Auditing Work in Progress
Many types of businesses — such as homebuilders and manufacturers — turn raw materials into finished products for customers. Production is a continuous process. So, any work that’s been started but isn’t yet completed before the end of the accounting period is reported as work in progress (WIP) under U.S. Generally Accepted Accounting Principles ( GAAP ).
The value of WIP relies on management’s estimates. Auditors often give special attention to these estimates during fieldwork. Here’s what to expect during a financial statement audit.
Inventory is classified as a current asset on the balance sheet under GAAP. There are three types of inventory:
- Raw materials. These are tangible inputs received from suppliers but haven’t yet been worked with. For example, a construction firm may have a supply of lumber and drywall in a warehouse that counts as raw materials.
- Work in progress. This term refers to partially finished products at various stages of completion. Items classified as WIP still require further work, processing, assembly, and/or inspection. It includes raw materials, labor, and overhead allocations.
- Finished goods. These items are fully complete. They may be ready for customers to purchase or, in the case of custom products, available for delivery or title transfer to customers.
Accounting For Costs: Standard vs. Job Costing
When a company produces large volumes of the same product, management allocates costs as each phase of the production process is completed. This is known as standard costing . For example, if a production process involves eight steps, the company might allocate 50% of its costs to the product once the fourth stage is completed.
On the other hand, when a company produces unique products — such as the construction of a factory or made-to-order parts — a job costing system is typically used to allocate materials, labor, and overhead costs as incurred.
Most experienced managers use realistic estimates, but inexperienced or dishonest managers may inflate WIP values. This can make a company appear healthier than it really is by overstating the value of inventory at the end of the period and understating cost of goods sold during the current accounting period.
Auditors focus significant effort on analyzing how companies quantify and allocate their costs. Under standard costing , companies typically record inventory (including WIP) at cost, and then recognize revenue once they sell finished goods. The WIP balance grows based on the number of steps completed in the production process. Auditors analyze the methods used to quantify a product’s standard costs, as well as how the company allocates the costs corresponding to each phase of production.
Conversely, with job costing , revenue recognition happens based on the percentage-of-completion or completed-contract method. Auditors analyze the process to allocate materials, labor, and overhead to each job. In particular, they test to ensure that costs assigned to a particular product or project correspond to that job.
Get Work in Progress Right
Under both methods, accounting for WIP affects the balance sheet and the income statement. We can help determine whether your company’s WIP estimates are reasonable and whether your accounting practices comply with the recent changes to the revenue recognition rules for long-term contracts, if applicable. Contact us for more information on auditing work in progress.
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Auditing and Work in Progress (WIP) Reporting
Smolin » Blog » Auditing and Work in Progress (WIP) Reporting
If you work in an industry that takes raw materials and turns them into products for your customers, you know that production is a continuous process. Under U.S. Generally Accepted Accounting Principles (GAAP), any work you’ve started but haven’t yet completed by the end of the accounting period must be reported as work in progress (WIP).
The reported value of WIP depends on estimates made by management, and these estimates are often given special attention by auditors during a financial statement audit. Here’s a quick guide on what to expect.
Under GAAP, inventory is classified as a current asset. Inventory falls into three categories:
Inventory is classified as raw materials if it consists of tangible inputs that have been received from suppliers but haven’t been worked with yet—a supply of lumber and drywall in the warehouse of a construction firm, for example, would count as raw materials.
Work in progress (WIP)
Partially finished products that still require further work, processing, assembly, and/or inspection are classified as work in progress. WIP includes allocations for raw materials, labor, and overhead.
Finished goods are fully complete items which are ready for purchase by customers (or are available for delivery or title transfer to customers in the case of custom products).
Two ways of allocating costs
One method of allocating costs, known as standard costing , is typically used by companies that produce large volumes of the same product. Management at companies using standard costing will allocate costs as each phase of the production process is completed—so if a production process requires four steps, 50% of the product’s costs might be allocated to the product once the second stage is completed.
Another method, known as job costing , is typically used by companies that are producing unique products, like made-to-order parts or the construction of a factory. Unlike standard costing, job costing allocates materials, labor, and overhead costs as they are incurred.
While the majority of experienced managers use realistic estimates, dishonest or inexperienced managers may inflate the value of WIP inventory. Overstating the value of inventory at the end of an accounting period and understating the cost of goods sold during the current accounting period can make a company appear healthier than it actually is.
Auditors and WIP
Auditors place a significant emphasis on analyzing the way a company quantifies and allocates costs. Companies using standard costing typically record inventory (including WIP) at cost and recognize revenue after they’ve sold the finished goods, and the WIP balance grows depending on the number of completed steps in the production process. During an audit, an analysis will be made of the methods the company uses to quantify a product’s standard costs. Auditors will also look at the way the company allocates costs corresponding to each phase of production.
