Inventory Audit Procedures - AccountingTools

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Home >> Inventory Accounting Topics

Inventory Audit Procedures

If your company records its inventory as an asset, and it undergoes an annual audit, then

the auditors will be conducting an audit of your inventory. Given the massive size of some

inventories, they may engage in quite a large number of inventory audit procedures before

they are comfortable that the valuation you have stated for the inventory asset is

reasonable.

Here are some of the inventory audit procedures that they may follow:

Cutoff analysis. The auditors will examine your procedures for halting any further

receiving into the warehouse or shipments from it at the time of the physical inventory

count, so that extraneous inventory items are excluded. They typically test the last few

receiving and shipping transactions prior to the physical count, as well as transactions

immediately following it, to see if you are properly accounting for them.

Observe the physical inventory count. The auditors want to be comfortable with the

procedures you use to count the inventory. This means that they will discuss the

counting procedure with you, observe counts as they are being done, test count some

of the inventory themselves and trace their counts to the amounts recorded by the

company's counters, and verify that all inventory count tags were accounted for. If you

have multiple inventory storage locations, they may test the inventory in those

locations where there are significant amounts of inventory. They may also ask for

confirmations of inventory from the custodian of any public warehouse where the

company is storing inventory.

Reconcile the inventory count to the general ledger. They will trace the valuation

compiled from the physical inventory count to the company's general ledger, to verify

that the counted balance was carried forward into the company's accounting records.

Test high-value items. If there are items in the inventory that are of unusually high

value, the auditors will likely spend extra time counting them in inventory, ensuring that

they are valued correctly, and tracing them into the valuation report that carries

forward into the inventory balance in the general ledger.

Test error-prone items. If the auditors have noticed an error trend in prior years for

specific inventory items, they will be more likely to test these items again.

Test inventory in transit. There is a risk that you have inventory in transit from one

storage location to another at the time of the physical count. Auditors test for this by

reviewing your transfer documentation.

Test item costs. The auditors need to know where purchased costs in your accounting

records come from, so they will compare the amounts in recent supplier invoices to the

costs listed in your inventory valuation.

Review freight costs. You can either include freight costs in inventory or charge it to

expense in the period incurred, but you need to be consistent in your treatment - so the

auditors will trace a selection of freight invoices through your accounting system to see

how they are handled.

Test for lower of cost or market. The auditors must follow the lower of cost or market

rule, and will do so by comparing a selection of market prices to their recorded costs.

Inventory Audit Procedures - AccountingTools

http://www.accountingtools.com/inventory-audit-procedures[3/29/2015 11:01:30 AM]

Finished goods cost analysis. If a significant proportion of the inventory valuation is

comprised of finished goods, then the auditors will want to review the bill of materials

for a selection of finished goods items, and test them to see if they show an accurate

compilation of the components in the finished goods items, as well as correct costs.

Direct labor analysis. If direct labor is included in the cost of inventory, then the auditors

will want to trace the labor charged during production on time cards or labor routings to

the cost of the inventory. They will also investigate whether the labor costs listed in the

valuation are supported by payroll records.

Overhead analysis. If you apply overhead costs to the inventory valuation, then the

auditors will verify that you are consistently using the same general ledger accounts as

the source for your overhead costs, whether overhead includes any abnormal costs

(which should be charged to expense as incurred), and test the validity and consistency

of the method you use to apply overhead costs to inventory.

Work-in-process testing. If you have a significant amount of work-in-process (WIP)

inventory, the auditors will test how you determine a percentage of completion for WIP

items.

Inventory allowances. The auditors will determine whether the amounts you have

recorded as allowances for obsolete inventory or scrap are adequate, based on your

procedures for doing so, historical patterns, "where used" reports, and reports of

inventory usage (as well as by physical observation during the physical count). If you

do not have such allowances, they may require you to create them.

Inventory ownership. The auditors will review purchase records to ensure that the

inventory in your warehouse is actually owned by the company (as opposed to

customer-owned inventory or inventory on consignment from suppliers).

Inventory layers. If you are using a FIFO or LIFO inventory valuation system, the

auditors will test the inventory layers that you have recorded to verify that they are

valid.

If the company uses cycle counts instead of a physical count, the auditors can still use the

procedures related to a physical count. They simply do so during one or more cycle counts,

and can do so at any time; there is no need to only observe a cycle count that occurs at the

end of the reporting period. Their tests may also evaluate the frequency of cycle counts, as

well as the quality of the investigations conducted by counters into any variances found.

The extent of the procedures employed will decline if inventory constitutes a relatively small

proportion of the assets listed on a company's balance sheet.

Related Topics

How do I ensure a proper inventory cutoff?

How do I improve inventory record accuracy?

How do I reconcile inventory?

Inventory internal controls

Types of inventory errors

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