A cement distributor holds ₦2 billion of stock in three warehouses. A fire destroys part of one store, and the records do not show what was lost. A new truck is bought and charged to repairs by mistake. Inventory and non-current assets are often the largest items on the statement of financial position. Each has its own risks: movement and safekeeping for inventory, authorisation and classification for assets.
This topic covers the risks, control objectives, controls and tests for the inventory system, and for the purchase and recording of non-current assets. The sales and purchases tests are not repeated here. The previous topic covered cash, and the next covers management letters.
In 30 seconds
Inventory risks: inaccurate records, theft or damage, wrong valuation, too little stock, too much stock. Controls: segregation of ordering, custody and accounting; documents for every movement; restricted access; regular counts; valuation at the lower of cost and net realisable value under IAS 2; maximum, minimum and re-order levels. Non-current asset risks: unneeded assets bought; wrong amounts or capital/revenue errors. Controls: authorisation, analysis of invoices, asset register, proof of ownership.
Key terms in plain English
| Term | What it means |
|---|---|
| Inventory | Goods held for sale or for use in production |
| IAS 2 | The standard on inventories |
| Net realisable value | Expected selling price less costs to sell |
| Re-order level | The stock level at which a new order is placed |
| Asset register | A record of each non-current asset |
| Capital expenditure | Spending that creates a long-term asset |
Syllabus check
This topic is in syllabus area B, the nature and use of internal control (20% of marks). It covers:
- accounting systems and internal controls over inventory and non-current assets
- the evaluation of internal controls
- tests of controls
CAMA 2020 and inventory and assets
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 404(2) | The auditor states whether proper books of account were kept | Stock and asset records are part of the books |
| s. 405 | Corporate responsibility for financial reports | Management designs the controls |
| s. 407(3) | Right of access to books, accounts and vouchers | Access to stock and asset records and to the assets |
The rules in more depth
The inventory system
Inventory is often a material item and can be high risk, so the auditor usually wants some assurance about controls over it. The tests here do not repeat those for sales and purchases. They focus on inventory movements and security. Audit work on valuation is normally done at the substantive stage.
The main risks are: inaccurate records; theft or damage; incorrect valuation; too little inventory, so customers' orders cannot be met; and too much, so money is tied up.
| Control objective | Principal controls | Tests of control |
|---|---|---|
| Recording. Records are complete, accurate and include only the company's items; all movements are recorded and authorised | Segregation of ordering, custody and accounting. Proper documents for all issues from the store. All goods received are checked and recorded. Inventory records properly maintained | Look for evidence that movements in the inventory department agree to dispatch and goods received documents. Look for evidence that movements are authorised |
| Physical safeguards. Inventory is protected from loss and damage | Restricted access to storage areas. Regular counts using appropriate procedures | Look for compliance with access restrictions. Obtain confirmation that periodic counts are performed and checked to the records |
| Valuation. Inventory is valued at the lower of cost and net realisable value | IAS 2 is applied. Procedures to identify obsolete and slow-moving items | Look for evidence of how valuations are reviewed to apply IAS 2 |
| Management. Appropriate levels are held | Maximum and minimum levels for all items of value; appropriate re-order levels and quantities | Review for excessive levels, perhaps through exception reports in an IT system, often at the time of the count. Monitor how often items run out of stock |
Further controls are physical protection from fire, theft and damage, such as locks, alarms, CCTV and insurance; a gate pass and a signed requisition for each issue from stores; a stores ledger or perpetual record reconciled to the general ledger; investigation of differences between counts and records; separate quarantine of damaged and returned goods; and control over inventory held by third parties or held for them.
Non-current assets
The main risks are that assets the company does not need are ordered, and that expenditure is recorded at wrong amounts or as revenue instead of capital expenditure. Assets are also at risk of loss, theft, disposal without authority and impairment that is not recognised.
| Control objective | Principal controls | Tests of control |
|---|---|---|
| Authorisation. All expenditure on non-current assets is properly authorised | Appropriate authorisation for purchases; documents and analysis to support capital expenditure requests; approval procedures for paying suppliers of non-current assets. Many purchases controls are similar to those for inventory | Look for documentary evidence of capital expenditure authorisation |
| Recording. All expenditure is properly recorded and analysed as capital or revenue | Invoices analysed and account codes entered on them. Management reviews the analysis of items as capital or revenue to comply with standard accounting practice | Check the capital and revenue analysis of invoices. Check that entries are made in the non-current asset register |
| Rights and obligations. The entity has rights to the assets purchased and recorded | Ownership documents, such as invoices, contracts, leases and title deeds for property, checked before the asset is recorded in the register | Look for documentary evidence of checking of ownership. Check ownership documents for a sample of additions and see that they relate to the entity |
Other controls are:
- a non-current asset register that is reconciled to the ledger and checked to the physical assets at least once a year
- tagging of assets
- authorised disposals with proceeds banked and the asset removed from the register
- a depreciation policy applied consistently and reviewed
The tests include checking the register to the ledger, sampling assets from the register to the floor and from the floor to the register, which tests existence and completeness, and checking disposals for authority.