By contrast, companies using job costing recognize revenue based on the percentage-of-completion or completed-contract method. In this case, auditors will make an analysis of the process the company uses to allocate materials, labor, and overhead to each job. They will also specifically test to make sure that costs assigned to a particular job actually correspond to that product or project.
Questions? We can help
Regardless of the method used, accounting for WIP will affect your balance sheet and income statement. We can help you ensure that your company’s WIP estimates are reasonable—and assist you in staying compliant with recent changes to revenue recognition rules for long-term contracts. For more information, contact us today.
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Detailed below are some individual tests that can be applied in order to help satisfy the objectives noted in Audit objectives . It may not be appropriate to undertake all of the tests; in each case, the auditor should review this bank of tests and determine which are most appropriate for the circumstances of the particular client being dealt with. The auditor should, however, ensure that each objective is satisfied. Where the balance includes accounting estimates, refer to the guidance in Auditing accounting estimates .
In each section are some substantive analytical procedures that can be used to give additional audit comfort regarding whether or not inventory and work in progress is fairly stated.
Planning substantive analytical procedures
The following procedures can be applied in respect of analytical review on inventory.
Inventory turnover ratio
The inventory turnover ratio is usually calculated as part of the final review of the financial statements. However, in accordance with ISA (UK) 315 , it should also be calculated at the planning stage if the figures are available. Certainly, the ratio should be examined as soon as practicable.
The ratio may be expressed in two ways:
(a) cost of sales/inventory;
(b) (inventory/cost of sales) × 365.
Ratio (a) measures the number of times during the year that inventory flows through the business.
Ratio (b) gives the average number of days taken for the inventory to flow through the business.
On the assumption that a client would like as little money as possible tied up in inventory, any increase in the figure for inventory turnover days is described as ‘worsening’. Similarly, if the inventory turnover ratio decreases, this is also a worsening.
A worsening inventory turnover ratio may indicate that inventory is overstated. However, there are many legitimate reasons why the ratio would ‘worsen’ and it is important for the auditor to ascertain which of these reasons apply. For example, there may be a change in the inventory holding policy. This could be for reasons such as potential future expansion, bulk buying to take advantage of discounts or seasonal factors (especially if the entity has changed year ends).
Conversely, an improving inventory turnover ratio may indicate a potential understatement of inventory. Similarly, there may be legitimate reasons for the improvement, e.g. a concerted effort by the entity to reduce inventory levels to reduce financing costs. Seasonal factors or a change in the year end could also affect the ratio. It is important that the auditor fully corroborates any explanations received.
It may also be useful, if applicable, to split the ratio between the various different types of inventory, such as raw materials, work-in-progress and finished goods.
If allowed by the accounting records, it may be possible to further split the inventory turn ratios into inventory categories. This will allow a very detailed analytical review to be performed – the more disaggregation that can be achieved when conducting analytical review, the more reliable the evidence is.
The main form of substantive analytical procedure that will enable a reduction in detailed inventory testing is to examine any significant changes in the value of individual inventory lines or inventory groups. The auditor should ensure that explanations are obtained and corroborated for all significant variances.
The auditor should also follow up any changes in the level of inventory that were expected from discussions with the client at the planning stage.
Where applicable, the auditor should also consider obtaining the inventory turnover ratio for each individual inventory line or group and comparing with previous years.
The auditor should also consider the level of inventory held by the client in relation to the cycle of activity within the business.
There are numerous examples of situations where the level of inventory held by the client will vary significantly due to seasonal fluctuations. It is important that the auditor considers whether or not the level of inventory held is reasonable in relation to the cycle of activity.
Expansion and contraction
The auditor should consider the possibility of changes to the client’s business that would result in a change in inventory levels. Expansion of the client’s business usually means an increase in inventory levels, while a contraction of the client’s business usually results in inventory reduction. Obviously, the timing of the planned expansion or downsizing will affect the expected change. The increase or reduction in inventory may not be immediate and may take, for example, 18 months to two years to work through.
Attendance at the stocktake
ISA (UK) 501 (Updated May 2022) Audit evidence – specific considerations for selected items notes that, ordinarily, inventory is physically counted at least once a year to serve as a basis for the preparation of the financial statements and, if applicable, to ascertain the reliability of the perpetual inventory system.
