Inventory valuation and the physical count (ISA 501)

A paint manufacturer in Ikeja reports closing inventory of ₦2.8 billion. On the night of the year-end count, a tag is missing from one warehouse, two pallets of finished goods are loaded onto a truck while the counters work, and goods supplied on sale-or-return by a supplier are counted with the rest. None of this appears in the inventory schedule, yet it can all change profit by hundreds of millions.

Inventory is usually the hardest balance to audit: it is large, it is judged, it moves, and it is usually outside the double-entry system until the count is done.

This topic covers why inventory matters to the auditor, the principal risks, how inventory is valued under IAS 2 and tested, the purpose and timing of physical counts, what management must put in place, the auditor's work before, during and after the count under ISA 501, cut-off, weaknesses in count procedures, and what to do when the auditor cannot attend. The previous topic covered intangible assets, and the next covers receivables.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence and substantive procedures (25% of marks). It covers:

• substantive procedures for inventory
• attendance at inventory counts under ISA 501
• valuation of inventory under IAS 2
• cut-off

CAMA 2020 and inventory

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

Why closing inventory matters

For many businesses, though services are often an exception, inventory is one of the areas needing most attention. The reasons are:

• Inventory is often a material item in the financial statements.
• It can be high risk and involve a high degree of judgement, especially in valuation, for example estimating the stage of completion of work in progress.
• It may deteriorate, be lost or stolen without this being recognised in the accounts.
• It may be highly technical, so the auditor may have to consider relying on an expert.
• Establishing the closing figure can be lengthy and complex for the client, with a high risk of error.
• Closing inventory is often not part of the double entry system until the year end, so directional testing of other balances may not reveal a misstatement in inventory.

Work on inventory is often given to more experienced members of the audit team and is subject to rigorous review. Analytical procedures are widely used to supplement the detailed tests.

Principal risks of misstatement

The inventory figure reflects the quantity on hand at the year end and the value of each item, so the procedures mostly address existence and valuation. Test counts in both directions also cover completeness. At the count the auditor checks that third parties' inventory is separated, which covers rights and obligations.

For presentation and disclosure, the auditor checks that the year-end schedule agrees to the financial statements and that inventory is classified properly between raw materials, work in progress and finished goods.

Valuation of inventory: IAS 2

IAS 2 requires inventory to be valued at the lower of cost and net realisable value, item by item.

• Cost includes the costs of purchase and all other costs of bringing the inventory to its present location and condition. For work in progress and manufactured goods this includes production overheads, with the absorption rate based on normal levels of activity. Cost may be estimated by methods such as first-in-first-out or weighted average cost, provided the method gives a close approximation to actual cost. Last-in-first-out is not permitted.
• Net realisable value (NRV) is the estimated selling price in the ordinary course of business, less any estimated costs to complete and the estimated costs of making the sale.

Selling and general administration costs, storage costs not needed for production, abnormal waste and exchange differences are not included in cost.

Example. A company holds 1,000 units. Cost is ₦600 each. The selling price is ₦700, but ₦150 per unit will be spent on repackaging and ₦50 on selling. NRV is 700 less 150 less 50 = ₦500, below cost, so inventory is valued at ₦500 per unit, a write-down of ₦100,000 in total.

Substantive procedures on valuation

The procedures should fit the nature of the inventory. A retailer's cost is mostly the purchase cost of goods for resale. A manufacturer's cost includes direct labour and production overhead as well as materials.

Raw materials and goods for resale.

• Confirm the client's method of estimating cost, such as first-in-first-out or weighted average.
• Check the cost of inventory to purchase invoices or official supplier price lists, plus delivery costs.

Manufactured goods and work in progress. Obtain schedules showing the make-up of cost for each item of work in progress and finished goods, and check the arithmetic. Then check each element:

• Materials: the same tests as for raw materials, and check that the correct quantity of materials has been used.
• Labour: check pay rates for direct labour to payroll and personnel records for the employees who produced the items, and check hours to time records.
• Production overheads: confirm that only production overheads are included, not selling and administration overheads, and that the absorption rates are based on normal levels of output.
• Work in progress: also check the stage of completion for materials and conversion costs.

Cost or net realisable value?

The auditor looks at the client's procedure for deciding whether each item should be at cost or NRV, and:

• reviews and tests the procedures for comparing NRV with cost for each item;
• follows up information from other work that NRV may be below cost for some items, such as deterioration seen at the count, or the amount of returns and allowances granted to customers;
• reviews inventory records and order books for slow-moving items, whose selling price may need to be reduced;
• reviews prices at which goods were sold after the year end, which can show that NRV exceeds cost; and
• for work in progress, compares the costs incurred to date with selling price less costs to complete, using the client's management accounts for costs to complete.

