13 Inventory

Question 1

The key assertions relating to inventory are:

Answer 1

 Existence  Completeness  Rights and obligations  Valuation  Cut-off

Question 2

The key assertions relating to inventory are: Define and explain Existence and occurrence

Answer 2

– Recorded purchases and sales represent inventories bought and sold. – Inventory on the statement of financial position physically exists

Question 3

The key assertions relating to inventory are: Completeness

Answer 3

– All purchases and sales are recorded. – All inventory at year end is included on the statement of financial position.

Question 4

The key assertions relating to inventory are: Rights and obligations

Answer 4

– The entity has rights to inventory recorded in the period and at the year-end

Question 5

The key assertions relating to inventory are: Accuracy, valuation and allocation

Answer 5

– Costs are accurately determined in accordance with accounting standards. – Inventory is recorded at year end at the lower of cost and net realisable value (NRV).

Question 6

The key assertions relating to inventory are: Classification

Answer 6

– Inventory is recorded in the proper accounts

Question 7

The key assertions relating to inventory are: Cut off

Answer 7

– All purchases and sales of inventories are recorded in the correct period.

Question 8

The key assertions relating to inventory are: Presentation (classification and understandability, completeness, accuracy and valuation)

Answer 8

– Inventory is properly classified in the accounts. – Disclosures relating to classification and valuation are adequate and in accordance with accounting standards

Question 9

What should inventory be value at?

Answer 9

The valuation and disclosure rules for inventory are laid down in IAS 2 Inventories. Inventory should be valued at the lower of cost and net realisable value

Question 10

Define cost and Net realisable value

Answer 10

Cost is defined by IAS 2 as comprising all costs of purchase and other costs incurred in bringing inventory to its present location and condition. Net realisable value is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale.

Question 11

Production costs (costs of conversion) include:

Answer 11

(a) Costs specifically attributable to units of production (b) Production overheads (c) Other overheads attributable to bringing the product or service to its present location and condition

Question 12

What are the year end tests for inventory completeness

Answer 12

 Complete the disclosure checklist to ensure that all the disclosures relevant to inventory have been made.  Trace test counts to the detailed inventory listing.  Where inventory is held in third-party locations, physically inspect this inventory or review confirmations received from the third party and match to the general ledger.  Compare the gross profit percentage to the previous year or industry data

Question 13

What are the year end tests for inventory Existence

Answer 13

Observe the physical inventory count (see Section 4 for details of attendance at the inventory count).

Question 14

What are the year end tests for inventory Rights and obligations

Answer 14

 Verify that any inventory held for third parties is not included in the year-end inventory figure by being appropriately segregated during the inventory count.  For any ‘bill and hold’ inventory (ie where the inventory has been sold but is being held by the entity until the customer requires it), identify such inventory and ensure that it is segregated during the inventory count so that it is not included in the year-end inventory figure.  Confirm that any inventory held at third-party locations is included in the yearend inventory figure by reviewing the inventory listing.

Question 15

What are the year end tests for inventory Accuracy, valuation and allocation

Answer 15

 Obtain a copy of the inventory listing and agree the totals to the general ledger.  Cast the inventory listing to ensure it is mathematically correct.  Vouch a sample of inventory items to suppliers’ invoices to ensure it is correctly valued.  Where standard costing is used, test a sample of inventory to ensure it is correctly valued.  For materials, agree the valuation of raw materials to invoices and price lists.  Confirm that an appropriate basis of valuation (eg FIFO) is being used by discussing with management.  For labour costs, agree costs to wage records.  Review standard labour costs in the light of actual costs and production.  Reconcile labour hours to time summaries.  Make enquiries of management to ascertain any slow-moving or obsolete inventory that should be written down.  Examine prices at which finished goods have been sold after the year end to ascertain whether any finished goods need to be written down.  If significant levels of finished goods remain unsold for an unusual period of time, discuss with management and consider the need to make allowance.  Compare the gross profit percentage to the previous year or industry data.  Compare raw material, finished goods and total inventory turnover to the previous year and industry averages.  Compare inventory days to the previous year and industry average.

