1. 1 Auditing Inventories and Fixed Assets 1 Inventory Inventory is an area of major importance for the auditor and, historically, has been the balance sheet item that creates most problems, because: 1.It significant to the determination of profit and a significant component of the balance sheet 2.Accounting for inventory is often not part of the double entry system 3.The determination of year-end quantities can be problematic 4.There are different approaches to valuation 5.It is often the subject of manipulation and fraud, both by management and others In a merchandising entity inventory consists of goods acquired for resale. In a manufacturing company inventory includes: Raw materials Partly manufactured items (wip) Finished goods Smaller entities may not maintain inventory records. Large manufacturing entities maintain comprehensive inventory records, with subsidiary inventory ledgers. In both case the prime audit objective is to determine (a) the quantity and (b) the value of the inventory appearing in the financial statements.

2. Auditing Inventories and Fixed Assets Audit Objectives The principal audit objectives for each assertion and audit controls are shown in Table 1. 2

3. Auditing Inventories and Fixed Assets Recording Inventory Transactions The use of computer information systems has made it much easier to maintain perpetual inventory records. If the recording of sales and purchase is computerized, it is relatively simple to exited the system to record the input and removal of goods from inventory. Simpler systems maintain records of quantity only. More sophisticated maintain records by quantity and value. In any case, the accounting function of inventory recording should be segregated from the physical custody of the inventory. The functions of inventory recording are: 1.Recording the movement of goods into inventory (entered through the purchasing system; inventory keeper acknowledges receipt) 2.Recording the movement of goods from inventory (the dispatch note is the basis for authorization of the release of the goods from inventory and for the entry in inventory records, reducing the quantity on hand; in retail stores this is often done by scanned barcodes) 3.Recording transfer of inventory (usually occurring in manufacturing; production move orders control the movement of goods from raw materials, through work in process to finished goods) 4.Physically comparing inventory with inventory records (perpetual inventory records need to be compared with physical inventory at regular intervals; the funcitions involved are: Inventory count and Comparison with records 3

4. Auditing Inventories and Fixed Assets Developing the audit plan The selected approach to the audit of inventory depends on 1.The materiality of inventory 2.Risk factors 3.The availability and reliability of inventory records 4.Significant and high value items 5.The location of inventory Materiality and risk factors In a manufacturing entity, inventories and cost of goods sold are usually significant to both the entity's financial position and the results of its operations. Moreover, numerous factors contribute to the risk of misstatements in the assertions for these accounts, including those described below: The volume of purchase, manufacturing and sale transactions that affect these accounts is generally high, increasing the opportunities for misstatements to occur. There are often contentious valuation and measurement issues such as: – the identification, measurement and allocation of indirect materials, labour and manufacturing overhead; – joint product costs; – the disposition of cost variances; – accounting for scrap and wastage. 4

5. Auditing Inventories and Fixed Assets Materiality and risk factors (cont’d) Special procedures are sometimes required to determine inventory quantity or value, such as geometric volume measurements of volume or weight of inventory using aerial photography, and estimation of value by experts. Inventories are often stored at multiple sites, leading to difficulties in maintaining physical control over theft and damage and in accounting for goods in transit between sites. Inventories are vulnerable to spoilage, obsolescence and general economic conditions that may affect demand and saleability and thus their valuation. Inventories may be sold subject to right of return and repurchase agreements. Inventories may have been purchased subject to 'reservation of title' clauses. Audit strategy In verifying the existence (and completeness) assertions, auditors have the choice of three audit strategies depending on the entity's policy for determining inventory quantity. The options are: Inventory quantity determined by perpetual inventory records where the entity does not intend to count inventory at or close to the balance sheet date. This strategy requires that control risk over inventory records be assessed as low. Inventory quantities determined by inventory count near the balance sheet date, adjusted to balance sheet quantities by reference to perpetual inventory records. This strategy requires that control risk over inventory records, or of purchases and sales cutoff, is not assessed as high. Inventory quantities determined by inventory count at or within a few days of the balance sheet date. 5

6. Auditing Purchases, Trade Payables and Payroll 6 This is a predominantly substantive approach in which the auditors would not test control over inventory records, which may not even exist. An entity may use each of the three methods for different categories of inventory or for inventory at different locations. For example, a manufacturing entity may determine the quantity of raw materials and finished goods at a year-end inventory count, but rely on perpetual records in determining the work-in-process inventory. In developing the audit plan, auditors will need to discuss the approach that management intends to take. If management intends to rely solely on inventory records, then more extensive tests of control will be necessary to confirm the required assessment of control risk. Moreover, this assessment must be completed before the balance sheet date in the event that tests of control fail to confirm the assessment of control risk as being low, and the auditors are required to advise management to count inventory at or near the balance sheet date. Specialized inventories may require the assistance of experts in determining either the quantity (as in the case of aerial measurement of inventory volume or weight - such as piles of coal) or value (as in the case of antiques or diamonds). Depending on the circumstances, including such factors as the materiality of the inventory, the risk of material misstatement and the degree of independence of the expert, the auditor may decide to rely on the work of an expert engaged by management or may prefer to engage an independent expert for the purpose of providing sufficient evidence to support the valuation assertion.

7. 7 For merchandise inventory, a predominantly substantive approach is usually more efficient in verifying the valuation assertion. For manufacturing entities, it is usually necessary for the auditors to have assessed control risk over the maintenance of costing records (used as the basis for costing closing inventory) as being less than high. This is an area that frequently receives insufficient audit attention owing to a reluctance to unravel the complexities of the costing system. Control risk over inventory records Table 2 contains a partial listing of potential misstatements, necessary controls, possible tests of the operating effectiveness of those controls and the specific audit objective to which each belongs. As explained above, auditors would assess control risk over perpetual inventory records only where they are used in determining inventory at the balance sheet date. If the preliminary assessment, based on the design effectiveness of controls, is that control risk is likely to be high, then the auditors would advise management not to rely on the records in determining inventory at the balance sheet date. If the preliminary assessment supports management's intended reliance on inventory records, then the auditors would proceed to draw up an audit programme incorporating possible tests of the operating effectiveness of controls such as those identified in Table 2. Auditing Inventories and Fixed Assets

8. Auditing Inventories and Fixed Assets Table 2: Control Risks Assessment-Inventory Records 8

9. Auditing Inventories and Fixed Assets Tangible Fixed Assets Tangible noncurrent assets are tangible assets intended to be retained for use in the entity's operations. This category, on the balance sheet, includes land and buildings, plant and equipment and the related accumulated depreciation. Land and buildings may be freehold or leasehold and plant and equipment may include assets held under finance leases. The principal related profit and loss accounts are depreciation expense, repairs expense, finance charges on finance leases and rent on operating leases. The principal transaction class relating to noncurrent asset balances is that of purchases. The relevant objectives are listed in Table 3. Table 3: Audit Objectives for Fixed Assets 9

10. 10 Auditing Inventories and Fixed Assets Table 4: Substantive Procedures for Fixed Assets Audit