Where inventory is material, ISA (UK) 501:4 requires the auditor to obtain appropriate evidence by:
• attending a stocktake, unless it is ‘impracticable’ to do so; and
• performing audit procedures over the entity’s final inventory records to determine whether they accurately reflect actual inventory count results (see Year end procedures on the stocktake ).
As part of their stocktake attendance procedures, the auditor should:
• evaluate management’s instructions and procedures for recording and controlling the results of the entity’s physical inventory counting (see Review of stocktake instructions );
• observe the performance of management’s count procedures; and
• inspect the inventory (see At the stocktake: observing the count ) and perform test counts (see At the stocktake: test counting and inspection ).
Before the stocktake
Risk assessment procedures.
The auditor should start by considering their knowledge of the client, inventory and related systems, as this should direct the planned level of work on inventory. Factors to consider when planning stocktake attendance include:
• risks of material misstatement related to inventory;
• reliability of accounting and recording systems and related controls for inventories including, in relation to work in progress, the systems that track location, quantities and stages of completion;
• whether adequate procedures are expected to be established and proper instructions issued for physical inventory counting;
• timing of stocktakes relative to the year-end date and the reliability of records used in any ‘roll-forward’ of balances;
• whether the entity maintains a perpetual inventory system;
• location of inventories, including inventories on ‘consignment’, inventories in transit and inventories held at third-party warehouses;
• whether ISA (UK) 600 (Revised November 2019) (Updated May 2022) Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) may be relevant if other auditors are involved with regard to stocktakes at a remote location;
• physical controls over the inventories and their susceptibility to theft or deterioration;
• objectivity, experience and reliability of the inventory counters and of those monitoring their work;
• degree of fluctuation in levels of inventories;
• nature of the inventories, for example, whether specialist knowledge (e.g. an auditor’s expert) is needed to identify the quantity, quality, identity and/or stage of completion of items of inventories; and
• difficulty in carrying out the assessment of quantity and/or stage of completion of items of inventory, for example, whether a significant degree of estimation is involved.
Decide which locations to visit
It may not be practical to attend all the stocktakes if the client has several locations. When deciding which locations to visit, the auditor should consider:
• the relative materiality of inventories held at each location;
• unusual inventory levels, gross margins or operating results at a particular location;
• results of the client’s counts in previous years and the current period;
• any internal audit reports; and
• management expectations.
The auditor should aim to cover all locations on a cyclical basis.
Where there are logistical problems in attending a stocktake, the auditor may use the services of the client’s internal auditors or a local firm of auditors. In these circumstances, the auditor would have to be satisfied as to the independence and competence of the staff to be used and the scope of work to be performed in accordance with ISA (UK) 610 (Revised June 2013) (Updated May 2022) Using the Work of Internal Auditors or ISA (UK) 600 respectively.
Review of stocktake instructions
The auditor needs to review and evaluate the client’s stocktaking instructions to ensure that they are likely to lead to an accurate count, including:
(a) use, whenever possible, of independent counters not involved with day-to-day inventory control;
(b) checks to ensure that all items are counted and are correct;
(c) cut-off procedures before and during the counts (and in relation to the year end, if different);
(d) separation of inventories held for customers or third parties, so that these are excluded;
(e) investigation of differences highlighted by the stock counts where the client has a continuous stock-recording system;
(f) identification of obsolete, slow-moving and damaged inventories;
(g) procedures to ensure that the stock records are up to date;
(h) procedures used to estimate physical quantities, where applicable, such as may be needed in estimating the physical quantity of a coal pile;
(i) controls over movements between areas and locations during the count;
(j) a logical layout of the stock to make the count easier;
(k) controls to ensure no double counting of stock held at a single location, such as the marking of items once they have been counted on the floor;
(l) controls to ensure no double counting of stock held at different locations (there is a potential problem if counts are held at different locations at different times – stock can be moved from one location to another and be counted more than once); and
(m) controls over the issue and completion of stock sheets.
At the stocktake: observing the count
Many of the procedures and controls set out in the stocktake instructions are designed to prevent fraud, a key risk consideration under ISA (UK) 240 (Revised May 2021) (Updated May 2022) The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements . The auditor should therefore ensure that the stocktaking procedures as set out by the management are actually followed in practice by attending the count while it is still in progress.
The auditor should also perform following actions:
(a) ensure that non-client inventory is identified and excluded from the count;
(b) consider whether the count is orderly, well controlled and methodical from the outset;
(c) check that inventory sheets issued to counters are adequately controlled;
(d) check that slow-moving, obsolete or damaged inventory is clearly identified;
(e) review cut-off controls to segregate inventory received during the count;
(f) ensure that no movements in or out of inventory took place during the count;
(g) consider checking that any measuring or weighing machine to be used in the count gives accurate results;
(h) obtain details of a sample of selling prices of the stock lines; and
(i) note details and serial numbers of the last goods in and out, together with goods despatched note (GDN) and goods received note (GRN) references. The information is required for cut-off testing, though precisely what the auditor requires will vary from system to system.
