recorded cost of the inventory. We determine that the
costing method used is consistent with the entity’s policy and with the method used in
the prior year.

Our pricing tests consist of verifying invoices to support the listed cost for a sample of
inventory items. The sample generally includes all key-items and a representative
sample of the remaining inventory items. Since there is usually no priced inventory
listing available at the count and a portion of our test-counts are selected from the
physical inventory at the time of the count, we do not know if we identified and
counted all of the key inventory items. For this reason, we select a separate sample
of inventory items from the compilation (i.e., final inventory listing) for our pricing
test.

For each item selected, we agree the unit cost per the final inventory listing to the
cost records, if available, to confirm that the unit cost in extending the inventory is
correctly transcribed.
For raw materials and goods purchased for resale, we verify the unit prices used in
pricing the inventory against past purchase invoices (e.g., to build-up a FIFO cost). It
is not sufficient in pricing tests only to verify the latest invoice price. The test for
each item normally covers the whole quantity in inventory and takes into account the
method of costing (e.g., FIFO).

Our procedures for testing the content of raw material, direct labor and overhead
costs in WIP and finished goods depend, in part, on the nature of the production
process, on the nature of the relevant accounting applications and on the
effectiveness of controls over the applications. Generally, we verify the unit costs for
the items selected by test-checking their build-up from unit material costs, unit labor
costs and unit overhead rates.

Raw materials included in WIP and finished goods are tested by tracing the unit cost
to the raw material perpetual records to confirm it was relieved from raw materials at
the appropriate cost. It is not necessary to trace the costs to the supplier invoices if
we have tested pricing of raw materials inventory at the count date and pricing of
purchases during the year.

Many manufacturing entities use standard costs to value their inventory. Standard
costs are accepted as being equivalent to actual costs if there is no significant
variation between aggregate standard costs and aggregate actual costs applicable to
the inventory. Therefore, if the entity values their inventory at standard cost, we test
the standard costs to determine whether they reasonably approximate actual costs
under one of the recognized bases of determining costs.

In auditing inventories priced at standard costs, we test the standard costs to

determine whether they reasonably approximate actual costs under one of the
recognized bases of determining costs (such as FIFO or average cost). Two
techniques for auditing standard costs are:

· Examining the make-up of the detailed standard costs for a sample of

inventory items; and

· Determining the extent to which the overall standard costs approximated the
actual total costs during the year. This technique may be accomplished by
reviewing the variance accounts to determine their amounts and causes, and by
determining whether the variances that relate to inventory at the balance sheet
date have been reflected in the year end inventory balances, if appropriate.

We often use a combination of both techniques.

Our procedures for testing the direct labor and overhead costs included in WIP and
finished goods inventories and in cost of sales depend in part on the nature of the
production process, on the nature of the accounting applications that record the
costs, and on the effectiveness of the controls over the applications.

Direct labor costs may be verified by testing the detailed records that support the
labor costs for individual inventory items. The extent of these tests depends on the
degree of reliance we place on the controls over the payroll application.

We may verify the overhead cost pools by testing the costs included in them. In
performing these tests, we consider the appropriateness of the types of costs included
in overhead (for example, selling and administrative costs are not normally included)
and the consistency with which the costs are allocated among the overhead pools.
The extent of these tests depends on the degree of reliance we place on the controls
over the purchasing application.

The application of overhead to inventory is normally accomplished by relating total

overhead costs (including indirect labor costs) to some measure of production or
production costs (such as direct labor costs). We review the propriety and consistency
of the method of applying the overhead costs, and the accuracy of the calculations
and the data used in applying the overhead.

The rate used to allocate overhead to inventory can have a very marked effect on the
closing inventory figure. To establish that the rate used approximates actual, we look
at the over or under absorption for the year, and if this is sufficiently small, or if it
has been prorated between cost of sales and closing inventory, the overhead costs in
closing inventory are sometimes accepted as close enough to actual.

In some businesses, considerable time elapses between the completion of the first
and the final items of a customer’s order. In such cases, partial shipments of the
items completed to date are frequently made. Determining the costs of the items
shipped may be difficult because the entity may have to estimate the costs yet to be
incurred and the number of items to be produced in order to determine the costs of
the units already shipped. In evaluating and testing an entity’s methods for costing
partial shipments, we obtain information to enable us to test and evaluate the market
value of the unbilled items in the jobs examined. For those items, we satisfy
ourselves that the final costs of the unbilled items will not exceed their sales prices
less the costs of their disposal. We further satisfy ourselves that the entity has
established satisfactory procedures for evaluating the market value of all incomplete
production.

3.7 PSP F7: Net Realizable Value Testing

PSP F7: Test the allowances to reduce the valuation of inventory to net realizable value, e.g.,
reserves for slow moving items, obsolescence or lower of cost or market.

The term “market” refers to replacement cost (by purchase or reproduction) or net
realizable value (estimated selling price less reasonably predictable costs of
completion and disposal) or, on occasion, net realizable value reduced by a normal
profit margin. The replacement cost of purchased materials can generally be verified
by referring to purchase orders, vendors’ catalogues or market quotations.

