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Inventory Observation - Staff
Flashcards for Inventory Observations presentation

Additional Accounting Flashcards




When you must perform an inventory observation for an audit client?
Professional standards require attendance at the physical inventory carried out by the client whenever inventory is material (quantitatively or qualitatively) to the financial statements.
What is the auditor’s objective when an inventory observation is required?
The auditor’s objective in observing the inventory count activities is to determine that the client’s counting procedures are complete, reliable, and accurate.
What information must an auditor obtain and understand prior to performing an inventory observation?

To plan an appropriate and effective inventory observation, it is important for the engagement team to have an understanding of the client's business, its products, its computer processing applications, and relevant controls before the physical count occurs, including knowledge of the physical inventory or cycle count procedures and the inventory summarization, pricing, and cut-off procedures.  The auditor in charge should contact the relevant client contact to discuss specific counting procedures, inventory balances, location and timing to ensure appropriate staff are scheduled and proper planning is performed.  The auditor should discuss the control of count sheets and determine an approximate amount of test counts to perform.

What instances should an auditor consider when identifying factors which indicate a risk of material misstatement due to fraud?

a. Empty boxes or "hollow squares" in stacked goods. b. Mislabeled boxes containing scrap, obsolete items, or lower value materials.

c. Consigned inventory, inventory that is rented, or traded-in items for which credits have not been issued. d. Diluted inventory so it is less valuable (e.g., adding water to liquid substances).

e. Increasing or otherwise altering the inventory counts for those items the auditor did not test count.

f. Programming the computer to produce fraudulent physical quantity tabulations or priced inventory listings.

g. Manipulating the inventory counts/compilations for locations not visited by the auditor.

h. Double counting inventory in transit between locations.

i. Physically moving inventory and counting it at two locations.

j. Including in inventory merchandise recorded as sold but not yet shipped to a customer ("bill and hold sales").

k. Arranging for false confirmations of inventory held by others.

l. Including inventory receipts for which corresponding payables had not been recorded.

m. Overstating the stage of completion of work-in-process.

n. Reconciling physical inventory amounts to falsified amounts in the general ledger.

o. Manipulating the "roll-forward" of an inventory taken before the financial statement date.

What are some additional procedures an auditor can perform when factors are identified which indicate a risk of material misstatement due to fraud?

a. Request the client to conduct the physical count at year-end (when not already done so)

b. Request that the client make a complete wall-to-wall count in place of cycle counts or reliance on perpetual inventory records.

c. Observing inventory at more locations when an entity has inventory at multiple locations.

d. Increasing the extent of observation procedures such as being present for the entire inventory count; opening more sealed cartons or recording more test counts.

At times, the engagement team might not have attended a client's physical inventory for the current period such as when the Firm is appointed auditor after the year-end. In this case, the engagement team may be unable to obtain appropriate audit assurance regarding the existence of inventory and may need to modify (i.e., qualify or disclaim) the audit opinion for a scope limitation. However, the engagement team may be able to use alternative procedures satisfactorily. These  procedures should include:

a. Making and observing some physical counts of the inventory after the period-end.

b. Applying appropriate tests of intervening transactions during the roll forward period.

c. Reviewing records of client counts and counting methods.

d. Performing tests of transactions relating to the prior accounting records.

e. Reviewing the records of prior counts.

f. Performing gross profit margin tests. Comment: When inventory is material to the financial statements, the engagement team should document alternative procedures to be performed when the engagement team has been unable to observe the client’s physical inventory taking.

Other times, the client may have a perpetual inventory system and perform their inventory count on a day close to but not on the reporting date.  The engagement team must develop alternative procedures to ensure the inventory balances as of the reporting date is complete and accurate.  These procedures should include:

a. Making and observing some physical counts of the inventory after the period-end to test the effectiveness of the perpetual inventory system.

b. Reconcile the inventory counts from the date the inventory counts were taken to the reporting date.

c. Apply appropriate tests of intervening transactions during the roll forward period.

d.  Performing gross profit margin tests.

Engagement teams should consider multiple factors in determining locations to observe, and at a minimum, should observe warehouse or distribution centers. For example, an engagement involving retail inventory may have a warehouse or distribution center that represents a major portion of the inventory value at year end, and in such cases, the engagement team should choose that location for observation. The use of analytical procedures (e.g., review of preliminary high-to-low value inventory listings or comparison of year-to-year quantities) in planning the audit often helps identify inventory locations, areas, or items for specific attention or greater scrutiny during and after the physical count. Other factors to consider are:
a. The valuation of inventory by location.
b. The valuation of inventory by department category.
c. Observation history.
d. Any identified risks noted in the planning process.
In some industries, such as retailers, the engagement team may choose to perform additional existence procedures over retail inventory locations. Additional existence procedures generally are not substitutes for making inventory observations, but can be applied to assist in obtaining sufficient appropriate audit evidence related to the existence assertion, and may include:
a. Calling locations to assess whether the location is in operation.
b. Driving to locations to determine physical existence and operation.
c. Obtaining property tax statements to assess ownership of the location.
d. Obtaining vendor invoices and delivery statements to assess whether the location is in operation.
What procedures should an auditor perform in order to ensure a proper cut-off is achieved?
a. Make sure client does not ship or receive while counts are being performed. Be sure to call the respective client representative to ensure control of inventory movement is achieved.
b. If any boxes are spotted in the loading zone during test counts, make sure the inventory has been properly included or excluded depending on timing and nature of occurrence. It is important to understand when the title of the inventory is transferred when making these inquiries.
c. Be sure any inventory pulled for shipment has been counted once and only once and that it is properly labeled to avoid any confusion.
d. The auditor should obtain the first five and last five shipping and receiving documents prior to leaving the inventory count and plan to trace these to the accounting records during the audit to ensure proper treatment was achieved.
After you complete the inventory observation procedures you should compose a memo to summarize the audit procedures performed. What information should you include in this summary?
a. The summarization of quantities from the physical counts or inventory count sheets to the final inventory listing maintained by the client.
b. The name and contact information of the client representative who assisted the auditors.
c. Any problems incurred while performing the observation procedures.
d. Any instances of obsolete or damaged inventory.
e. Date and location the observation procedures were performed.
f. Tests of mathematical accuracy.
Why is it important to control the count sheets and make additional inquiries to ensure the auditors are given a complete inventory listing when they arrive for the inventory observation?
Fraud could be committed by the client by withholding certain count sheets from the auditor so the auditor does not have the opportunity to pick certain items from the count sheets. If the auditor does not perform “floor to sheet” test counts, this gives the client the opportunity to manipulate the counts after performance of the test counts and then add these the final general ledger balances. If this happens, it is very difficult to develop procedures to test the existence of these inventory items. Be sure this does not happen to you and ask your client to confirm your listing is complete. A sample should from the counts sheets should be traced to the final inventory listing to ensure this did not occur.
Why is it important to take a few “floor to sheet” test counts?
Sometimes “completeness” is an audit risk to our clients. If the risk of completeness is small, only a few “floor to sheet” test counts should be performed so we can determine the count sheet provided by the client is complete. If the risk of completeness is high, talk to the audit manager or in-charge audit of the engagement to determine the extent of “floor to sheet” test counts.
What procedures should an auditor perform in regards to obsolete, slow moving or damaged inventory?
a. Inquire management about which items they consider obsolete, slow moving or damaged and determine if they have been properly included or excluded in the final inventory counts.
b. Keep an eye out while walking around the client’s facility taking other test counts for items that appear to be obsolete and conclude management has properly included all questioned items in their analysis.
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