Linking to substantive tests
Good controls over inventory movements and counts reduce the extent of the year-end count work that must be done by the auditor, and make the perpetual records more reliable. For assets, effective authorisation and capital and revenue controls reduce testing of additions, though the auditor still tests depreciation, disposals and impairment. These are covered in the later topics on tangible and intangible assets and inventory.
Worked examples
Example 1: store access. Any employee may enter the stock room and take items without signing.
- Items may be stolen or taken without a record.
- Access should be restricted and every issue should have a signed requisition.
Example 2: capital or revenue. A repair of ₦300,000 and a new machine of ₦5 million are both coded to "repairs".
- The machine should be capitalised, and expenses are overstated and assets understated.
- Management should review the capital and revenue analysis of invoices.
Example 3: asset register. The auditor selects 20 items from the factory floor and finds that four are not in the register.
- The register is incomplete.
- The auditor assesses the completeness control as ineffective and extends substantive tests on additions.
Example 4: excessive stock. Reports show that 15 items have not moved in 18 months.
- The items may be obsolete and valued above net realisable value.
- The auditor discusses write-down with management and tests valuation at the substantive stage.
How to score full marks
- Split the answer into inventory and non-current assets.
- Use objectives: recording, safeguards, valuation, management; authorisation, recording, rights.
- Name IAS 2 and the lower of cost and net realisable value.
- Give a test for each control.
Common mistakes in the exam
- Repeating purchase and sales controls.
- Forgetting security of stores.
- Not mentioning the asset register.
- Missing capital and revenue classification.
Quick revision
- Inventory: record, protect, value, manage levels.
- Assets: authorise, record and classify, prove ownership.
- Counts; access; re-order levels.
- Register reconciled to ledger and physical checks.
Practice questions
Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.
Question 1. Inventory is valued at the:
- Lower of cost and net realisable value
- Highest price
- Selling price
- Replacement cost
Show the answer
A. IAS 2.
Question 2. A control over physical safeguards of inventory is:
- Restricted access to stores
- Monthly sales reports
- Customer statements
- Tax returns
Show the answer
A. Prevents theft.
Question 3. Maximum and minimum levels help to avoid:
- Too much or too little stock
- Fraud in payroll
- Bank errors
- Tax risk
Show the answer
A. Inventory management.
Question 4. A risk for non-current assets is that:
- Expenditure is recorded as revenue instead of capital
- Cash is banked
- Staff are paid
- Goods are sold
Show the answer
A. Classification error.
Question 5. Authorisation of capital expenditure should be:
- Documented and approved
- Verbal
- Unrecorded
- Optional
Show the answer
A. Documentary evidence.
Question 6. Title deeds are checked to establish:
- Rights and obligations
- Valuation of stock
- Payroll
- Cash
Show the answer
A. Ownership.
Question 7. An asset register should be:
- Reconciled to the ledger
- Kept secret
- Not updated
- Destroyed
Show the answer
A. And checked to the assets.
Question 8. Regular inventory counts check:
- Records against physical stock
- Prices
- Salaries
- Tax
Show the answer
A. Detect differences.
Question 9. Slow-moving inventory risks being:
- Overvalued
- Undervalued
- Stolen only
- Sold
Show the answer
A. May be above NRV.
Question 10. Tests of control on inventory movements look at:
- Agreement to dispatch and goods received documents
- Only the audit fee
- The tax return
- Payroll
Show the answer
A. Evidence of movements.
Question 11 (10 marks). Describe the risks, controls and tests of controls over inventory, excluding sales and purchases. (10 marks)
Question 12 (10 marks). Explain controls over the purchase and recording of non-current assets and the tests the auditor would perform. (10 marks)
Question 13 (6 marks). Explain how a company should safeguard its inventory and non-current assets against loss, and how the auditor would test those safeguards. (6 marks)
Model answers
Show the model answer to Question 11
Risks: inaccurate records; theft or damage; wrong valuation; too little or too much stock. (2) Controls: segregation; documents for all movements; goods received checked; restricted access; regular counts; IAS 2 applied and obsolete stock identified; minimum, maximum and re-order levels. (4) Tests: agree movements to documents; check authorisation; compliance with access; confirm counts; review valuations; exception reports and out-of-stock monitoring. (4)
Show the model answer to Question 12
Risks: unneeded assets; wrong amounts; capital or revenue errors. (2) Controls: authorisation with supporting documents; approval for invoices; invoices analysed and reviewed; asset register; ownership documents checked. (4) Tests: authorisation evidence; capital and revenue analysis; register entries; ownership documents for additions. (4)
Show the model answer to Question 13
Inventory: restricted access to stores; signed documents for every issue; regular counts agreed to records; protection against fire and theft, such as locks, alarms and insurance. (2) Non-current assets: an asset register reconciled to the ledger; tagging; periodic physical checks; authorised disposals.
(2) Tests: observe access controls; inspect issue documents and count records; trace a sample of assets from the register to the floor and from the floor to the register; check disposals for authority. (2)
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