Where the client has an IT inventory system, audit software can improve the efficiency and accuracy of tests: for instance, listing items with no recent purchase or sale, recalculating the lower of cost and NRV for every item and comparing prices with the current price list.

Physical counts: purpose and responsibilities

Many organisations rely on a count at the year end to arrive at the inventory figure. Even with sophisticated continuous records, the records should be checked by regular physical counts. The reasons for counts are:

• they may be easy to arrange where inventory is in a few locations;
• they give evidence of the actual existence of the inventory, important to both the client and the auditor;
• they let the entity check the accuracy of continuous records;
• without continuous records, a count may be the only way to establish the quantity at the year end;
• differences between the count and the records can show weak physical controls and losses by theft or other causes; and
• they allow checking of the physical condition of inventory and of any deterioration.

Responsibilities. Management arranges the count, sets the procedures so a complete and accurate count is taken, and is responsible for the reliability of inventory valuation in the financial statements. The auditor gathers evidence from which to reach a conclusion on the inventory figure, and attendance at the count provides part of it.

ISA 501. If inventory is material, the auditor must obtain sufficient appropriate evidence on its existence and condition by attending the count, unless it is impracticable. The purpose of attendance is to:

• evaluate management's instructions and procedures for recording and controlling the count results
• observe management's count procedures
• inspect the inventory
• perform test counts
• perform procedures over the final inventory records to see that they accurately reflect the count

Timing of the count

Counting procedures and management's instructions

The auditor must be confident that management's procedures will ensure a complete and accurate count. The directors should issue written instructions well in advance. The auditor reviews them before the count, and if not satisfied, raises the matter with management and asks for amendments. The instructions should cover:

Cut-off

Cut-off is the process of ensuring that all transactions are fully recorded in the correct period. Without a clean cut-off, figures for two consecutive years can be badly distorted. It affects inventory, sales, cost of sales, receivables and payables.

• Sales cut-off. A sale recorded in the year to 31 December Year 4 needs a receivable, removal of the goods from inventory and a cost of sales entry in that year. The same item must not be shown as both a receivable and inventory.
• Purchases cut-off. If goods received by 31 December Year 4 are in closing inventory, the purchase and the payable must also be recorded in that year. If an asset is recorded, the liability must also be recorded.

The auditor does substantive testing of cut-off, using information noted at the count.

The auditor's work: before the count

• Review the previous years' files for problems at past counts.
• Review the client's instructions for adequacy and suggest changes.
• Establish the date, time and location of the count and decide which counts at which locations the audit team will observe.
• Find out whether any inventory is held by third parties and decide whether written confirmation is needed.
• Arrange for a local firm to attend a location the firm's own staff cannot reach.
• Consider the use of the client's internal audit department.

The auditor in charge requests the right number and grade of staff, may circulate the instructions to the team, becomes familiar with the client's inventory, particularly high-value or complex items, decides the scope of testing at the count from materiality and risk, and considers whether an expert is needed for complex items.

The auditor's work: during the count

The auditor attends for two purposes. First, tests of control: to see that employees follow the instructions and to look for weaknesses in the counting system. Second, substantive tests: to make sure there is no material misstatement, which means checking not only that inventory exists but that the valuation method is appropriate. If inventory looks dilapidated or has old dates on its containers, the auditor considers NRV.

At the count, counters receive sheets for each item. Counted inventory is marked or tagged, to prevent double counting and to show what is uncounted. Each sheet is signed by its counter and handed in for summarising.

Observe:

• whether the count follows the written instructions;
• the condition of the inventory, for items whose NRV might be below cost;
• whether inventory not owned by the client, such as customers' goods held on the premises, is identified and labelled;
• whether production and movements of inventory are controlled and documented during the count; and
• at the end, whether all items have been counted and tagged.

The auditor normally prepares an inventory count memorandum recording the observations and a conclusion on how effective the count procedures were.

Record:

• Test counts: count a sample of items and compare with the client's records, which tests completeness; and select a sample of items from the client's count records and count them, which tests existence. Resolve differences with the client and record the results.
• The sequence numbers of the last tags and summary sheets used, for use after the count to check that all items are in the client's list.
• Cut-off information: details of the last few goods received notes and dispatch notes before the count and the first few after it.
• Details of slow-moving, obsolete or damaged inventory seen, to support the valuation assertion later.

The auditor's work: after the count

The final work may take place weeks after the count, by which time the client has computed a final inventory figure. The objective is to see that the quantities at the count date are properly reflected in the final figure. The auditor:

• obtains the final inventory sheets prepared at the count;
• checks the sequence of sheets against the auditor's record of the last sheet number, to see that none is missing;
• checks the sequence of tag numbers on the sheets against the record of the final tag number, to see that no items are missing;
• checks the arithmetic of the sheets;
• confirms that the inventory records were amended for differences between the count and the records;
• confirms that inventory belonging to the client but held by third parties is on the sheets;
• confirms that inventory belonging to third parties but on the premises at the count date is not on the sheets; and
• checks cut-off against the information recorded at the count.