To verify the net realizable values of finished goods and WIP, we generally use:

· Selling prices evidenced by sales subsequent to the balance sheet date, by the
entity’s catalogues or price lists or by customers’ contracts; and

· Calculations of the costs to complete or dispose of the items.

When using the lower of cost or market rule, we consider whether it is appropriately
and consistently applied to individual inventory items, to categories of related items,
or in certain circumstances, to the inventory as a whole.

Determining the propriety of the entity’s valuation of the inventory includes

procedures to test whether the inventory is saleable and to test for unrealized losses
on sales and purchase commitments. We investigate sales and purchase
commitments, back orders or sales options to determine whether any losses are likely
to be realized in the course of fulfilling the commitments, and we consider whether
the allowances for such unrealized losses are reasonable.

We compare costs of inventory items with current replacement costs per vendor
invoices, open purchase orders, current price lists, quotes or published market prices.
We consider the effect of lower current cost on materials and purchased parts content
of inventory, and on commitments for additional quantities of similar items.

We compare costs of WIP and finished goods to selling prices as shown by recent
sales invoices, current price lists (adjusted for discounts), and other sources to
determine whether there is sufficient margin to cover costs to complete and dispose.

Potential obsolescence losses may be discovered when examining the physical

inventory (e.g., the presence of dusty and “buried” items), when reviewing the
detailed perpetual inventory records for usage, and when comparing the inventory
compilation with those of prior years. The examination of sales backlogs, sales
catalogues, sales commitments, and sales contracts may also disclose changes in the
entity’s business that in turn may indicate that certain merchandise can be sold only
at “distress” prices.

We also consider:

· The existence of damaged, slow-moving, overstock, out-of-style and obsolete

inventories and of commitments for additional quantities of similar items. Make
note of such items during the physical inventory counts, review of perpetual
records, price tests and review of gross margins;

· The expected level of inventory provisions by projecting the expected

inventory levels and percentages from the prior year taking into account any
changes in the business or market place. If appropriate, we build our
expectation on a line by line basis. We investigate differences and consider the
need for further provision;

· Compliance with entity's accounting policy and applicable financial reporting

framework;

· The impact of technology, business or environmental changes that may

indicate the need for inventory provisions at a greater level than historic trends
would suggest;

· The overall ageing profile of inventory from our knowledge of inventory levels
and of the business. If the actual ageing of the inventory differs from our
expectations of the ageing profile, we investigate differences and consider the
need for further provision.

We review the allowances for reducing the inventory from cost to market by
evaluating the ultimate recoverability of the cost of the inventory items in question.
Among the factors we consider are:

· Their scrap or salvage value;

· Possible alternative uses for them (e.g., raw materials or components may be
used in manufacturing items other than the items in which they are normally
used);

· Their realizable value if they are sold by methods or in markets other than the
usual ones (e.g., through jobbers or for export rather than directly to domestic
retailers);

· Expected changes in customers’ preferences that may or may not result in the
items being or becoming obsolete;

· The possibilities of selling the items by reducing their prices;

 · The possibilities that raw materials may be returned to vendors for credit; and

· Projected or budgeted sales of apparently excess quantities.

We discuss with entity officials the reason for slow movement, the nature and
conditions of such goods, the possibility of selling them and the price likely
obtainable.

4 Procedures Responsive to Combined Risk

Assessment
Appendix 2 Illustrative Procedures for Inventories Responsive to Combined Risk
Assessment contains examples of procedures that may, together with the procedures
previously discussed, be useful in achieving the primary account balance audit
objectives when our evaluation of classes of routine transactions indicates possible
errors.

We need not perform these application-related procedures when we have evaluated

the controls as effective and tested them (using full tests of controls) and found that
we can rely on them, or when the primary substantive procedures can provide
sufficient assurance that the potential errors in question have not occurred.

We consider performing these procedures when we have evaluated the controls as

effective, but have only performed limited tests of controls (especially when our
combined risk assessment for the account is “moderate” since in such circumstances
we would have assessed inherent risk as higher), and we are more likely to perform
them when we have evaluated the controls as ineffective.

In determining whether classes of transactions are significant in auditing inventory

and cost of sales, we consider:

· How the classes of transactions affect the entity’s process for establishing the
inventory balance (i.e., whether they process information that could contain
errors) and;

· Whether they produce information that is important in auditing the data or

judgments in inventory.

For example, a class of transactions may be significant because:

· The entity relies on the of transactions to establish the quantities or the

 valuation of the inventory;

· The of transactions serves as the basis for rolling forward the inventory
balances;

· The of transactions produces records or information used in establishing the

balances (e.g., purchasing records are used to determine unit costs of materials
or payroll records are used to establish labor rates).

Previously selected procedures that relate to the Purchasing or Payroll class of

transactions may not provide adequate assurance for the inventory accounts. This is
because the population from which transactions are selected for testing is considered
when determining whether the procedures provide assurance for other accounts. For
example, if a sample is selected from all purchases during the year, it probably will
not provide much assurance for the inventory accounts unless the preponderance of
purchase transactions relate to inventory. Therefore, when planning our audit of the
inventory accounts, we separately evaluate the extent of procedures required.