The auditor should also consider whether other audit tests for different areas need to be performed at this time (e.g. fixed asset verification and trade debtor and creditor circularisations).
At the stocktake: test counting and inspection
Where the client counts most or all of the stock at one time, the auditor must attend the stocktake in order to obtain adequate evidence of existence (assuming the stock figure is material).
Inspecting the stock when attending the physical stocktake assists the auditor in ascertaining the existence of the inventory (though not necessarily its ownership) and in identifying, for example, obsolete, damaged or ageing inventory.
As well as observing management’s count procedures, the auditor must carry out test counts in both directions as follows:
(a) from the stock sheets to the physical stock, verifying the existence and quantity (that is, test for overstatement); and
(b) from the physical stock to the count records to ensure that all items are correctly included (that is, test for understatement).
The auditor should review any errors found and determine the potential for further errors and quantify the effect of any such errors.
The auditor should obtain the stock sheets at the end of the count to ensure that records have not been manipulated, suppressed, added to or substituted after the count. If it is not practical to keep a full copy of the stock sheets, the auditor should extract details for a sample of items that can be checked later.
Sample sizes at the stocktake
The auditor should estimate risk, materiality and the stock value to arrive at a sample size in accordance with the firm’s usual procedures.
Note that the full sample size should then be used for testing from sheet to floor, and vice versa, as these are two separate tests. The sample size should not be split in two, with one half tested from floor to sheet and the other half from sheet to floor.
Work in progress
The auditor should ensure that the nature and stage of completion of work in progress is consistent with the records. Where work in progress consists of a small number of high value items or projects, it may be worth the auditor taking photographs of the actual state of completion when attending the stocktake. The auditor should ensure that any important or contentious issues are included in the letter of representation.
A third-party expert stocktaker should be used where the auditor does not have the necessary expertise in relation to the stock to be counted. In such cases, the auditor would have to consider the competence and reliability of the expert’s work in accordance with ISA (UK) 620 (Revised November 2019) (Updated May 2022) Using the work of an auditor’s expert , which is considered in more detail in Using the work of an auditor’s expert .
Confirmation of title
Stock held at a client’s premises is often the property of that client, but this is not always the case. Ensure confirmation is obtained as to ownership. Possible risk areas include:
(a) stock purchased by the client may be subject to a Romalpa (reservation of title) clause that may need to be disclosed (but this does not affect the treatment of the stock as being effectively owned ( FRS 102:23.13 ));
(b) the client may hold stock on behalf of third parties;
(c) the stock may represent items returned by customers for repair or upgrade; and
(d) the client may be holding consignment stock – in which case the auditor must ensure that proper consideration has been given to who has the risks and rewards of ownership in accordance with FRS 102:23A.6 .
Year end procedures on the stocktake
In addition to recording the auditor’s test counts, obtaining copies of management’s completed physical inventory count records assists the auditor in performing subsequent audit procedures to determine whether the entity’s final inventory records accurately reflect actual inventory count results. The auditor should:
(a) agree the balance on the nominal ledger to the final inventory sheets;
(b) trace all items selected at the stocktake to the final stock sheets, and where appropriate, internal inventory records, ensuring that all items have been included in the final valuation;
(c) select a sample of items from the final inventory sheets and trace to the copies of the counters’ inventory sheets taken during the stocktake;
(d) check the arithmetic accuracy of a sample of the final inventory sheets;
(e) review stock sheets and ensure that any amendments are properly authorised and valid. It may be necessary to review any movements by reference to the goods despatched and received records; and
(f) carry out a general examination of the inventory sheets to ensure there are no obvious omissions or unusual items.
Stocktake not at the year end
In some cases, it may be necessary to count inventory before the year end in order to meet a short reporting deadline. If this is the case, the auditor needs to ensure that:
(a) the system will produce a reliable inventory figure at the year end; and
(b) stock movements are tested for the period between the count and the year end. The movements may be audited by analytical procedures or detailed testing of a sample of individual transactions, to ensure that they are valid stock movements.
In other cases, it may be necessary to count stock at a time very close to the year end, but not actually at the year end (e.g. on a day of the week when the premises are closed), or the count may continue over a couple of days. The procedures will be the same in (b) above. Remember, though, that a company’s actual year-end day can fluctuate by seven days either side of the accounting reference date specified to the Registrar of Companies. This is common for retail businesses and those who supply retailers.