The auditor can then reach a conclusion on the quantity of inventory held at the year end. The valuation tests are done at this stage too.

Example: Spares R Us

Spares R Us holds large quantities of spare parts for cars. It runs a perpetual inventory system backed by a rolling programme of counts through the year. There is no year-end count, and the year-end figure comes from the computer records.

The auditor's procedures are:

• carry out spot checks during the year
• do sample counts at the year end and compare with the perpetual records, investigating differences
• review the results of the rolling counts and see that differences between book and actual were investigated and adjusted
• check a sample of cost prices to purchase invoices
• assess obsolescence
• consider audit software on the year-end inventory file

Possible control weaknesses in an inventory count

• Count sheets not pre-numbered, so sheets can be lost or counted twice. All sheets should be numbered and accounted for.
• Expected quantities printed on the count sheet, which may influence counters in what they look for. Counters should not be told what to expect.
• Quantities written in pencil, which can be erased and altered later without trace.
• Only stores staff counting, so they might collaborate to hide errors or missing items. The client should use non-stores staff, such as accounts employees.
• Inventory not marked when counted, so items may be counted twice or missed.
• Count sheets not signed by the counter, so queries cannot be referred back.
• Imprecise instructions to the counting team, which raises the risk of missed or double-counted items.

When the auditor cannot attend

If the auditor cannot attend on the planned date because of unforeseen circumstances, ISA 501 expects the auditor to attend on an alternative date and perform tests on the movements in the intervening period. If attendance is impracticable, for example because of the danger to the auditor's safety, the auditor performs alternative procedures, such as inspecting documents of the subsequent sale of specific items acquired or purchased before the count.

If the alternative procedures cannot give sufficient appropriate evidence, the auditor modifies the opinion because of a limitation of scope. It is not enough that attendance is inconvenient or expensive.

The same applies where inventory is held by a third party, for which the auditor asks for written confirmation, or attends the count of that third party, or gets a report from its auditor, and where the client's inventory is in a remote place.

Inventory held at third-party locations and in transit

Inventory held in a public warehouse or consigned to agents needs evidence of existence, condition and ownership. The auditor can ask the custodian directly for confirmation of quantities, review the controls at the custodian, attend its count or read a report on its controls.

Goods in transit at the year end are tested through dispatch notes, goods received notes and the terms of delivery, since ownership may pass at dispatch or on delivery, depending on the contract.

Cost formulas: first-in-first-out and weighted average

The auditor must understand the formula the client uses and test that it is applied consistently. Suppose a company bought 100 units at ₦500, then 200 units at ₦560, and sold 150 units, leaving 150. Under first-in-first-out, the oldest units are sold first, so the 150 left are the latest purchases: 150 × ₦560 = ₦84,000. Under weighted average, the average cost is (100 × 500 + 200 × 560) ÷ 300 = ₦540, so the 150 left are valued at ₦81,000.

In a period of rising prices, first-in-first-out gives a higher closing inventory and a higher profit. The auditor recalculates a sample using the client's stated formula and checks the formula has not been switched from one year to the next without good reason. A change that increases profit is a warning sign.

Estimating stage of completion for work in progress

For work in progress the auditor asks how the client estimates the stage of completion and whether the method is reasonable. The evidence includes the production manager's records, production schedules, the quantities of materials issued to jobs, and the time sheets for the job.

The auditor may inspect work in progress at the count, ask engineers or production staff about the stage, and compare the stage recorded to the stage seen. For long jobs, the auditor tests a sample of jobs against the quotation or contract price to see that the expected result is a profit.

If a job is expected to make a loss, the loss must be recognised at once through an NRV write-down.

Obsolescence and slow-moving stock

Management should have a policy for provisions against old or slow-moving items, for example a percentage of cost for items with no movement for 12 months. The auditor tests that the policy is reasonable, that it is applied consistently, that the ageing report is accurate and that no items needing a larger write-down are hidden.

The auditor considers the nature of the business: fashion goods and perishables lose value fast, while spare parts for long-lived machines may hold their value, though they can be made obsolete by model changes. The auditor also compares the provision with prior years and with what was later sold or scrapped, to see whether management's estimates have been reliable.

