Testing Inventory Transactions
After you test inventory and verify that your audit client is following its standards, you’re ready to start testing management assertions. For inventory transactions you test these five management assertions during your audit:
Occurrence: Occurrence tests if the inventory transactions actually took place. To test occurrence, you should take a sample of additions to inventory (purchases) and vouch them to purchase requisitions and receiving reports. Vouching means you take a recorded amount and trace it back to the supporting document.
Completeness: Completeness evaluates the management assertion opposite of occurrence. In the inventory management process, understatement (lack of completeness) is your highest risk. In other words, the company buys inventory but the purchase isn’t recorded in the inventory account.
The one big reason this problem may occur is poor inventory controls. For example, employees act together to steal inventory. First, they team up to order inventory. Then, after the inventory is received, it doesn’t hit the books — the employees misappropriate the inventory (taking it home for personal use or to resell).
To check for completeness, you sample and then trace the inventory receiving reports to the inventory records to make sure the two reports match.
When it comes to inventory, the physical inventory at the period end is another measure of completeness. You measure completeness by comparing your client’s inventory compilations to the general ledger listing for inventory.
Authorization: This step addresses whether your client’s management and staff follow proper internal control or other company authorization procedures when handling inventory transactions. Disbursements of stored merchandise or raw material inventory should also be made only when approved by appropriate levels of management. To test this assertion, select a sample of material or inventory requisitions and bills of lading to check that all have proper authorization.
Accuracy: Testing accuracy addresses whether transactions are free from error. Your two big issues with accuracy are making sure that your client’s mathematical physical inventory figures are correct and that the correct amount of inventory flows from the balance sheet to the income statement as cost of goods sold.
If you’re auditing a manufacturing company, to test the accuracy assertion you need to dust off your cost accounting book and brush up on standard costs to sample and test your client’s standard cost calculations. When using standard costing, your client assigns anticipated costs (instead of actual) for direct material and labor, plus manufacturing overhead. These anticipated costs are merely the planned or expected costs usually derived from past costing experience.
Cutoff: This step involves making sure all transactions have been reported in the proper financial period. You do so by testing receiving and shipping documents to prove that the client has correctly recorded movement into inventory (receiving) and out of inventory (shipping). For example, a client on a calendar year-end can’t record merchandise received on January 2 as December inventory.