The timing and extent of the procedures performed are responsive to our combined
risk assessments.

5 Documentation
Documentation includes, but is not limited to, identification of the following:

· The procedures performed (generally the audit plan or reference to it) and
conclusions reached with respect to the procedures performed, together with a
conclusion statement with respect to inventories;

· The evaluation of the flow of significant estimation, routine and non-routine

transactions and related controls within significant processes, as well as the
sources and preparation of information resulting in significant disclosures;

· The problems encountered and bases of resolution; and

· To the extent appropriate, the following:

o A statement of the nature of the inventories and the costing methods used;

o Information regarding the observation and confirmation of physical

inventories (e.g., locations; test counts; cutoff data; the count tags, sheets or
cards used; monetary value of the inventory observed; and confirmation
replies);
 o Explanations of major adjustments to recorded inventories resulting from
physical inventories or other causes;

o Identification of valuation considerations, such as loss contracts, net

realizable value; replacement cost, obsolescence, slow-moving and excess
quantities, and defective merchandise;

o Analyses of the changes in the composition, amount, quality, etc. of the

inventory and in the gross profit and turnover ratios since the preceding year,
and the reasons for such changes;

o Analyses of commitments to purchase, manufacture or sell inventories that

will result in losses to the entity;

o Summary of extent of our quantities and pricing tests;

o Results of other analytical review procedures performed;

o A description of the entity’s plans that could affect the valuation of existing
inventories, and its plans for developing the entity’s products;

o A list of the liens against, pledges of, and other security interests in,
inventories; and

o The procedures followed to disclose cutoff errors if physical inventories were

taken at one date and receivables were confirmed at another date.

It may also be helpful to include a carryforward schedule that provides a summary of

key inventory information such as:

· A brief summary of the overall system;

· Details of the methods of costing;

· Details on timing and determination of standards (e.g., standard hours,

standard labor rates and overhead rates); and

· Methods of allocating labor and overheads.

Appendix 1 – Illustrative Procedures for Inventories

Regardless of Combined Risk Assessment

This Appendix sets out possible general and analytical audit procedures that may be
carried out for inventories.
General Procedures

Determine the entity’s procedures for investigating outside warehouses prior to entering into
warehousing agreements and for maintaining controls over the inventories in warehouses
after the agreements become effective.

If warehouse receipts are used as collateral for loans, confirm the details with the lenders.

Review minutes, contracts and other documents for evidence of liens, pledges or other
security interests in inventories; determine that the necessary disclosures are made.

Verify the calculations of inter- and intra-company profits in inventories, and that such profits
have been eliminated on consolidation.

Review the raw materials, WIP and finished goods inventories accounts and the cost of sales
accounts in the general ledger and subsidiary ledgers for unusual items.

Review the nature of items included in non-inventory and cost of sales accounts in the general
ledger for amounts that should be included in inventory.

Review the raw materials, WIP and finished goods inventories accounts not tested in detail for
unusual items.

Review the reasonableness of the costs applied to the inventory balances not tested in detail.

Determine that the costing method used is consistent with the entity’s policy and with the
method used in the prior year.

Inquire as to the existence of damaged, slow-moving, overstock, out-of-style and obsolete

inventories, and of commitments for additional quantities of similar items. Make note of such
items during the physical inventory counts, review of perpetual records, price tests and review
of gross margins.

Review and test the procedures for identifying obsolete, damaged, excess and slow-moving
inventories. Review the values assigned to such items.

Investigate any sales and purchase commitments, back orders or sales options to determine
whether any losses are likely to be realized in the course of fulfilling the commitments. Verify
the reasonableness of the allowances for such unrealized losses.

Investigate significant price variance accounts. High variances may indicate incorrect standard
costs. Review for reasonableness the allocation of variances between cost of sales and year
end inventory.
Compare costs of inventory items with current replacement costs per vendor invoices, open
purchase orders, current price lists, quotes or published market prices. Consider the effect of
lower current cost on materials and purchased parts content of inventory, and on
commitments for additional quantities of similar items.

Compare costs of WIP and finished goods with selling prices as shown by recent sales
invoices, current price lists (adjusted for discounts), and other sources to determine whether
there is sufficient margin to cover costs to complete and dispose.

Physical inventory general procedures

Review and determine the adequacy of the instructions and other written materials concerning
the counting of inventories and the recording of inventory transactions near the count date.

If the physical inventory is taken on a staggered basis throughout the year, determine the
extent of the entity’s counts during the year; observe one or more of the inventory counts;
test the recording of the adjustments resulting from the counts to the inventory records; test
count the quantities recorded in the inventory records; and test the recording of the
adjustments in the general ledger accounts.

If physical inventories are taken at an interim date or on a staggered basis during the year,
review the rollforward of activity from the date of the physical inventory to the balance sheet
date and investigate unusual items; consider observing (at the balance sheet date) significant
new items and those items with significant increases or decreases between the physical
inventory date and the balance sheet date.