Using the perpetual records

Where the client keeps perpetual records, the auditor tests the reliability of the records. The tests include:

• checking a sample of receipts and issues to documents
• checking that unrecorded movements are caught by the controls
• reviewing the results of the client's cycle counts and how differences were handled
• reconciling the perpetual records to the general ledger

If the cycle counts show a high error rate, the auditor cannot rely on the records and plans more year-end test counts. An item with a large difference needs a follow-up to see if it is a pricing error, a theft or a miscount.

An inventory count memorandum

A good memorandum is brief and states:

• the client, the location and the date and time of the count
• who attended for the audit firm and for the client
• the count procedures observed
• whether the instructions were followed
• the test counts done and the results
• the last tag and sheet numbers
• cut-off details
• slow-moving, damaged or obsolete items noted
• third-party goods noted
• any weaknesses found and how they were resolved
• a conclusion on whether the count was reliable and whether the auditor can rely on it as evidence of existence

The memorandum is the main record of the work and supports the conclusion on the quantity of inventory.

Test count results and follow-up

Where test counts agree with the client's counts, the auditor gets comfort that the count is reliable. Where there are differences, the auditor asks the counters to recount, identifies the cause and decides whether the error is isolated or pervasive. If the errors are systematic, such as units of measure being confused, the auditor asks for the whole area to be recounted.

If differences are immaterial but all in the same direction, the auditor considers whether there is bias. The auditor projects the errors found in the sample to the whole population to estimate the possible misstatement and compares it with materiality.

Inventory and the going concern and fraud risks

Inventory is a classic area for fraud. Examples are counting empty boxes, stacking goods to hide gaps, counting the same goods twice at two locations, including goods that belong to others, and recording inflated unit costs. The auditor remains alert, uses surprise visits where it is appropriate, selects items for test counts in an unpredictable way and, in a multi-location business, visits locations on a rotating basis.

Large changes in inventory days, or inventory that rises while sales fall, are warning signs for overstatement and may also suggest going concern problems if cash is tied up in unsold stock.

Disclosure of inventory in the financial statements

IAS 2 requires the financial statements to disclose the accounting policy for inventory, including the cost formula used; the total carrying amount of inventories and the amount in each classification, such as raw materials, work in progress and finished goods; the amount carried at net realisable value; the amount of inventory recognised as an expense in the period; the amount of any write-down recognised as an expense; any reversal of a write-down; and inventory pledged as security for liabilities.

The auditor checks these disclosures against the year-end schedule and the underlying records, and checks that a reversal of a write-down arises from a real increase in NRV and not from a wish to improve profit.

Consignment, bill-and-hold and inventory with customers

Goods may be in the client's warehouse but belong to someone else, as in consignment stock, or may be physically held by customers or agents but still belong to the client. The test is who has the risks and rewards of ownership and control.

The auditor reads the agreement, looks at the terms of sale and the records of movements, and may confirm the position in writing with the other party.

Bill-and-hold sales, in which the customer has been invoiced but the goods stay at the client's premises, are a risk of overstated revenue, so the auditor checks that the criteria for recognising the sale, such as a substantive reason for the arrangement and the goods being ready for delivery, are all met. If they are not, the sale and receivable are reversed and the goods stay in inventory.

Inventory at several locations

For a business with many branches or depots, the auditor chooses locations to attend by the value of inventory held and the risk at each location, with some locations visited every year and others on a rotating basis, and includes at least some locations unannounced or chosen late.

The auditor reviews the consolidation of the counts from the different locations and checks that transfers between locations around the count date are recorded once, by a clean cut-off at both ends, so that goods in transit are neither counted twice nor missed. Where the work of another auditor is used, the group auditor evaluates that auditor's competence and the work done.

Worked examples

1. Floor to sheets tests completeness.
2. Sheets to floor tests existence.

1. Those goods arrived after the year end and must not be in closing inventory or payables.
2. The auditor checks that the count sheets and the purchase records exclude them.

1. NRV is ₦26,000 per unit, below cost.
2. The write-down is ₦14,000 × 500 = ₦7 million, which the client must record.

1. The goods belong to the distributor until sold, so they should not be in inventory.
2. The auditor proposes removal of ₦5.4 million and checks the related payable.

How to score full marks

• Divide a count answer into before, during and after.
• Link procedures to assertions: existence, completeness, valuation, rights.
• Quote IAS 2: lower of cost and net realisable value.
• For a scenario adapt the procedures to a perpetual or a periodic system.

Common mistakes in the exam

• Saying the auditor does the count. Management does; the auditor observes and test counts.
• Forgetting cut-off information and tag sequence records.
• Valuing inventory at selling price.
• Missing slow-moving and damaged stock.

Quick revision

• Lower of cost and NRV, item by item.
• ISA 501: attend the count if inventory is material.
• Before: plan. During: observe, test count both ways, record tags and cut-off. After: follow up.
• Cut-off ties inventory to sales and purchases.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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