Question 16

What are the year end tests for inventory Accuracy, valuation and allocation part 2

Answer 16

 Compare the current year standard costs to the previous year after considering current conditions.  Compare actual manufacturing overhead costs with budgeted or standard manufacturing overhead costs.  Obtain a copy of the inventory listing and cast it, and test the mathematical extensions of quantity multiplied by price.  Trace test counts back to the inventory listing.  If the entity has adjusted the general ledger to agree with the physical inventory count amounts, agree the two amounts.  Where a continuous (perpetual) inventory system is maintained, agree the total on the inventory listing to the continuous inventory records, using CAATs

Question 17

What are the year end tests for inventory for Cut-off

Answer 17

 Note the numbers of the last GDNs and GRNs before the year end and the first GDNs and GRNs after the year end and check that these have been included in the correct financial year.

Question 18

What are the year end tests for inventory for Occurrence and rights and obligations

Answer 18

 Enquire of management and review any loan agreements and board minutes for evidence that inventory has been pledged or assigned.  Enquire of management about warranty obligation issues.

Question 19

What are the year end tests for inventory for Classification

Answer 19

 Review the inventory listing to ensure that inventory has been properly classified between raw materials, work-in-progress and finished goods.  Read the notes to the accounts relating to inventory to ensure they are understandable.

Question 20

What are the year end tests for inventory for Presentation

Answer 20

 Review the financial statements to confirm whether the cost method used to value inventory is accurately disclosed.  Read the notes to the financial statements to ensure that the information is accurate and properly presented at the appropriate amounts.

Question 21

It states that where inventory is material, auditors shall obtain sufficient appropriate audit evidence regarding its existence and condition by attending the physical inventory count (unless this is impracticable) to do the following:

Answer 21

 Evaluate management’s instructions and procedures for recording and controlling the result of the physical inventory count  Observe the performance of the count procedures  Inspect the inventory  Perform test counts

Question 22

Factors to consider when planning attendance at the inventory count include the following:

Answer 22

 The risks of material misstatement of inventory  Internal controls related to inventory  Whether adequate procedures are expected to be established and proper instructions issued for counting  The timing of the count  Whether the entity maintains a perpetual inventory system  Locations at which inventory is held (including materiality at different locations)  Whether the assistance of an auditor’s expert is required

Question 23

A business may count inventory by one or a combination of the following methods.

Answer 23

(a) Physical inventory counts at the year end From the viewpoint of the auditor, this is often the best method. (b) Physical inventory counts before or after the year end This will provide audit evidence of varying reliability depending on: (i) The length of time between the physical inventory count and the year-end (the greater the time period, the less the value of audit evidence) (ii) The business’s system of internal controls (iii) The quality of records of inventory movements in the period between the physical inventory count and the year end (c) Continuous (or perpetual) inventory where management has a programme of inventory counting throughout the year

Question 24

If continuous inventory counting is used, auditors will verify that management:

Answer 24

(a) Ensures that all inventory lines are counted at least once a year (b) Maintains adequate inventory records that are kept up to date. Auditors may compare sales and purchase transactions with inventory movements and carry out other tests on the inventory records, for example, checking casts and classification of inventory. (c) Has satisfactory procedures for inventory counts and test-counting. Auditors should confirm the inventory count arrangements and instructions are as rigorous as those for a year-end inventory count by reviewing instructions and observing counts. Auditors will be particularly concerned with cut-off, that there are no inventory movements while the count is taking place and inventory records are updated up until the time of the inventory count. (d) Investigates and corrects all material differences. Reasons for differences should be recorded and any necessary corrective action taken. All corrections to inventory movements should be authorised by a manager who has not been involved in the detailed work. These procedures are necessary to guard against the possibility that inventory records may be adjusted to conceal shortages. Auditors should check that the procedures are being operated.

Question 25

IN AN AUDIT PLAN: CONTINUOUS INVENTORY COUNT

Answer 25

 Attend one of the inventory counts (to observe and confirm that instructions are being adhered to).  Follow up the inventory counts attended to compare quantities counted by the auditors with the inventory records, obtaining and verifying explanations for any differences, and checking that the client has reconciled count records with book inventory records.  Review the year’s inventory counts to confirm the extent of counting, the treatment of discrepancies and the overall accuracy of records (if matters are not satisfactory, auditors will only be able to gain sufficient assurance by a full count at the year end).  Assuming a full count is not necessary at the year end, compare the listing of inventory with the detailed inventory records, and carry out other procedures (cut-off, analytical review) to gain further comfort.

