ATC f8 materials FF8 AA (int)session23 j08

SESSION 23 – INVENTORY OVERVIEW Objective To identify and explain areas of risk To apply procedures to obtain appropriate audit evidence INVENTORY SYSTEM SOURCES OF EVIDENCE IMPORTANCE Types of inventory Materiality Control objectives Internal control examples “Ideas list” RISKS C “CUTOFF” Importance Audit procedures A P E IAS PHYSICAL INVENTORY COUNTING Measurement Cost formulas NRV Provisions Purpose Types of stocktaking Perpetual inventory Physical counting R THIRD PARTY INVENTORY Inventory held by other parties Third party inventory Reservation of title A comprehensive audit program for inventory is set out in Appendix and must be studied 2301 SESSION 23 – INVENTORY IMPORTANCE 1.1 Types of inventory Raw materials and consumables Work in progress Finished goods and goods for resale Long-term contracts 1.2 Materiality Balance sheet Current assets Inventory Income statement Revenue Cost of sales * x Gross profit x (x) _ x _ * = Opening inventory + Purchases (+ conversion costs) – Closing inventory Inventory is frequently material to both BS & IS SOURCES OF EVIDENCE Example Complete the following ideas list 2.1 “Ideas list” Accounting systems ⇒ Documentation ⇒ Tangible assets ⇒ Management and employees ⇒ Customers and suppliers ⇒ Other third parties (e.g banks, solicitors) ⇒ Analytical procedures ⇒ 2302 SESSION 23 – INVENTORY INVENTORY SYSTEM 3.1 Control objectives To ensure that … Stage Goods received Goods despatched … damaged goods are not accepted … goods cannot be misappropriated Stage Receipt recorded Despatch recorded Movement posted to general ledger and inventory records Stage 3.2 Internal control examples 3.2.1 Goods received … all movements are accurately recorded … management has accurate/timely info concerning inventory levels Physical inspection Securely stored 3.2.2 Goods dispatched Two warehouse employees involved Maintain “open orders” file Notification of “stock-outs” 3.2.3 Receipt recorded Serially numbered goods received notes (GRNs) sequentially controlled Matched to purchase order 3.2.4 Dispatch recorded Serially numbered dispatch notes (DNs) sequentially controlled Customer signature (proof of delivery) Matched with customer order Serially numbered goods returned notes 3.2.5 Postings GRNs and DNs used to update inventory records GRNs and DNs evidenced as processed (e.g stamped) and filed numerically Regular physical inventory counting, comparison book v actual and variances investigated 2303 SESSION 23 – INVENTORY RISKS Not all quantities of materials, goods etc may be recorded on stocksheets Inventory may not be adequately safeguarded Inventory may not be valued consistently and in accordance with IAS Inventories “Cutoff” for inventory movements may be inaccurate Inventory belonging to third parties may not be excluded from physical count Inventory with third parties belonging to the client may be omitted from count “CUTOFF” A procedure for isolating the flow of inventory, cash and related documentation to ensure that all aspects of a transaction are dealt with in the same accounting period 5.1 Importance Accurate “cutoff” may be crucial to inventory, purchases and sales Cutoff determines where one accounting period ends and another one commences PURCHASES receive inventory receive inventory YEAR END despatch inventory despatch inventory INVENTORY Errors or inconsistencies in cutoff can create misleading measurements of profit Illustration A purchase invoice for 5,000 tons of metal worth $1m was received on April for goods received on 31 March, and the business has a yearly reporting period ending 31 March The metal must be included in the figure for trade payables If, due to an error, the invoice was not entered in the records until the new period had commenced, then profits in the preceding period would be overstated by $1m 2304 SESSION 23 – INVENTORY Illustration If goods invoiced to a customer (worth $10,000 at cost) were erroneously included in the closing inventory, there would be an element of double counting and profits would be overstated by $10,000 5.2 Audit procedures To avoid double counting it is essential that purchase and sales invoices are checked against inventory records to ensure that: all goods received into inventory by the end of the reporting period and included in the statement of financial position have the corresponding invoice entered in the purchase day book and included in trade payables all goods despatched at the end of the reporting period and excluded from the statement of financial position have a corresponding sales invoice raised, entered in the sales day book and included in trade receivables To avoid omissions, all purchase or sales invoices entered in the books before the end of the reporting period must have the corresponding inventory movement