Although the client will not count all the stock at any one time, the auditor should still attend one of the counts, preferably as near as possible to the balance sheet date. The stocktaking instructions should still be reviewed to ensure they are effective as noted above .
Alternatively, the auditor can conduct test counts at the fieldwork stage of the audit, or at the year end, checking a sample of counts from the stock floor to perpetual stock records, and vice versa.
The auditor should consider whether attending the stocktake is the most effective method of valuing stock, as it can be cheaper and more effective to use an external valuer. If the client does not wish to pay for this service, there is no reason why the auditor should not pay and include the costs within disbursements. This is common practice when conducting audits for clubs, pubs, chemists and newsagents.
However, where a professional valuation has been used it is important that the requirements of ISA (UK) 500 (Updated May 2022) Audit evidence are followed (using management’s expert). The general requirements are considered in Using the work of management’s expert . In applying these principles to the valuation of inventory, the following procedures are followed:
• the auditor should ensure that the valuer is both independent of the entity and competent to undertake the assignment;
• the work of the expert should be understood by the auditor; and
• when the valuation has been undertaken, the auditor should obtain a detailed report from the valuer providing details of:
• how the count was undertaken;
• the method of valuation used;
• cut-off procedures; and
• how obsolete inventory was identified.
The report should incorporate a full list of all individual inventory items. If this is unavailable for any reason, the auditor should consider the impact that this will have on the audit report due to the requirements of either SI 2008/409 or SI 2008/410 to keep full details of all inventories held at the year end and of the Companies Act 2006 to maintain adequate accounting records.
The auditor should perform a limited amount of work to confirm that the third party inventory report is adequate for the purposes of the audit, as it will have been prepared principally for management’s use. In addition to reviewing the scope, competence and objectivity of the stocktaker, the auditor should also consider attending the stocktake, even if only irregularly. Also, some verification work should be performed on the valuations made by the stocktaker on a sample of inventory lines. At the very least, some analytical procedures should be conducted on the third-party stocktaker’s results.
It is important to fully understand the scope of the work of the external ‘valuer’. It is sometimes the case that external valuers only count inventory and do not independently value it, relying instead on the purchase cost per the client’s systems. In such circumstances, it is vital that the auditor tests the valuation of inventory and does not rely on the external report for this purpose.
Non-attendance at stocktake
Attendance at the stocktake is mandatory under ISA (UK) 501 , unless it is impracticable, and then alternative procedures must be performed.
The auditor is required to document on file how the existence of inventory has been confirmed. This objective applies whether or not the auditor attended the stocktake. Where the auditor did not attend the stocktake and inventory is material, it is essential that any alternative procedures to confirm existence are fully documented. For example, it may be that comfort can be gained through performing counts at the time of the audit and reconciling back via post-year end accounting records. Alternatively, analytical procedures may confirm that the inventory figure is not materially misstated. In some cases where attendance is impracticable, alternative audit procedures, e.g. inspection of documentation of the subsequent sale of specific inventory items acquired or purchased prior to the physical stocktake, may provide sufficient appropriate audit evidence about the existence and condition of the inventory.
If alternative procedures do not provide sufficient appropriate audit evidence, then the auditor must consider whether there has been a limitation on scope requiring modification to the audit report (see Non-attendance at stocktake and Drafting the audit report ).
There can be a higher risk of error with cut-off testing, as year-end procedures happen infrequently and could be manipulated. Errors can arise when systems are inconsistent in recording transaction dates. At the period end, this can cause a cut-off issue if a transaction is recognised in the incorrect period. Cut-off tests on inventory should be coordinated with cut-off tests for sales, purchases, debtors and creditors. Tests should ensure that despatches and receipts of goods are recorded in the correct accounting period and that corresponding sales or purchases are also recorded in the same period.
Substantive analytical procedures.
Where applicable, the auditor should carry out an analytical review on inventory held at different locations and the inventory levels should be compared – in as much detail as possible – with those of previous years and also reviewed in relation to any management information available for the location.
Tests of detail
The auditor should test cut-off at the year end and at the stocktaking date. The following procedures should be applied:
(a) using the details collected at the stocktake, select items from the goods inwards and goods outwards records either side of the year end, and agree these to the relevant inventory records, and hence to the sales and purchase records; and
(b) where inventory moves between internal departments or locations, ensure that cut-off also operates correctly so that items are neither omitted nor double counted.
Valuation of raw materials, work in progress and finished goods
The audit of production work in progress is a very difficult and judgemental area. Analytical procedures can provide an effective tool for assessing the reasonableness of specific judgements and also of the overall work in progress figure. The components of work in progress should be examined in as much detail as possible.