Question 26

What does attendance at an inventory count do?

Answer 26

Attendance at an inventory count gives evidence of the existence and apparent ownership of inventory. It also gives evidence of the completeness of inventory, as do the follow-up tests to ensure all inventory sheets were included in the final count.

Question 27

Before the physical inventory count the auditors should ensure audit coverage of the count is appropriate, and that the client’s count instructions have been reviewed:

Gain knowledge

Answer 27

 Review previous year’s arrangements  Discuss with management the inventory count arrangements and significant changes

Question 28

Before the physical inventory count the auditors should ensure audit coverage of the count is appropriate, and that the client’s count instructions have been reviewed:

Assess key factors

Answer 28

 The nature and volume of the inventory  Risks relating to inventory  Identification of high value items  Method of accounting for inventory  Location of inventory and how it affects inventory control and recording  Internal control and accounting systems to identify potential areas of difficulty

Question 29

Before the physical inventory count the auditors should ensure audit coverage of the count is appropriate, and that the client’s count instructions have been reviewed:

Plan procedures

Answer 29

 Ensure a representative selection of locations, inventory and procedures are covered  Ensure sufficient attention is given to high value items  Arrange to obtain from any third parties confirmation of inventory they hold  Consider the need for expert help

Question 30

REVIEW OF INVENTORY COUNT INSTRUCTIONS

Organisation of count

Answer 30

 Supervision by senior staff including senior staff not normally involved with inventory  Tidying and marking inventory to help counting  Restriction and control of the production process and inventory movements during the count  Identification of damaged, obsolete, slow-moving, third-party and returnable inventory

Question 31

REVIEW OF INVENTORY COUNT INSTRUCTIONS

Counting

Answer 31

 Systematic counting to ensure all inventory is counted  Teams of two counters, with one counting and the other checking or two independent counts

Question 32

REVIEW OF INVENTORY COUNT INSTRUCTIONS

Recording

Answer 32

 Serial numbering, control and return of all inventory sheets  Inventory sheets being completed in ink and signed  Information to be recorded on the count records (location and identity, count units, quantity counted, conditions of items, stage reached in production process)  Recording of quantity, conditions and stage of production of work-in-progress  Recording of last numbers of goods inwards and outwards records and of internal transfer records  Reconciliation with inventory records and investigation and correction of any differences

Question 33

AUDIT PLAN: ATTENDANCE AT INVENTORY COUNT

Answer 33

 Observe whether the client’s staff are following instructions, as this will help to ensure the count is complete and accurate.  Perform test counts to ensure procedures and internal controls are working properly, and to gain evidence over existence and completeness of inventory.  Ensure that the procedures for identifying damaged, obsolete and slow-moving inventory operate properly; the auditors should obtain information about the inventory’s condition, age, usage and, in the case of work-in-progress, its stage of completion to ensure that it is later valued appropriately.  Confirm that inventory held on behalf of third parties is separately identified and accounted for so that inventory is not overstated.  Conclude whether the count has been properly carried out and is sufficiently reliable as a basis for determining the existence of inventories.  Consider whether any amendment is necessary to subsequent audit procedures.  Gain an overall impression of the levels and values of inventories held so that the auditors may, in due course, judge whether the figure for inventory appearing in the financial statements is reasonable

Question 34

The auditors’ working papers should include:

Answer 34

 Details of their observations and tests  The manner in which points that are relevant and material to the inventory being counted or measured have been dealt with by the client  Instances where the client’s procedures have not been satisfactorily carried out  Items for subsequent testing, such as photocopies of (or extracts from) rough inventory sheets  Details of the sequence of inventory sheets  The auditors’ conclusions

Question 35

Where the entity has inventory that is held by third parties and which is material to the financial statements, the auditor shall obtain sufficient appropriate audit evidence by performing one or both of the following:

Answer 35

 Direct confirmation from the third party regarding quantities and condition (in accordance with ISA 505 External confirmations)  Inspection or other appropriate audit procedures (if third party’s integrity and objectivity are doubtful, for example)

Question 36

The other appropriate audit procedures referred to above could include the following:

Answer 36

 Attending, or arranging for another auditor to attend, the third party’s inventory count  Obtaining another auditor’s report on the adequacy of the third party’s internal control for ensuring that inventory is properly counted and adequately safeguarded  Inspecting documentation in respect of third-party inventory (eg warehouse receipts)  Requesting confirmation from other parties when inventory has been pledged as collateral

Question 37

What is Cut-off testing

Answer 37

Auditors should test cut-off by noting the serial numbers of GDNs and GRNs received and despatched just before and after the year end, and subsequently testing that they have been included in the correct period.