reflected in the statement of financial position inventory VALUATION AND IAS Lower of cost and net realisable value for separate items of inventory 6.1 Measurement methods 6.1.1 Standard cost It must approximate to actual Price variance accounts will highlight obvious differences between standard and actual price 6.1.2 Retail method Selling price less standard gross profit % % may be average for each “department” Suited to large numbers of rapidly changing items having similar margins 2305 SESSION 23 – INVENTORY 6.2 Cost formulas Specific identification of individual costs Need to confirm: material costs to suppliers’ invoices labour to payroll and time summaries the basis of unit cost calculations for allocating overheads Otherwise (for interchangeable items): First-in, first-out (FIFO) Weighted average 6.3 Net realisable value NRV is affected by obsolescence condition/damage etc market price fluctuations In computerised inventory systems, an exception report may identify items which have not moved in a specified period A review of selling prices after the end of the reporting period may confirm NRV 6.4 “Allowances” An example of an “accounting estimate” which is an allowance Determination may be simple (e.g a % of inventory value); or complex (e.g by analysing current data and sales forecasts to estimate slow-moving or surplus inventory) Any formulae used (e.g different %s applied to inventory ageing) need to be reviewed regularly by management to assess their appropriateness Audit approaches Review and test management’s process used to develop the estimate Use an independent estimate for comparison with management’s Review after-date sales to confirm the estimate made 2306 SESSION 23 – INVENTORY ATTENDANCE AT PHYSICAL INVENTORY COUNTING [ISA 501] When inventory is material … the auditor should obtain sufficient appropriate audit evidence regarding its existence and condition (⇒ valuation) by attendance at physical inventory counting unless impracticable 7.1 Purpose To inspect inventory To observe compliance with the operation of management’s procedures for recording and controlling the results of the count To provide evidence as to the reliability of management’s procedures 7.2 Types of stocktaking Full physical count Before/after y/e Perpetual system At y/e Example Suggest advantages and disadvantages of a full physical count at the end of the reporting period Solution Advantages Disadvantages 2307 SESSION 23 – INVENTORY Example Suggest advantages and disadvantages of a full physical count shortly before the end of the reporting period Solution Advantages 7.3 Disadvantages Perpetual inventory system Inventory is counted on a regular basis and just not once (at the end of the reporting period) Acts as a check on the accuracy of the book records (usually computerised incorporating purchases and movements between raw materials, work-in-progress and finished goods) Counts should be programmed so all inventory (eg each product line) counted at least ONCE a year (i.e “continuous stocktaking”) High value items/product lines are usually counted more often, eg every month or in some cases (eg high value jewellery) every day All material differences between book inventory and physical counts must be investigated and corrected at the time of each count Auditors should attend at least one of the physical counts (preferably more than one if inventory is homogeneous and each product line is counted only once) Movements throughout the year into book records (eg from goods received records) and out (eg transfers to next production stage/goods out as sales) must be audited to establish occurrence and measurement assertions This is necessary to support the assertion that quantity records are reliable (existence and completeness) as a basis for the determination of the year-end valuation Example Suggest advantages and disadvantages of a perpetual inventory system 2308 SESSION 23 – INVENTORY Solution Advantages 7.4 Disadvantages Attendance at physical inventory counting Applies equally to end of the reporting period counts and perpetual inventory counts Before = Planning During = Attendance review prior year working papers observe compliance with instructions discuss instructions with management perform test counts (from physical to recorded and vice versa) familiarisation; nature, value, location(s) etc arrange third party certificates consider need for expert(s) assess accounting and internal control system take copies of stocksheets obtain more details of damaged inventory note cutoff details After = Follow-up follow up cut-off tests check “in bulk” copies of stocksheets and check sequence ensure perpetual inventory records adjusted follow up third party certificates conclude on reliability of quantities used as a basis for computing inventory consider role of internal