Review for reasonableness any adjustments to the compiled inventory.

General procedures for unobserved locations

Obtain a copy of the physical inventory compilation and review it for reasonableness (large
and/or unusual items).

Obtain entity records of the physical count and review the results and disposition of any
exceptions/problems noted.

Review the activity in the inventory account since the physical count for reasonableness (large
and/or unusual items).

Vouch activity in the inventory account since physical count to supporting documents.

Perform analytics such as comparing current year balance to prior year and to budget.

Analytical Procedures

General

Compare the current year’s inventory turnover based either on cost or on units sold or
produced with prior years’ turnovers.
Inventory turnover is defined as the average inventory balance divided by cost of sales.
Declines in turnover, or increases in the number of days’ cost of sales in inventory, usually
indicate an overstatement of inventory, overstocking, or the presence of slow-moving items in
inventory that may require a provision.

Compare inventory quantities and/or costs by location, by type and by product with prior
years’ amounts.
A wide variation in opening and closing inventories of the same item may indicate an error in
the count; the same quantity sometimes indicates the presence of obsolete goods.

Compare inventory quantities by product with units sold or used.

Compare the current year’s gross profit ratios (by month, by location and by product line)
with those of prior years and/or industry averages.

Compare the current year’s cost of sales accounts to the prior years’ and to the current year’s
budget (in value or percentages), and investigate any large or unusual fluctuations or the
absence of expected fluctuations.

Compare the current year’s payroll expense accounts to the prior year’s and budgets by
classification and investigate any large/unusual fluctuations or the absence of expected
fluctuations.

Compare with prior years the relationship of payroll expense to cost of sales and sales.

Compare budgeted usage of raw materials with the actual usage.

Compare production reports with the recorded warehouse receipts of finished products.

Compare the relationships of material, direct labor and overhead costs to cost of sales with
prior years. Investigate significant unusual fluctuations or the absence of expected
fluctuations.

Valuation

Compare the average actual unit cost charged to cost of sales during the year by product line
with the costs used to price year end inventory.

Compare unit prices for inventory items with those of prior years and investigate significant
changes and/or unusual trends in pricing.

Compare the relationships of actual labor and overhead costs to materials put into production
with the same relationships in ending inventory. Compare with prior years.

Review product line operating statements and overall profitability to determine if costs are
being recovered through selling prices.

Obsolete and excess inventory

Compare quantities estimated to be sold with forecasts of industry sales.

Compare the quantities the entity is committed to purchase and has in hand to the quantities
required for future production and/or with forecasted sales.

Compare inventory quantities with production and storage capacities.

Compare current year’s to prior year’s excess and obsolete reserve, write-offs and related
expense as a percentage of inventory and cost of sales.

Compare current year’s to prior year’s number of days cost of sales in inventory by inventory
category and product line.

Compare monthly/annual amounts sold (by product/product line) for current year and prior
year.

Compare monthly/annual amounts purchased and/or production (by product/product line) for
current year and prior year.

Compare excess and obsolete experience to patterns in entity’s industry.

Appendix 2 – Illustrative Procedures for Inventories

Responsive to Combined Risk Assessment

The following are examples of procedures that may, together with the procedures
previously discussed, be useful in achieving the primary account balance audit
objectives when our evaluation of classes of routine transactions indicates possible
errors.

Counting and costing physical inventory application:

1. Confirm inventories held by the entity for others at the physical inventory
date.

2. Determine that the inventory quantities in the inventory compilation are the
same as those in the physical inventory or as established by the rollforward.

3. Review the inventory compilation for items with zero values or negative
values and investigate them.

4. Determine that the prices tested are used in the inventory compilation.

5. Test the mathematical accuracy (footings and extensions) of the inventory

compilation.

6. Test the mathematical accuracy of the compilation of unit costs of items in

WIP and finished goods.
7. Test raw material unit costs by reference to veendor invoices.

8. Vouch the costs and agree the quantities of materials in WIP and finished
goods inventory that have been costed at actual costs to supporting
documentation.

9. Vouch the hours and rates for labor in WIP and finished goods inventory that
have been costed at actual costs.

10. Review the expense accounts included in or excluded from overhead to

determine whether their inclusion or exclusion is appropriate and consistent.

11. Consider whether overhead costs are overstated due to the inclusion of the
costs of idle capacity in overhead rather than charging off the costs as period
costs.

12. Review the activity in the accounts included in overhead and vouch any
large/unusual items.

13. Review the activity in the accounts excluded from overhead to determine
whether any items should have been included in overhead.

14. Verify the accuracy of the denominator (e.g., direct labor dollars or hours)
used in calculating the overhead rate.

15. Test the calculation of the overhead rate.

16. Test the application of overhead to WIP and finished goods inventory.

17. Test the buildup of overhead costs in WIP inventory and review the stage of
production for reasonableness.

18. Review the materials purchase price variance account taking into
consideration whether:

19. Test the unit costs of materials in WIP and finished goods inventories by
reference to recent invoices.

20. Review the reasonableness of the required materials shown on engineering

reports and bills of materials.