Method of valuation
The auditor should review the methods of valuing raw materials, work in progress and finished goods and ensure that they have been consistently applied and are in accordance with the applicable accounting standard and the entity’s accounting policies. The following matters should be considered:
• inclusion of import duties, transport and handling costs in the inventory valuation;
• inclusion of direct labour, direct expenses and an appropriate proportion of production and other overheads in a manufacturing company in the inventory valuation; and
• exclusion of selling and distribution overheads and inter-branch profits from the inventory valuation.
Guidance on valuing inventory is available in Navigate UK GAAP Accounting .
The auditor should check, on a sample basis, that the unit costs of raw materials and costs recorded for work in progress and finished goods on the inventory sheets are accurate and appropriate by reviewing such supporting evidence as:
• suppliers’ invoices (if inventory is valued on the ‘first in first out’ basis): the auditor should ensure that sufficient invoices have been examined to cover the amounts in inventory;
• labour costs (timesheets, clock cards, etc.);
• overhead allocation calculations; and
• standard costing calculations (review for reasonableness by reviewing variance analysis).
The auditor should check the arithmetic accuracy of the final costing calculations.
When performing this testing, an alternative approach to selecting a sample of inventory lines from the final inventory listings is to extract a sample of purchase invoices from the period it takes inventory to turn over (say, the two months before the year end) and to check that the appropriate cost is recorded on the inventory sheet. Performing this test from the purchase invoice still satisfies the objective of ensuring that inventory is valued correctly.
Reasonableness of provisions
Analytical procedures are useful in assessing the reasonableness of inventory provisions. If there have been increases in the level of inventory held without an adequate explanation and there has been a worsening of the inventory turnover ratios, then this could, potentially, lead the auditor to conclude that an increase in the level of inventory provision is required. When considering this issue, the auditor may be able to review the inventory records (including details such as inventory ageing) to determine the last time that a particular inventory line was sold and bought.
Unless the stockholdings have changed significantly, or there have been other changes to inventory, the level of the inventory provisions should be relatively consistent over time. While the main risk is usually understatement of inventory provisions, in the case of profitable clients, the main risk is that inventory provisions are overstated to reduce the tax burden. In some cases, therefore, it is important to critically evaluate whether any inventory provision is necessary. This may best be done through analytical procedures, assessing the provision for reasonableness compared with previous years and the auditor’s knowledge of the client (including any changes to the business).
The auditor may also be able to conduct analytical procedures on the client’s inventory provision calculations. A key point with inventory provisions is consistency; any changes to the level of inventory provisions need to be properly justified. The auditor also needs to consider whether the method of arriving at the level of provision is appropriate, particularly where a fixed percentage is applied. Developing a point estimate may also be useful if a ‘proof in total’ style analytical review test can be used.
Confirming that inventories are valued at the lower of cost and estimated selling price less costs to sell can usually be achieved by further testing of the sample used to check unit costs in raw materials, work in progress and finished goods.
FRS 102 requires the auditor to consider the net realisable value of inventory on an item-by-item basis and so it is not sufficient to look at it globally. The auditor should review individual lines to determine whether any provision is in fact necessary.
When testing for impairment, any related selling costs should also be taken into account along with the selling price at which a unit was sold after the year end. Also consider how many units have been sold at the price. The auditor should consider the following questions when assessing the risk of estimated selling price less costs to sell being less than cost.
(a) If production levels are high and inventory turnover is low, does this indicate that inventory levels are excessive?
(b) Are production levels falling?
(c) Will the introduction of new products make existing products obsolete?
(d) Have any inventory lines been discontinued?
(e) What is the shelf life of goods, particularly perishables and those with expiry dates?
(f) Has all inter-branch or departmental profit been eliminated?
(g) Have the costs of completing items and any selling and distribution costs been considered?
(h) Were any items identified as old, obsolete or slow moving at the stocktake?
(i) Have the contract price, after-date orders and sales and other relevant information been reviewed in relation to work in progress?
(j) Are there any likely changes in technology or market demands?
(k) Are actual inventory levels high compared to expected inventory levels from budgets and previous years?
(l) Are actual inventory levels high in comparison to orders received and anticipated demand?
(m) Do costs or selling prices fluctuate?
Agree sales prices to invoices ensuring any discount given is taken into consideration.
At the time the auditor is undertaking much of the audit work, it is usual for some items that were in inventory at the year end to still be unsold. The auditor should consider not just the sales price, but also how many items have been sold after the year end as a proportion of the quantity in inventory at the year end in order to assess whether there is an issue of slow-moving inventory.
