As auditors, we usually audit inventory by testing the various audit assertions including existence, completeness, rights and obligations, and valuation. In the audit process of inventory, physical inventory count may be the most important part of the inventory audit. This is due to physical inventory count can provide evidence on existence and completeness.
It is also important for us to evaluate whether the inventory reported in the financial statements is correctly valued. The misstatement on inventory not only affects the balance sheet but also the income statement. Likewise, the whole financial statements may be materially misstated due to the over or undervaluation of the inventory.
In the audit of inventory, we usually test the audit assertions included in the table below:
In the audit of inventory, we usually focus more on existence and valuation. This is due to we concern more about whether the inventory does actually exist; and that it has been properly valued in accordance with applicable accounting standards.
In the audit of inventory, we want reasonable assurance that the inventory actually exists and is really owned by the client. And inventory balances are all included on the balance sheet and their value reflects actual economic value on the market.
In the audit of inventory, existence or occurrence assertion tests whether the inventory on balance sheet actual exists and whether inventory transactions actually took place.
Example: test of existence in physical inventory count procedure
Completeness assertion in the audit of inventory tests whether all the inventory at year-end is included in the balance sheet and all purchases and sales of inventory are recorded. One high risk of inventory is that the company bought the inventory but the purchases were not recorded into the inventory account. This could be the result of intentional fraud or unintentional error, in which they both lead to an understatement of inventory.
Example: test of completeness
In the audit of inventory, completeness assertion tests whether all the inventory recorded in the balance sheet really belongs to the company.
Example: test of rights and obligations
Valuation assertion tests whether the inventory figures in the client’s account are correct and the evaluation method used by the client in determining the cost of various items for inventory valuation is appropriate.
One important rule that always applies to the inventory valuation is that the value of the inventory is measured at the lower of cost and net realizable value. As the auditors, we need to confirm that the client correctly follows the above rule or the misstatement might occur.
More likely than not, the overstatement statement tends to happen in this case as the client sometimes determines the value by cost on all of the inventory including obsolete inventory which their net realizable value is usually lower than the cost.
One more important aspect of the inventory valuation is whether the overhead allocation made by the client is appropriate. We usually meet this case when testing the working-in-progress and finished goods of the client’s manufacturing products.
All in all, inventory existence and valuation are primary concerns that we need to pay close attention to. This is due to the overstatement of inventory at the end of the accounting period will lead to the understatement of the cost of goods sold which then makes the net profit higher than it actually is. In this case, it is considered as a risky area as the company usually links the management’s bonus to the net profit.