Inventory Control

Question 1

10 jan 2024

Answer 1

Substantive procedures for inventory focus on verifying the quantity and value of inventory on hand at the end of the reporting period. These procedures primarily address the existence and valuation assertions, but also cover completeness, rights and obligations, and classification and presentation assertions.

1. Existence Assertion:
- Physical Inventory Count: Perform a physical count of inventory to ensure that the inventory recorded in the financial statements actually exists.
- Example: Count the number of units of raw materials, work in progress, and finished goods in the warehouse and compare with inventory records.

2. Valuation Assertion:
- Inventory Valuation: Verify that inventory is valued correctly, considering cost, net realizable value, and any necessary write-downs.
- Example: Check the cost of raw materials against purchase invoices, and ensure finished goods are valued at the lower of cost or net realizable value.

3. Completeness Assertion:
- Test Counts in Both Directions: Perform test counts from inventory records to physical inventory and vice versa to ensure all inventory is recorded.
- Example: Select items from inventory records and verify their physical presence, and select items from the warehouse and ensure they are recorded in the inventory system.

4. Rights and Obligations Assertion:
- Third-Party Inventory: During the year-end physical inventory count, ensure that inventory belonging to third parties is separated and not included in the company’s inventory count.
- Example: Identify and exclude consignment inventory or inventory held on behalf of others from the company’s inventory records.

5. Classification and Presentation Assertion:
- Inventory Schedule Agreement: Ensure the schedule of year-end inventory agrees with the financial statements.
- Example: Verify that the total inventory value on the schedule matches the amount reported in the financial statements.
- Correct Classification: Ensure inventory is correctly classified as raw materials, work in progress, or finished goods in the financial statements.
- Example: Review inventory records to confirm that items are properly categorized and presented in the financial statements.

By performing these substantive procedures, auditors can obtain sufficient and appropriate evidence to support the inventory figures reported in the financial statements. This helps ensure the accuracy and reliability of the financial statements, providing assurance to stakeholders.

IAS 2 Overview:

IAS 2 requires that inventory should be valued at the lower of cost or net realizable value (NRV) on an item-by-item basis.

1. Cost:
- Components of Cost: Includes purchase costs and other costs incurred to bring inventories to their present location and condition. For work-in-progress and finished goods, this includes production overheads.
- Estimation Methods: Cost can be estimated using methods like first-in-first-out (FIFO) or weighted average cost. The chosen method should closely approximate the actual cost of the inventory.

2. Net Realizable Value (NRV):
- Definition: NRV is the estimated selling price in the ordinary course of business, minus any estimated costs to complete and sell the items.

Substantive procedures should be tailored to the nature of the inventory and the specific circumstances of the audit.

1. Retailing Organization:
- Major Component: The primary cost is the purchase cost of goods for resale.

2. Manufacturing or Processing Entity:
- Components of Cost: Includes direct labor, production overhead, raw materials, and components.

1. Cost of Raw Materials or Goods Purchased for Resale:
- Confirm Cost Estimation Approach: Verify the method used by the client to estimate the cost of materials or goods (e.g., FIFO, weighted average cost).
- Check Purchase Invoices: Compare the cost figures with prices in purchase invoices to ensure accuracy.

Scenario:

XYZ Ltd., a manufacturing company, is being audited. The inventory includes raw materials, work-in-progress, and finished goods.

Steps Involved:

1. Confirm Cost Estimation Approach:
   
   • Audit Step: Verify that XYZ Ltd. uses the FIFO method to estimate the cost of raw materials.
   • Example: Review the company’s inventory policy and ensure it aligns with IAS 2 requirements.
2. Check Purchase Invoices:
   
   • Audit Step: Compare the recorded cost of raw materials with purchase invoices.
   • Example: Select a sample of raw materials and match the recorded cost with the corresponding purchase invoices to ensure accuracy.
3. Valuation of Work-in-Progress and Finished Goods:
   
   • Audit Step: Verify that production overheads are included in the cost of work-in-progress and finished goods.
   • Example: Review the absorption rate for production overheads and ensure it is based on normal levels of activity.
4. Net Realizable Value (NRV):
   
   • Audit Step: Ensure that inventory is valued at the lower of cost or NRV.
   • Example: Compare the estimated selling price of finished goods with their cost and adjust the inventory value if NRV is lower.

By following these substantive procedures, auditors can ensure that inventory is accurately valued in accordance with IAS 2, providing reliable financial information to stakeholders. If you have any more questions or need further clarification, feel free to ask! 😊

When auditing the cost of manufactured goods and work in progress, the auditor needs to verify each element of the cost: direct materials, direct labor, and production overheads. Here are the steps involved:

1. Obtain Schedules:
- Audit Step: Obtain schedules showing the breakdown of cost figures for each item of work in progress and finished goods.
- Example: Review the cost schedules prepared by the client to understand the composition of costs.

2. Check Accuracy of Calculations:
- Audit Step: Verify the accuracy of the cost calculations.
- Example: Recalculate the total cost for a sample of work in progress and finished goods to ensure accuracy.

3. Materials:
- Substantive Tests for Raw Materials:
- Audit Step: Perform the same substantive tests as for raw materials.
- Example: Compare the recorded cost of raw materials with purchase invoices.
- Quantity Used:
- Audit Step: Check that the correct quantity of materials has been used in the valuation.
- Example: Verify the quantity of materials used in production against production records.

4. Labor:
- Pay Rates:
- Audit Step: Check pay rates for direct labor costs against payroll/personnel records.
- Example: Verify that the pay rates used in the cost calculations match the rates in the payroll records.
- Hours Worked:
- Audit Step: Check the hours worked (used to calculate labor costs) with time records.
- Example: Compare the hours recorded in the time sheets with the hours used in the cost calculations.

5. Production Overheads:
- Inclusion of Overheads:
- Audit Step: Confirm that only production overheads (not selling and administration overheads) are included in the valuation.
- Example: Review the overhead allocation to ensure only production-related costs are included.
- Absorption Rates:
- Audit Step: Confirm that overhead absorption rates are based on normal levels of output.
- Example: Verify that the overhead rates used are consistent with normal production levels.

6. Work in Progress:
- Stage of Completion:
- Audit Step: Check the stage of completion of work in progress for both materials and conversion costs (labor and overheads).
- Example: Assess the stage of completion by reviewing production records and discussing with production managers.

In substantive testing of inventory, the auditor should also evaluate the client’s procedures for deciding whether each item of inventory should be valued at cost or NRV. This involves:

1. Evaluating Procedures:
- Audit Step: Review the client’s procedures for estimating NRV.
- Example: Ensure that the client considers factors like estimated selling price, costs to complete, and costs to sell.

2. Applying ISA 540 (Revised):
- Audit Step: Apply ISA 540 (Revised) for auditing accounting estimates and related disclosures.
- Example: Assess the reasonableness of the client’s estimates and the assumptions used in determining NRV.

By following these substantive procedures, auditors can ensure that the cost of manufactured goods and work in progress is accurately reflected in the financial statements, providing reliable information to stakeholders. If you have any more questions or need further clarification, feel free to ask! 😊