This approach principally makes use of reviewing subsequent events (i.e. post year-end inventory sales and write offs) to test valuation.
Assessing the adequacy of provisions is an area that requires judgement and discussion with the client. The auditor must ensure that sufficient evidence has been noted on file to satisfy the objective that the level of any inventory provision is fairly stated. Auditors need to take care that they have performed the mandatory procedures required by ISA (UK) 540 (Revised December 2018) (Updated May 2022) Auditing Accounting Estimates and Related Disclosures as described in Auditing accounting estimates . It is essential that the auditor maintains a high level of professional scepticism when auditing the inventory provision and robustly challenges management’s assertions.
Inventory held by third parties
There isn’t often a substantive analytical procedure which can be performed for identifying inventory held by third parties.
Where a third party holds inventory on behalf of a client, the auditor should:
• establish the reasons why the client’s inventory is held by a third party and determine whether this is reasonable in the circumstances;
• be particularly wary of cases where this is not in the normal course of business or is unusual in the particular industry sector;
• ensure that the client exerts control over such inventory and keeps adequate records; and per ISA (UK) 501:8 , must either:
(a) confirm in writing with the third party the quantities and condition of the inventory and that the client retains title to the goods (this should be done even if the records suggest that the third party is holding immaterial amounts of inventory or none at all at the year end); or
(b) perform physical inspection or other alternative audit procedures. (This should obviously be agreed with the client and the third party. Depending on the materiality of the amounts involved, such counts could be performed on a cyclical basis. Other alternative procedures might include obtaining evidence that the client bought the goods and that they were delivered to the third party on condition that title remained with the client (there should be some form of confirmation to this effect, e.g. the delivery address is usually specified on an invoice, which may indicate where such inventory is held).)
The auditor should consider whether any inventory held on consignment should be included in the client’s balance sheet. Consignment inventory is inventory held by one party (the ‘dealer’) but legally owned by another (usually the ‘manufacturer’), on terms that give the dealer the right to sell the inventory in the normal course of its business or, at its option, to return it unsold to the legal owner. Such inventory is commonly seen in new car main dealerships.
Guidance on accounting for consignment stock can be found in Navigate UK GAAP Accounting .
Design and perform appropriate tests for estimates, e.g. inventory provisions, using the estimates work paper for each estimate identified that is material or contains a risk of material misstatement.
Further guidance can be found in Auditing accounting estimates .
Presentation and disclosures
As with all account balances, the auditor needs to ensure that there is sufficient evidence on the file to support the disclosures made in the financial statements.
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Inventory audit procedures
What are inventory audit procedures.
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. Noted below are some of the inventory audit procedures that they may follow. 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 .
Analyze the Cutoff
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.
Related AccountingTools Courses
Accounting for Inventory
How to Audit Inventory
How to Conduct an Audit Engagement
Observe Cycle Counts
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.
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.
Analyze Finished Goods Costs
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.
Analyze Direct Labor
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.
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 used to apply overhead costs to inventory.
If you have a significant amount of work-in-process (WIP) inventory, the auditors will test how you determine the percentage of completion for WIP items.
Review 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.
Review 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).
Review 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.
How to Calculate Ending Inventory
How to Estimate Ending Inventory
Inventory Cost Flow Assumption
Inventory Count Procedure
Work in Process Accounting
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- Audit procedures
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Relevant to Paper F8/FAU
Audit procedures are an important area of the syllabus, though candidates often use inappropriate audit procedures to answer questions. The following tips will help you to understand the concepts and write appropriate audit procedures.
Every procedure must state:
- the assertion tested
- the audit procedure
- the reason for the procedure.
Each of these points is explained below.
Step 1 – Identify the assertion tested
Audit procedures are performed in order to test financial statement assertions. Therefore, the first step in explaining an audit procedure is to identify the assertion that needs to be tested .
The assertions embodied in the financial statements, as used by the auditor to consider the different types of potential misstatements that may occur, may take the following forms:
A brief explanation of the various assertions is as follows:
Completeness This means that all transactions have been recorded in the financial statements – ie all assets, liabilities, equity interests (capital and reserves) and other disclosures have been included in the financial statements.
Occurrence This assertion means that transactions and events and other matters that have been recorded actually took place – and relate to this organisation.
Valuation and allocation This means that all items have been included in the financial statements at appropriate amounts according to company policy and the relevant financial reporting framework. Furthermore, any allocations or valuation adjustments required (like impairment) have been made and financial and other information is disclosed fairly and at appropriate amounts.
