If your company records its inventory as an asset, and it undergoes an annual audit, then the auditors will be conducting an audit of your inventory. Given the massive size of some inventories, they may engage in quite a large number of inventory audit procedures before they are comfortable that the valuation you have stated for the inventory asset is reasonable.
Here are some of the inventory audit procedures that they may follow:
- Cutoff analysis. The auditors will examine your procedures for halting any further receiving into the warehouse or shipments from it at the time of the physical inventory count, so that extraneous inventory items are excluded. They typically test the last few receiving and shipping transactions prior to the physical count, as well as transactions immediately following it, to see if you are properly accounting for them.
- Observe the physical inventory count. The auditors want to be comfortable with the procedures you use to count the inventory. This means that they will discuss the counting procedure with you, observe counts as they are being done, test count some of the inventory themselves and trace their counts to the amounts recorded by the company's counters, and verify that all inventory count tags were accounted for. If you have multiple inventory storage locations, they may test the inventory in those locations where there are significant amounts of inventory. They may also ask for confirmations of inventory from the custodian of any public warehouse where the company is storing inventory.
- Reconcile the inventory count to the general ledger. They will trace the valuation compiled from the physical inventory count to the company's general ledger, to verify that the counted balance was carried forward into the company's accounting records.
- Test high-value items. If there are items in the inventory that are of unusually high value, the auditors will likely spend extra time counting them in inventory, ensuring that they are valued correctly, and tracing them into the valuation report that carries forward into the inventory balance in the general ledger.
- Test error-prone items. If the auditors have noticed an error trend in prior years for specific inventory items, they will be more likely to test these items again.
- Test inventory in transit. There is a risk that you have inventory in transit from one storage location to another at the time of the physical count. Auditors test for this by reviewing your transfer documentation.
- Test item costs. The auditors need to know where purchased costs in your accounting records come from, so they will compare the amounts in recent supplier invoices to the costs listed in your inventory valuation.
- Review freight costs. You can either include freight costs in inventory or charge it to expense in the period incurred, but you need to be consistent in your treatment - so the auditors will trace a selection of freight invoices through your accounting system to see how they are handled.
- Test for lower of cost or market. The auditors must follow the lower of cost or market rule, and will do so by comparing a selection of market prices to their recorded costs.
- Finished goods cost analysis. If a significant proportion of the inventory valuation is comprised of finished goods, then the auditors will want to review the bill of materials for a selection of finished goods items, and test them to see if they show an accurate compilation of the components in the finished goods items, as well as correct costs.
- Direct labor analysis. If direct labor is included in the cost of inventory, then the auditors will want to trace the labor charged during production on time cards or labor routings to the cost of the inventory. They will also investigate whether the labor costs listed in the valuation are supported by payroll records.
- Overhead analysis. If you apply overhead costs to the inventory valuation, then the auditors will verify that you are consistently using the same general ledger accounts as the source for your overhead costs, whether overhead includes any abnormal costs (which should be charged to expense as incurred), and test the validity and consistency of the method you use to apply overhead costs to inventory.
- Work-in-process testing. If you have a significant amount of work-in-process (WIP) inventory, the auditors will test how you determine a percentage of completion for WIP items.
- Inventory allowances. The auditors will determine whether the amounts you have recorded as allowances for obsolete inventory or scrap are adequate, based on your procedures for doing so, historical patterns, "where used" reports, and reports of inventory usage (as well as by physical observation during the physical count). If you do not have such allowances, they may require you to create them.
- Inventory ownership. The auditors will review purchase records to ensure that the inventory in your warehouse is actually owned by the company (as opposed to customer-owned inventory or inventory on consignment from suppliers).
- Inventory layers. If you are using a FIFO or LIFO inventory valuation system, the auditors will test the inventory layers that you have recorded to verify that they are valid.
If the company uses cycle counts instead of a physical count, the auditors can still use the procedures related to a physical count. They simply do so during one or more cycle counts, and can do so at any time; there is no need to only observe a cycle count that occurs at the end of the reporting period. Their tests may also evaluate the frequency of cycle counts, as well as the quality of the investigations conducted by counters into any variances found.
The extent of the procedures employed will decline if inventory constitutes a relatively small proportion of the assets listed on a company's balance sheet.