How to Assess Inventory Management Control Risk

By Maire Loughran from Auditing For Dummies

When you assess a client’s inventory management control risk during your audit, remember that the business’s internal controls directly affect that risk. The inventory management process has control risk associated with one major issue: making sure all inventory on the balance sheet actually exists.

A business must have in place proper segregation of duties so that no single individual handles all or most aspects of the inventory transaction authorization, preparation, and payment. The following list is an example of the proper segregation of duties:

Purchasing inventory: Operating or production departments that require inventory submit purchase requisitions to the purchasing department for approval. When a requisition is approved by purchasing, a purchase order (PO) is provided to the vendor supplying the goods. Good internal controls dictate that employees working in the purchasing department should not also handle inventory.
Using inventory: Every company is different, but manufacturing production departments typically use material requisitions that authorize the release of raw materials from the raw material stores (or raw material inventory). The client’s policies and procedures manual will indicate the authority level for material requisitions. Most likely, a shop foreman or head of the department has that authority.

Employees working in the inventory department shouldn’t have requisition authority or work in the departments making the requisitions.
Taking care of inventory: The physical custodians of any types of inventory should have no access to accounting records, including the inventory records, cost accounting records, or the general ledger.

This segregation of duties is crucial if a client wants to properly manage the two circumstances in which inventory errors and fraud typically occur.

The whole point of observing the taking of a client’s physical inventory is to make sure the balance sheet inventory balance is correct. To make absolutely certain that recorded inventory actually exists, here are some procedures you should employ prior to and during your observation:

Reperformance: Select and count stacks of the client’s inventory and compare your count to the client’s count. If your figures materially reconcile with the client’s figures, all is well. If they don’t, you have to sample and check additional sections of inventory.
Tracing: Select year-end shipping and receiving documents and follow them to the financial statements and the client’s inventory forms. By doing so, you’re checking to make sure the client has appropriately included all inventory.

Safeguarding inventory means that the client sets in place procedures to prevent and detect misuse of inventory so that the financial statements are adjusted and fairly stated to reflect theft or other misuse. Remember, you’re not in law enforcement, and how the company handles its thieving employees isn’t your concern. Your objective is to make sure the inventory balance is materially correct. Although the physical inventory count doesn’t safeguard the inventory from theft or loss, if performed in an effective and timely manner, it prevents a material misstatement to the inventory-related account balances on the financial statements.

A retail client can have different control measures in place, such as the following:

Self-alarming antitheft tags: The tag sounds an alarm when a shoplifter attempts to remove it from merchandise while in the store or walks out of the store with the tagged merchandise.
Electronic cash register (ECR) transactions: They prevent an employee from ringing up a product for less than its actual cost.