audit extract representative sample An audit program for attendance is set out in Appendix and must be studied 2309 SESSION 23 – INVENTORY THIRD PARTY INVENTORY 8.1 Inventory held by other parties Client’s inventory may be held by third parties when third party warehousing/storage is being used goods are on consignment goods are in transit If the inventory held by third parties is material, it must be inspected by the auditor or alternative evidence sought for goods that cannot be inspected (eg in transit on board a boat – inspect shipping documentation, insurance arrangements, subsequent arrival and offloading, confirmation letter from agents, management representations) If the inventory is not material, a confirmation letter should be obtained from the third party 8.2 Third party inventory held by client Where inventory is received from a third party, eg for processing ( electroplating) or repair (under warranty) the auditor must consider the controls in place to ensure such inventory is not included within the inventory of the entity (eg identified and segregated at the time of a physical inventory count) 8.3 Reservation of title Suppliers may include a “reservation of title” clause in their contracts of sale (usually on the purchase invoice) This states that title (i.e ownership) of the goods does not pass to the customer until paid for, even if the goods are used within the manufacturing process before payment Considering substance over form: Legal form – goods belong to supplier until fully paid for No liability or asset is recognised Commercial substance – goods are treated as property of purchaser, who recognises the liability and includes such goods held at the end of the reporting period on their statement of financial position Commercial substance takes precedence unless there are significant going concern doubts – in which case strict legal form should be recognised 2310 SESSION 23 – INVENTORY FOCUS You should now be able to: explain the importance of inventory; describe physical inventory counting procedures; explain “cutoff”; value inventory; select appropriate audit procedures for inclusion in a work program (see also Appendix 3) relating to financial statement assertions concerning inventory EXAMPLE SOLUTION Solution — Sources “Ideas list” Accounting systems ⇒ Perpetual inventory records Documentation ⇒ Inventory cards, purchase invoices (cost) (also payroll for manufactured products), sales invoices (NRV) Tangible assets ⇒ Raw materials, WIP, finished goods Management and employees ⇒ Buyer, storekeeper Customers and suppliers ⇒ Major (raw material) suppliers, customer complaints (NRV < cost?) Other third parties (e.g banks, solicitors) ⇒ Bank (floating charge?), warehousing agents Analytical procedures ⇒ Inventory turnover by product category, GP margin review 2311 SESSION 23 – INVENTORY Solution — Full count Advantages Disadvantages Evidence most effective/inventory physically in BS Potential disruption and cost of full count (e.g if production halted or outlets closed) “Cutoff” ascertained at just one (end of the reporting period) date Movements to be confirmed are minimised Number of locations to be attended at one time (by client and audit staff) Inventory records are not required Heavy demand on audit staff at popular end of reporting periods (e.g 31 December) Solution — Before end of the reporting period Advantages Disadvantages Time can be made more convenient (e.g holiday closure) Movements to be substantiated therefore need records and ICs (to confirm “roll forward”) Still time to full count at the end of the reporting period if significant problems found “Cutoff” needs to be examined at count date and the end of the reporting period also Facilitates a tighter audit reporting deadline Reliable inventory records required Solution — Continuous stock-checking Advantages Disadvantages A method of internal control – operates throughout year Requires adequate inventory records be kept up-to-date (⇒ clerical cost) Material and risk prone items can be confirmed at any time No full counts The end of the reporting period count of certain (e.g high value) items is not precluded The end of the reporting period “cut-off” tested separately 2312 ... sequentially controlled Matched to purchase order 3.2.4 Dispatch recorded Serially numbered dispatch notes (DNs) sequentially controlled Customer signature (proof of delivery) Matched with customer... ensure that … Stage Goods received Goods despatched … damaged goods are not accepted … goods cannot be misappropriated Stage Receipt recorded Despatch recorded Movement posted to general ledger... ends and another one commences PURCHASES receive inventory receive inventory YEAR END despatch inventory despatch inventory INVENTORY Errors or inconsistencies in cutoff can create misleading measurements