Special Note: Physical Inventory Observation

1
Special Note Physical Inventory Observation

• Importance of Inventory
• Major component of current assets on the balance
  sheet.
• Significant effect on net income.
• Valuation is usually very subjective.
• Potential obsolescence
• Goods have not been sold, so marketability may be
  uncertain.

2
Special Note Physical Inventory Observation

• AICPA Professional Standards specifically address
  the need to observe the client's inventory
  counting procedures "it will always be necessary
  for the auditor to make, or observe, some
  physical counts of the inventory and apply
  appropriate tests of intervening transactions"
  (AU 331.12).
• If the client is on a perpetual system, the
  auditor may make test counts at a time other than
  year-end.
• If inventory is observed on a date other than
  fiscal year-end, the auditor must be able to rely
  on the client's internal controls in order to
  roll-forward (or back) inventory quantities to
  fiscal year-end balances.

3
Special Note Physical Inventory Observation

• If possible, try to stop flow of goods on
  inventory date
• Make TEST COUNTS
• From INVENTORY LISTING, choose sample of items to
  count (Existence)
• From WAREHOUSE FLOOR, choose sample of items to
  count to TRACE to final INVENTORY LISTING
  (Completeness)
• Record all counts in working papers

4
Special Note Physical Inventory Observation

• Use tags to indicate whether all items have been
  counted
• Be wary of "Hollow squares" and "empty boxes
• Tour shipping and receiving areas
• Watch for OBSOLETE and SLOW-MOVING inventory
  (Valuation)
• Inventory on CONSIGNMENT and at other locations
  should be CONFIRMED (Rights and obligations)
• For Specialty Inventory, consider the use of
  SPECIALISTS
• Inventory in transit must be confirmed.

5
Inventory Cost Testing

• Valuation (Price Tests)
• VENDOR INVOICE or cost records (include cost of
  inventory, freight, and other costs)
• Consider COST FLOW ASSUMPTION
• Evaluate LOWER OF COST OR MARKET for inventory
• Check Extensions and Footings of INVENTORY
  LISTING and agree to PERPETUAL INVENTORY RECORDS.
  

6
Purchase Cutoffs

• Verify CUT-OFFs for purchases
• Examine Receiving Reports and Vendor Sales
  Invoices occurring around year-end to ensure
  inventory received is included in the appropriate
  period.

7
Analytic Procedures

• Verify REASONABLENESS of COGS
• Calculate Gross Profit Margin
• Compare to prior year, industry averages
• Verify REASONABLENESS of ending inventory
• Days Sales in Inventory - provides evidence
  concerning management's assertion about
  valuation.
• Inventory Turnover - provides evidence concerning
  management's assertion about valuation.