21. Test the reasonableness of materials included in the development of standard

costs or as shown on engineering reports and bills of materials by comparing
them to the materials actually used in finished products.

22. Review the materials usage variance account taking into consideration
whether:

- There were changes to standards during the year that might affect the
allocation of the variance between inventory and cost of sales at year
end;
 - The variance is representative of the year end mix of inventory;

- The data in the variance account or the application that generates the
data in the variance account has been tested.

23. Test the labor rates used to audited payroll records, union agreements, etc.

24. Review the reasonableness of the labor hours on engineering reports and
bills of materials.

25. Test the reasonableness of the labor hours included in the development of
standard costs or as shown on engineering reports and bills of materials by
comparing them to the actual labor hours in finished products.

26. Review the labor variance accounts taking into consideration whether:

- There were changes to standards during the year that might affect the
allocation of the variance between inventory and cost of sales at year
end;

- The variance is representative of the year end mix of inventory;

- The data in the variance account or the application that generates the
data in the variance account has been tested.

27. Test the buildup of the costs of materials in WIP inventory and review the
determination of the stage of production for reasonableness.

28. Determine whether the labor hours in WIP are reasonable when compared
with those tested when auditing finished goods.

29. Test the buildup of labor costs in WIP inventory and the relationship of the
costs to the stage of production for reasonableness.

Inventory and Cost of Sales:

Purchases application
30. Test the records of goods and services ordered by comparing purchase
requisitions and purchase orders to vendors’ invoices.

31. Test the record of goods and services received by comparing receiving
documents to vendors’ invoices.

32. Test vendors’ invoices to the voucher register (or other initial record of
entry).

33. Test the records of goods and services purchased to the records of goods
and services ordered and received by comparing the voucher register to
vendors’ invoices.

34. Test the records of goods and services purchased to the records of goods
and services ordered and received by comparing vendors’ invoices to
purchase orders and requisitions, receiving documents or evidence of
receipt of services.

35. Consider the reasonableness of the quantities and the business purposes of
the items purchased.

36. Compare the prices on purchase orders and vendors’ invoices with those in
vendors’ catalogs.

37. Test the mathematical accuracy of invoices.

38. Test the timely recording of purchases to the voucher register.

39. Test the account distributions in the voucher register by comparing the
nature of the goods or services purchased with the descriptions of the
accounts.

40. Test the posting of individual purchases in the voucher register to the
vendors’ ledger accounts as to the proper vendor, invoice number, date and
amount.

41. Test the mathematical accuracy of the voucher register.

42. Test the postings of the totals in the voucher register to the general ledger
and subsidiary ledgers.
Payroll application

43. Account for the numerical sequence of paid payroll checks during a specified
time period.

44. Compare the payrolls at the beginning and end of the year to identify
changes in employees and pay rates.

45. Compare hours paid with the record of hours worked (e.g., time cards).

46. Trace the payroll checks to the payroll register.

47. Agree the record of labor performed (time cards or job tickets) to the labor
cost distribution.

48. Obtain a list of employees who left during the year from a source other than
the payroll department (e.g., the personnel department) and determine
that the former employees were removed from the payroll on a timely
basis.

49. Observe, on a surprise basis, the distribution of payroll checks to employees.

50. Investigate the handling of unclaimed payroll checks.

51. Compare employee data (e.g., name, identification number, department,

employee status or group, location, wage rate, deductions) to
authorizations on file (e.g., hiring records, personnel files for wage rates
and deductions, union contracts and authorization forms for inncome tax
withholding).

52. Compare names, net pay and other data in the payroll register to the
canceled payroll checks or substitute checks. Examine endorsement(s) on
payroll checks or substitute checks and compare them to specimen
signatures in the personnel files; investigate unusual or multiple
endorsements.

53. Test the extensions of the wage rates times the hours worked.

54. Test the timely recording of payroll cost to payroll records.

 55. Review the appropriateness of the labor cost distributions based on the
nature of work performed (e.g., examine time cards or job tickets).

56. Test the mathematical accuracy of payroll register and the labor cost
distribution.

57. Test the postings of totals in the payroll register and the labor cost
distribution to the general ledger and the subsidiary ledgers.

58. Compare the labor cost distribution totals to the payroll register.

59. Test the mathematical accuracy of the individual labor cost distributions.

Inventory/cost of sales application

60. Test the posting of purchases, production, transfers and shipments of

inventories to the perpetual (or other) inventory records.

61. Test the recording of acquisitions, transfers and dispositions of inventories to

the general ledger accounts.

62. Test transactions recorded in the perpetual (or other) inventory records to
the supporting documentation.

63. Test transactions recorded in the general ledger inventory accounts to

supporting documentation.

