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.

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.

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

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.

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.

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.

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.