What to Look for When Auditing Inventory

By Maire Loughran from Auditing For Dummies

The primary reason auditors observe their client taking the physical inventory is to make sure the inventory reflected on the balance sheet actually exists and that the balance sheet includes all inventory owned by the company. This includes all raw materials, supplies, inventory in transit when using Free on Board (FOB) shipping point, inventory the company may have on consignment with another business, and inventory stored off the premises. Confirming the existence of inventory through your observations addresses the occurrence and completeness assertions as well.

Keep in mind that whoever the client may be, you merely observe — you don’t participate.

To know whether your client is getting an accurate count, you need to know many different things about the business. Do your investigative work in advance so that you know what to expect and can have an informed opinion about whether everything is going as it should.

Here are some basic suggestions to get ready for the inventory audit. Tailor them to your client. For some clients, these steps may be too much. For other clients, you may have to add steps. If the company is a repeat client, you’ll have the prior year’s workpapers to help you. Otherwise, your audit team leader can provide further assistance.

Identify inventory locations: Find out from your client where it stores inventory. Is more than one location involved?
Review client procedures: Get a copy of the client’s inventory manual (which lays out the company’s policies and procedures for managing inventory), review it, and discuss with your client any modifications you want to make to the procedure.
Tour the business: Check out the warehouse or other storage areas before the physical inventory count so you know the lay of the land.
Arrange to stop production: If your client is in manufacturing, make sure it doesn’t have any production planned while taking the physical inventory. If your client is in retail, make sure the shop is closed to the public during the count.
Forbid the movement of inventory: Your client’s inventory should stay put until the count is complete. Inventory shouldn’t be transferred between retails shops or manufacturing facilities. Sounds like a no-brainer, right?

Just as you can’t prepare the financial statements you audit, you can’t assist in the taking of the physical inventory. Your job is to watch the employees and make sure they follow the agreed -upon procedures. You want to make certain that they don’t count inventory twice, that they include all inventory, and that they record the counts carefully. (For example, you want to catch if 100 swimsuits are recorded as 1,000.)

If they don’t follow the procedures, you’ll likely have to do more sampling and testing of client counts to verify whether the ending inventory is materially correct. If need be, you can propose a journal entry to adjust ending inventory on the books to actual, per your sampling and testing. Discuss this matter with your audit supervisor for more guidance. Remember, under no circumstances do you step in and help the client take its own inventory.

Consignment goods are never included in ending inventory at any value.

When your client is taking its inventory, make sure it keeps special track of obsolete and damaged items. Whatever the reason, your client should note any obsolete or damaged inventory and reduce its valuation to its net realizable value (the item’s expected selling price less the cost to sell it). Obviously, smashed items probably have a net realizable value of $0 and should be scrapped (removed from the ending inventory).