64. Test the costing of inventories produced and sold by reference to cost data.

65. Test the timely recording of purchases, shipments and other activity to the
inventory records.

66. Test the mathematical accuracy of the inventory and related journals (e.g.,
cost of sales journal, production journal, labor distribution reports).
Procedures responsive to possible errors — physical inventory count

Primary Other
Substantive Substantive
1 2 3
Assertion Possible Error Procedure Procedure

Possible Errors in Counting the Inventory:

E Inaccurate count/description resulting in inventory F1 1

overstatement (quantity, identification, percent
completion).

C Inaccurate count/description resulting in inventory F1 1

understatement (quantity, identification, percent
completion).

Possible Errors in Compilation of Physical Counts:

E Inaccurate compilation resulting in inventory F1

overstatement (e.g., quantities changed, compiled
twice, inventory added).

C Inaccurate compilation resulting in inventory F1

understatement (e.g., quantities changed, tags not
compiled, inventory deleted).

E, C Inventory description inaccurately compiled (under F1

or overstatement).

V Conversion errors (e.g., counted in one unit of F1

measure, costed in another).

Possible Errors in Cutoff: F1

E, C Receipts F1; F5 1

E, C Shipments F1; F5 1

E, C Transfers F1; F5 1

Possible Errors in Consigned Inventory:

C, R&O Inventory on consignment to others. F2

E, R&O Inventory on consignment from others. 1

Procedures responsive to possible errors — physical inventories

Primary
Substantive Other Substantive
1 2 3
Assertion Possible Error Procedure Procedure

Possible Mechanical (Compilation)

Errors:

C, V Incorrect physical or perpetual F1, F3 2

quantities used in compilation.

C, V Incorrect costs applied in F3, F6 3, 4

compilation.

C Errors in extensions or footings in F3 5

compilation.

C, V Errors in compiling unit costs. F3, F6 6

Possible Valuation Errors (Actual

Costs):

C, V Material quantities in WIP/FG 8

(e.g., unit assemblies) are
incorrect.

V Material prices are incorrect. F6 7, 8

V Labor hours are incorrect. F6 9

V Labor rates are incorrect. F6 9

V Errors in overhead F6 10, 11, 12, 13, 17

accounts/amounts included in OH
 pool.

V Errors in calculation of OH rate. F6 14, 15, 17

V Errors in application of OH rate. F6 16, 17

Possible Valuation Errors

(Standard Costs):

C, V Material quantities in WIP/FG 20, 21, 22

(e.g., unit assemblies) are
incorrect.

V Material prices are incorrect. F6 7, 18, 19

V Labor hours are incorrect. F6 24, 25, 26, 28

V Labor rates are incorrect. F6 23, 26

V Build-up of material and labor F6 20, 24, 27, 29

costs (WIP) does not accurately
reflect stage of production
(percentage completion).

V Errors in accounts/amounts F6 10, 11, 12, 13, 17

included in OH pool.

V Errors in calculation of OH rate. F6 14, 15, 17

V Errors in application of OH rate. F6 16, 17

Procedures responsive to possible errors — purchases application

 Other
Primary Substantive Substantive
1 2 3
Assertion Possible Error Procedure Procedure

E Debits to inventory accounts are F5 33, 34, 35

not represented by goods or
services received.

V Additions to inventory accounts F6 36, 37

are computed incorrectly.

C Charges for inventory related F5 30, 31, 32

goods or services are not
recorded.

C Additions to inventory accounts F5 38

are recorded in the wrong period.

C Inventory is incorrectly classified. 39, 40

C Voucher register is not correctly 41

summarized.

C Inventory additions are not 32, 39, 40

correctly posted to the voucher
register.

C Totals for inventory in the voucher 42

register are not correctly posted
to general ledger and subledger.

Procedures responsive to possible errors — payroll application

Other
Primary Substantive Substantive
1 2 3
Assertion Possible Error Procedure Procedure

E Charges to Payroll accounts are not 43, 44, 45,

represented by services performed. 48, 49, 50,
51, 52

V Payroll charges are incorrectly 44, 51, 53

 computed.

C Services performed by employees are 43, 44, 45,

not recorded. 46, 47

C Payroll charges are recorded in the 54

wrong period.

C Payroll charges are incorrectly 47, 51, 55

classified.

C Payroll register labor distribution and 56, 59

time cards are incorrectly
summarized.

C Payroll register/labor distribution is 57

not correctly posted to the general
ledger.

C Payroll data are not correctly posted 46, 47, 52, 58

to the payroll register/labor
distribution.

Procedures responsive to possible errors — inventory/cost of sales application

Other
Primary Substantive Substantive
1 2 3
Assertion Possible Error Procedure Procedure

E Debits and credits to inventory 62, 63

accounts are not represented by
actual inventory transactions.

V Inventory transactions are computed 60, 61, 62,

incorrectly 63, 64

C Inventory transactions are not F5 60, 61

recorded.

C Inventory transactions are recorded in F5 65

the wrong period.

C Inventory transactions are incorrectly 60, 61, 62, 63

classified.

C Inventory related journals (e.g., cost 66

of sales journal, labor distribution
reports) are not correctly summarized.

