Auditing Inventory and Cost of Sales
Inventory is often one of the largest and most complex assets on the balance sheet. It is susceptible to overstatement through fictitious quantities, improper valuation, or failure to write down obsolete items. The auditor must obtain evidence regarding the existence, completeness, valuation, and rights to inventory.
Observing the Physical Inventory Count
The observation of the client's physical inventory count is a required audit procedure when inventory is material (unless it is impracticable). The auditor does not conduct the count—rather, the auditor observes the client's personnel performing the count and performs test counts to verify accuracy.
Key Steps During Inventory Observation
- Review the client's count instructions – Before the count, the auditor reviews management's written instructions to ensure they provide for an orderly, complete count.
- Tour the facility – Walk through the warehouse and production areas to gain an understanding of the nature and volume of inventory.
- Perform test counts – The auditor independently counts selected items and compares the results to the client's count sheets.
- Observe count procedures – Ensure that count teams are following instructions, using pre-numbered tags or sheets, and that movement of goods is controlled during the count.
- Identify obsolete, damaged, or slow-moving items – Note any inventory that appears to be in poor condition, outdated, or excessive in quantity.
- Trace test counts to the final inventory compilation – After the count, the auditor traces the test count results to the client's final inventory report to ensure they are properly included.
The auditor performs test counts in two directions:
- From the floor to the count sheets → Tests completeness (are all items on the floor recorded?)
- From the count sheets to the floor → Tests existence (do items on the sheets actually exist?)
Example: Inventory Observation at Kingfisher Industries
Kingfisher Industries manufactures electronic components and holds significant raw materials, work-in-process, and finished goods. During the year-end count, the auditor:
- Reviews the count instructions and notes that two-person teams are assigned to each warehouse section
- Independently counts 40 items from various locations (test counts)
- Observes that shipping and receiving are shut down during the count to prevent movement errors
- Identifies a bin of outdated circuit boards that appear to be from a discontinued product line
- Records all test counts and later traces them to the final inventory compilation report
Inquiring About Obsolete or Damaged Goods
The auditor must specifically inquire of management about the existence of obsolete, slow-moving, damaged, or excess inventory. Simply observing the physical count is not sufficient—management may know of conditions not visible during a walk-through.
During the audit of Illini Entertainment, the auditor asks management whether any of the company's media inventory has become obsolete due to format changes or licensing expirations. Management discloses that a significant portion of physical media inventory is slow-moving due to the industry shift to digital distribution, requiring a write-down to net realizable value.
Valuation Procedures
- Test pricing – Verify that inventory is valued at the lower of cost or net realizable value (NRV) by examining recent purchase invoices (for raw materials) or production cost records (for WIP and finished goods)
- Review aging of inventory – Analyze inventory turnover and identify items held for extended periods
- Evaluate the allowance for inventory obsolescence – Assess whether management's reserve is reasonable given historical write-downs and current market conditions
- Test cost accumulation – For manufactured inventory, verify that material, labor, and overhead costs are properly accumulated
Example: Inventory Valuation at MSA Records
MSA Records holds a large inventory of vinyl records and related merchandise. The auditor tests pricing by comparing recorded costs to recent vendor invoices and examines sales prices to ensure inventory is not carried above NRV. The auditor also reviews the aging of inventory and notes that certain specialty pressings have not sold in over 18 months, prompting a discussion with management about the adequacy of the obsolescence reserve.
Cutoff Testing
Cutoff testing ensures that inventory transactions are recorded in the proper accounting period.
Purchases Cutoff
The auditor examines the last receiving reports before year-end and the first receiving reports after year-end to verify:
- Goods received before year-end are included in both inventory and accounts payable
- Goods received after year-end are excluded from both
Sales Cutoff
The auditor examines the last shipping documents before year-end and the first shipping documents after year-end to verify:
- Goods shipped before year-end are excluded from inventory and recorded as cost of sales
- Goods shipped after year-end are included in inventory
Cutoff testing for inventory is closely linked to cutoff testing for revenue (sales) and payables (purchases). An error in one area will affect the other.
Example: Cutoff at BIF Partners
BIF Partners' last receiving report before December 31 is #2945, and the first after year-end is #2946. The auditor verifies that goods on receiving report #2945 are included in the year-end inventory count and the related payable is recorded. Goods on receiving report #2946, received on January 2, are properly excluded from the year-end inventory and payable balances.
Disclosure Verification
The auditor reviews financial statement disclosures to ensure they are complete and accurate. Key inventory disclosures include:
| Disclosure Item | Description |
|---|---|
| Costing method | FIFO, weighted average, or other method used |
| Composition | Breakdown of raw materials, WIP, and finished goods |
| Pledged inventory | Whether any inventory is pledged as collateral for borrowings |
| Write-downs | Material write-downs to NRV and the circumstances |
| Consignment inventory | Inventory held on consignment (owned by others) should be excluded; inventory out on consignment (owned by client) should be included |
Example: Disclosures at Gies Co.
Gies Co. uses the FIFO costing method. The auditor verifies that the notes to the financial statements disclose the costing method, provide a breakdown of inventory by category ($2.1M raw materials, $800K WIP, $3.5M finished goods), and note that $1.2M of finished goods inventory is pledged as collateral under the company's revolving credit facility.
Summary of Key Inventory Audit Procedures
| Procedure | Assertion Tested |
|---|---|
| Observe physical inventory count | Existence, Completeness |
| Perform and trace test counts | Existence, Completeness, Accuracy |
| Inquire about obsolete/damaged goods | Valuation |
| Test pricing (lower of cost or NRV) | Valuation |
| Purchases and sales cutoff testing | Cutoff |
| Review inventory disclosures | Presentation and Disclosure |
| Examine consignment arrangements | Rights and Obligations |
The auditor observes the client's inventory count—the auditor does not take the inventory themselves. The responsibility for the physical count belongs to management. The auditor's role is to evaluate the adequacy of the count procedures and perform test counts to corroborate the client's results.