Question 38

Cut-off is most critical to the accurate recording of transactions in a manufacturing enterprise at particular points in the accounting cycle as follows.

Answer 38

 The point of purchase and receipt of goods and services  The requisitioning of raw materials for production  The transfer of completed work-in-progress to finished goods  The sale and despatch of finished goods

Question 39

The auditors should consider whether management has implemented adequate cut-off procedures:

Answer 39

Purchase invoices should be recorded as liabilities only if the goods were received prior to the count. A schedule of ‘goods received not invoiced’ should be prepared, and items on the list should be accrued for in the accounts. Sales cut-off is generally more straightforward to achieve correctly than purchases cut-off. Invoices for goods despatched after the count should not appear in the income statement for the period.

Question 40

Prior to the physical inventory count, management should make arrangements for cut-off to be properly applied.

Answer 40

(a) Appropriate systems of recording of receipts and despatches of goods are in place, and also a system for documenting materials requisitions. GRNs and GDNs should be sequentially prenumbered. (b) Final GRN and GDN and materials requisition numbers are noted. These numbers can then be used to subsequently check that purchases and sales have been recorded in the current period. (c) Arrangements should be made to ensure that the cut-off arrangement for inventories held by third parties is satisfactory.

Question 41

Auditing the valuation of inventory includes:

Answer 41

 Testing the allocation of overheads is appropriate  Confirming inventory is carried at the lower of cost and net realisable value

Question 42

There are several ways of determining cost. Auditors must ensure that the company is applying the method consistently and that each year the method used gives a fair approximation to cost. They may need to support this by additional procedures.

Answer 42

 Reviewing price changes near the year end  Ageing the inventory held  Checking gross profit margins to reliable management account

Question 43

‘Cost’ comprises the cost of purchase plus the costs of conversion. The cost of conversion comprises:

Answer 43

 Costs specifically attributable to units of production  Production overheads  Other overheads attributable to bringing the product or service to its present location and condition

Question 44

The auditors should ensure that the client includes a proportion of overheads appropriate to bringing the inventory to its present location and condition. The basis of overhead allocation should be:

Answer 44

 Consistent with prior years  Calculated on the normal level of production activity Thus, overheads arising from reduced levels of activity, idle time or inefficient production should be written-off to the income statement, rather than being included in inventory.

Question 45

Auditors should compare cost and NRV for each item of inventory. Where this is impracticable, the comparison may be done by group or category. NRV is likely to be less than cost when there has been:

Answer 45

 An increase in costs or a fall in selling price  Physical deterioration  Obsolescence of products  A marketing decision to manufacture and sell products at a loss  Errors in production or purchasing For work-in-progress, the ultimate selling price should be compared with the carrying value at the year end plus costs to be incurred after the year end to bring work-in-progress to a finished state.

Question 46

……………………. is defined by IAS 2 as comprising all costs of …………. and other costs incurred in bringing the inventory to its …………… …………….. and …………….. .

Answer 46

Cost, purchase, present location, condition

Question 47

list three methods of inventory counting. (1) …………………… (2) …………………… (3) ……………………

Answer 47

(1) Year end (2) Pre/post year end (3) Continuous

Question 48

Give four occasions when the NRV of inventory is likely to fall below cost.

Answer 48

 An increase in costs or a fall in selling price  Physical deterioration  Obsolescence of products  A marketing decision to manufacture and sell products at a loss  Errors in production or purchasing

Question 49

State four points in the accounting cycle when cut-off is critical

Answer 49

(1) The point of purchase and receipt of goods and services (2) The requisitioning of raw materials for production (3) The transfer of completed work in progress to finished goods (4) The sale and despatch of finished goods