C Inventory data are incorrectly posted F3 60, 62

to perpetual (or other) records.
 C Inventory data are incorrectly posted F3 61, 63
to the general ledger.

Appendix 3 – Cycle counts

1 Introduction

This appendix provides additional guidance on auditing inventories when the entity
uses cycle counts to confirm the accuracy of its perpetual inventory records, rather
than performing a complete annual inventory count at an interim date or at the year
end. This appendix should be read in conjunction with the Global Audit Methodology
(EY GAM) and the additional guidance on auditing inventories in section 5.5 (F)
Inventories.

2 What is a cycle count?

When an entity relies on perpetual inventory records to determine inventory

quantities, the entity may check the accuracy of these records by partial counts on a
continuous or cycle basis. The entity will aim to count each item in inventory several
times per year, counting some part of the inventory daily, weekly or monthly.

There are various methods for determining the basis on which items are to be
counted, for example:

1. The Geographic Method involves starting at one end of the stores and counting
a certain number of products each day/week/month until the counters reach the
other end of the warehouse. This results in counting all stock items an equal
number of times per year. This method helps to find misplaced or lost material,
especially items that have been stored between bins or on the wrong shelves.

2. The Ranking Method involves invoking the “80:20” rule, i.e., the 20% of
inventory items that make up 80% of the inventory value are counted more
frequently than the lower value items that make up less of the inventory balance.
The Ranking Method focuses on high value items, reducing the chance of a
material misstatement in the high value items.

3. The Frequency-of-Use Method involves counting the most frequently used

items more often than stock items that are less frequently used. This method
helps to improve the efficiency of the entity’s supply chain - if those frequently
used items run out, the supply chain could be significantly disrupted, even
though the stock item may have a low value and could not cause the inventory
 value to be materially misstated if incorrect.

The entity will select the method and the timeframe over which the stock is counted,
according to the needs of the business operations. However, we would expect that
the process adopted will be such that all inventory is counted several times per year.
Therefore, when reviewing management’s cycle count processes, we consider
management’s plan for determining the frequency with which products are counted
and how the process ensures that all stock items are counted regularly.

3 Relying on controls

If the entity relies principally on its inventory and cost of sales application for
determining the inventory quantities and/or the inventory and cost of sales amounts,
we place more emphasis on testing the effectiveness of controls over the application.
Thus, the effectiveness of controls is of greater importance to us when an entity relies
on cycle counts and the perpetual records than when the entity takes a complete year
end physical inventory.

When the entity relies on cycle counts and the perpetual inventory records, there is
the potential that errors in the inventory quantities will arise during the period from
the count date to the balance sheet date. In such a case, the effectiveness of controls
over the inventory and cost of sales, sales and accounts receivable, and purchases
and accounts payable applications will significantly affect the entity’s ability to
produce an accurate inventory balance at the balance sheet date. Even with effective
controls, the chances for error increase as the period between the count date and the
balance sheet date increases, so it is important to consider how management
determines the integrity of the perpetual inventory records at the balance sheet date.

If we plan to rely on cycle counts, we thoroughly document the design of the cycle
count procedures and evaluate the effectiveness of the procedures and the controls
embedded therein. Further, when testing the operational effectiveness of the cycle
count procedures, we document the nature, timing and extent of the procedures we
performed and the results thereof. Relying on cycle counts will ordinarily be adequate
for audit purposes only when the entity has designed and implemented adequate
controls over changes in inventory.

We understand management’s process for executing and controlling the cycle counts
and for reconciling the inventory records after each cycle count. For example, we
obtain an understanding of management’s processes for performing the inventory
count, for following up discrepancies and for monitoring the process for resolving and
correcting the discrepancies between the physical count and the records. We look for
evidence of appropriate monitoring controls, and in particular, for evidence that such
follow-up is timely.

Because the entity is performing cycle counts on an ongoing basis, some aspects of
the inventory count are different from those at a complete inventory count. For
example, when a complete inventory count is made, movement of inventory stops
and counts occur simultaneously at all locations. However, with a cycle count, it may
be more difficult to control the movement of stock, because the cycle count is of only
some stock each day/week/month, as part of the normal routine of the entity.
Consequently, when reviewing management’s inventory count processes and controls,
we consider the process for controlling or managing stock movements during the
cycle count and for managing cut-off. For example, with daily counts, management
may choose to schedule the cycle count for the quietest part of the day, so that stock
movement is minimized, or may have implemented a technological solution, such as
radio frequency (RF) barcoding.

We consider who performs the count. Usually, because the cycle counts are a regular
activity and part of their role, we would expect that the personnel performing the
cycle counts would be knowledgeable about the inventory, and that they would follow
the established procedures diligently when they perform the count. We also consider
whether appropriate segregation of duties is maintained, with those counting the
inventory being independent of those maintaining and processing adjustments to the
records.

We also consider whether cycle counts are appropriate as the basis for determining
the year end inventory balance. For example, manufacturers and suppliers of parts
often use cycle counts successfully to determine the year end inventory balance,
whereas it may not be appropriate for retailers that have many departments to do so
- the merchandise is unlikely to be sufficiently tightly controlled on the shop floor as
customers and employees move goods throughout the store and merchandise may be
mixed in window and in-store displays in several locations within the store. In this
environment, a complete physical count at or near the period end will generally be
more accurate.

