At every step of an audit, you have to consider risks and their associated controls. At this inventory stage, your focus is on identifying risks that exist in the inventory management process and the internal controls the company has established to offset those risks.
Generally, you look at three inherent inventory management risk factors:
Susceptibility to theft: All inventory, regardless of its nature, can potentially be stolen by either employees or customers. In the retail world, this problem is commonly known as inventory shrinkage, and in the United States it results in tens of billions of dollars in losses each year.
You may think that inventory theft occurs only if an employee or shoplifter has a personal use for the inventory. For example, an employee needs a new computer for home use and liberates one from her place of employment. But more and more, employees and shoplifters steal merchandise and raw materials to sell on venues such as eBay.
High-value inventory that’s small and easy to hide is inherently risky in both merchandising and manufacturing businesses.
Complexity of the year-end inventory procedure: Another risk factor you have to consider is the often complicated year-end inventory procedure. A wide variety of disagreements can surface that you need to address and resolve as quickly as possible. For example, maybe the client doesn’t write down obsolete or damaged merchandise, or it claims that the merchandise is still valuable, or it asserts what you believe to be unreasonable net realizable value for those items.
You may also disagree with the client’s work-in-process inventory valuations, which can be quite complex depending on the nature of the manufactured product. For work in process, this complexity includes valuation of the quantity and type of raw materials, man hours invested in each semi-assembled product, and allocation of manufacturing overhead. Usually, you can clear up any work-in-process disagreements by considering engineering estimates for raw materials and labor, which may be based on time-and-motion studies or historical information. You can obtain good historical info for labor through a schedule of authorized wages tied to the product.
Prior-period misstatements: When you’re auditing inventory management for a continuing client, check out past years’ work to see what types of misstatements existed. A big issue with inventory is valuation. If you’re auditing a manufacturing plant, a major issue with valuation is the degree of processing required to move products from the work-in-process stage to finished goods.
If the client had valuation problems (both understatements or overstatements) in prior years, or if any other aspect of inventory valuation was problematic, home in focus on these issues during the current audit. For example, maybe classification errors were high, meaning that purchases prematurely showed up in income statement expense accounts instead of hitting the inventory balance sheet account first.