Classification and understandability Financial information is appropriately presented and disclosed, and disclosures are clearly expressed so as to make them understandable to the users. For this, the disclosures should use simple language and state matters clearly and concisely.
Accuracy Accuracy means that amounts and other data relating to transactions and events have been recorded at the correct amounts – ie at the amounts appearing in the source documents.
Rights and obligations This means that the entity has a right to its assets – ie it is free to use or dispose of the assets as it sees fit. Furthermore, the entity is obliged to pay off the liabilities that are shown in the statement of financial position.
Existence This means that assets, liabilities and equity interests (capital and reserves) are physically present/belong to the entity on the reporting date.
Cutoff This means that transactions and events have been recorded in the correct accounting period – for example, if goods are delivered prior to year end, they are included in the cost of goods sold, not inventory.
Step 2: Identify the audit procedure
Follow the above method for testing other assertions too.
Choose audit procedures from AEIOU
A: A nalytical procedures E: E nquiry and confirmation directly from a third party – ie inquiry I: I nspection of records and assets O: O bservation U: recalc U lation and reperformance
Step 3: Note the following while writing down the audit procedure
1 Write it clearly Audit procedures should be written in such a way that even a junior auditor will be able to understand what is to be done. For example, avoid vague procedures like ‘check goods received notes’. This is vague as it does not explain what is to be examined in the goods received notes. Is it the description of items received, the quantity received or the name of the vendor?
2 Write down the reason for performing the audit procedure The audit procedure ‘check goods received notes’ does not mention why the goods received notes are to be checked. Instead, write the audit procedure as: ‘agree the description of items and the quantities ordered mentioned on the goods received note with the descriptions on the purchase orders raised on the vendor’. This confirms that the entity has procured goods based on an authorised purchase order.
3 Use audit terminology Use terminology relating to audit like ‘cast’, ‘agree’, ‘trace’, etc.
- Use the word ‘cast’ to mean totalling up a list – for example, ‘cast the trial balance’.
Use the words ‘agree’ or ‘trace’ to mean matching information from two documents/ records – for example, ‘agree the total sales of the sales day book to the general ledger account’; or ‘trace a sample of trade payables to the purchase invoices, to confirm the existence of the rights to the goods purchased’.
A complete audit procedure would read as follows: The auditor will agree a sample of items from the inventory sheets to the raw material inventory (1) to ensure that the inventory recorded on the sheets actually exists (2). This will confirm the assertion of existence of inventory as an asset in the financial statements (3).
(1 = the audit procedure; 2 = the reason for the audit procedure; 3 = the assertion).
If the above mentioned procedure is written as ‘The auditor will check a sample of items from the inventory sheets to the raw material inventory’, it is incomplete as it does not mention why the audit procedure is being performed.
Common errors that must be avoided
The examiner’s reports mention various errors that candidates make while writing audit procedures. Here is a summary of the common errors.
While writing audit procedures, avoid the following:
- Writing an audit procedure without explaining the reason for the procedure – for example, ‘The auditor will check a sample of items from the inventory sheets to the inventory.’
- Stating an assertion word as a reason for performing a procedure – for example, ‘confirming the occurrence of sales’.
- Writing what the internal control system should do rather than stating the audit procedure – for example, ‘for all goods received, there should be a goods received note raised’.
- Writing vague procedures – for example, ‘check the invoice’, ‘check the goods received note’, etc. These procedures are inappropriate as they do not mention what is to be checked and the reason for checking them.
- Quoting incorrect assertions – for example, ‘tracing details from the purchase orders to the goods received notes in order to confirm existence of the goods’ – the completeness assertion would apply here.
- Including procedures that cannot be carried out – for example, ‘agree individual items of physical inventory to the sales invoice’. It will not be possible to agree the physical goods to the sales invoice as the goods will already be sold.
- Including procedures that are incorrect – for example, ‘agree details from the purchase orders (like description of items ordered, quantities ordered) to the goods held in the inventory store’. This is an incorrect audit procedure as goods received notes (not purchase orders) are used to update inventory.
- Writing impractical procedures – for example, suggesting a segregation of duties between the person authorising petty cash vouchers, recording petty cash vouchers and dispensing the petty cash.
- Writing irrelevant audit procedures – for example, when you are asked to write audit procedures relating to depreciation of a non-current asset, it will be inappropriate to provide general audit procedures relating to audit of non-current assets.
Audit procedures are a vital part of Paper F8 and Paper FAU. Therefore, you need to practise explaining the audit procedures as suggested above in order to perform well in the exam.
Vijaya Swaminathan is a technical author for Paper F8 at Get Through Guides
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