4 Nature, timing and extent of audit procedures to test cycle counts

When we rely on an entity’s cycle count, we are placing greater reliance on the
strength of the entity’s overall controls over the existence of inventory than when we
attend a year end inventory count. We recognize that our approach to the audit of
physical quantities in these circumstances will differ from our approach when all the
inventory is counted at once. We perform tests designed to determine whether
management:

· Maintains adequate inventory records that are kept up-to-date;

· Has satisfactory procedures for the inventory count and test-counting; and

· Investigates and corrects all material differences between the book inventory
records and the physical counts.
We test the controls we plan to rely on in accordance with EY GAM. Our tests would
include:

· Considering whether the cycle count process covers 100% of the entity’s
inventory and inspecting reports and recording of the actual annual coverage of
the cycle counts performed by the entity, to establish that 100% of inventory had
been covered by the process in the 12 months.

· Attending one or more cycle counts to walkthrough and confirming our

understanding of the process by observing the cycle count in operation.

· Performing tests of the controls on which we plan to rely. For example, if the
control that we rely on as a result of a system of daily cycle counts is the regular
reconciliation of the stock quantities to the records after each count, we would
likely select 25 days (i.e., the results of 25 different cycle counts) and test how
management has followed up the results of the count.

· Completing the inventory observation checklist and including it in the

workpapers.

In determining the extent of our testing, we consider whether the entity’s internal
audit function has performed any work on the cycle counts, for example, attending a
sample of cycle counts at different locations, and determine the extent to which we
can rely on their work.

We evaluate whether the reasons for any significant differences between the physical
count and the perpetual inventory records are understood and the records are
properly adjusted. For example, we evaluate the entity’s controls for determining that
all the adjustments to the perpetual records to reflect the physical counts are
properly valued and recorded in both the perpetual records and the general ledger,
and that the adjustments reflect an appropriate cutoff of purchase, production and
sales transactions. We also recognize that the existence of numerous book-to-
physical adjustments may indicate that the controls over the inventory and cost of
sales application are not effective.

If the entity’s inventory records prove not to be reliable, we request that

management performs alternative procedures, which may include a full count at the
year end. Similarly, if the entity has ineffective controls over the inventory and cost of
sales accounts, a complete physical inventory count will generally need to be
performed at year end.
1 The Assertion column in the tables above refers to the financial statement
assertions: E=Existence; C=Completeness; V=Valuation.

2 The Primary Substantive Procedure column refers to the PSPs listed in EY GAM EY
GAM 10S11 Exhibit 1 Appendix A: Primary Substantive Procedures (PSP) by Account,
which are also discussed in subsection 3 Primary Substantive Procedures Applicable
to Inventories above.

3 The Other Substantive Procedure column refers to the numbered procedures set
out in this appendix.

1 The Assertion column in the tables above refers to the financial statement
assertions: E=Existence; C=Completeness; V=Valuation.

2 The Primary Substantive Procedure column refers to the PSPs listed in EY GAM EY
GAM 10S11 Exhibit 1 Appendix A: Primary Substantive Procedures (PSP) by Account,
which are also discussed in subsection 3 Primary Substantive Procedures Applicable
to Inventories above.

3 The Other Substantive Procedure column refers to the numbered procedures set
out in this appendix.
1 The Assertion column in the tables above refers to the financial statement
assertions: E=Existence; C=Completeness; V=Valuation.

2 The Primary Substantive Procedure column refers to the PSPs listed in EY GAM EY
GAM 10S11 Exhibit 1 Appendix A: Primary Substantive Procedures (PSP) by Account,
which are also discussed in subsection 3 Primary Substantive Procedures Applicable
to Inventories above.

3 The Other Substantive Procedure column refers to the numbered procedures set
out in this appendix.

1 The Assertion column in the tables above refers to the financial statement
assertions: E=Existence; C=Completeness; V=Valuation.

2 The Primary Substantive Procedure column refers to the PSPs listed in EY GAM EY
GAM 10S11 Exhibit 1 Appendix A: Primary Substantive Procedures (PSP) by Account,
which are also discussed in subsection 3 Primary Substantive Procedures Applicable
to Inventories above.

3 The Other Substantive Procedure column refers to the numbered procedures set
out in this appendix.

1 The Assertion column in the tables above refers to the financial statement
assertions: E=Existence; C=Completeness; V=Valuation.

2 The Primary Substantive Procedure column refers to the PSPs listed in EY GAM EY
GAM 10S11 Exhibit 1 Appendix A: Primary Substantive Procedures (PSP) by Account,
which are also discussed in subsection 3 Primary Substantive Procedures Applicable
to Inventories above.
3 The Other Substantive Procedure column refers to the numbered procedures set
out in this appendix.

Go To Document ID: GSAM 5.5

Last Modified Date: 26 Jan 2009