7062 Planning to attend physical inventory counting

Sep-2022

OAG Guidance

For each of the examples listed in CAS 501.A3, consider the following:

• The risks of material misstatement related to inventory:
  • Understand the nature and an approximation of the value, by inventory location or type.
  • Understand the volume of the inventory, the identification of high value items, the method of accounting for inventory and the conditions giving rise to obsolescence.
• The nature of the internal control related to inventory:
  • Review the business and accounting processes and related systems of internal control to identify any potential areas of difficulty.
  • Understand cut-off procedures (i.e., related to in-transit goods, items received/shipped during the count and items in-transit between locations during the count).
• Whether adequate procedures are expected to be established and proper instructions issued for physical inventory counting:
  • Review the instructions and consider whether they have been issued timely.
  • Consider the competence of personnel assigned.
• The timing of physical inventory counting:
  • Where the count is not performed at year-end, consider the reliability of records used in any roll-forward/roll-back of balances. See OAG Audit 7015 for roll-forward guidance.
• The locations at which inventory is held by the entity may consist of one or more facilities. We refer to locations where we observe the entity’s count as a count location. We need to:
  • Understand the location of and method adopted by the entity for testing the existence of inventory at each location and for each type of inventory. For location selection, see "Selecting locations to visit" below.
  • Inquire whether there are inventories owned by the entity in the custody of others or inventories owned by others on the entity’s premises. See OAG Audit 7068.

Note: There is no minimum coverage amount mandated by CASs or OAG Audit and use of accept-reject testing or audit sampling is not required. The selection of locations requires the exercise of professional judgment, and we need to assess the risk profile of the locations not observed to determine whether we have done sufficient work in respect of remaining inventory balance.

• Whether the assistance of an auditor’s expert is needed or a management’s expert is used:
  • Consider whether specialist/expert help is necessary to determine quantities or test valuation of inventory due to the characteristics of the inventory or its storage. For example, a quarry may inventory a pile of stones that was excavated. The angle of repose and circumference of the pile needs to be measured to calculate the volume, which then needs to be used with a conversion factor to determine the weight of the entire pile. We would ordinarily consider using an expert to perform this for us. If an auditor’s external or management’s expert is used for this purpose document their work and perform audit procedures as appropriate. See OAG Audit 3090 for guidance on using auditor's experts.

Selecting locations to visit

An effective starting point for selecting locations is to obtain a listing of inventory balances by location and inventory category (i.e., raw materials, work-in- progress, finished goods, etc.) that is reconciled to the general ledger. The listing includes inventory at all locations, including entity-owned warehouses, inventory in the custody of third parties, inventory in-transit and any other inventory the entity owns. This information assists us in gaining an understanding of the inventory balances, including the total amount of inventory, where the inventory is located and the nature of the inventory at each location (e.g., raw materials, work-in-progress, finished goods). The nature of the entity’s counting procedures (i.e., periodic cycle counts or annual wall-to-wall counts) and the types of facilities where the inventory is stored (i.e., entity-owned or third party) are important information when planning the specific procedures we will perform at the locations.

We first consider monetary coverage when selecting locations. We generally begin by selecting those locations that are most significant so that we can accumulate audit evidence to reduce the risk of misstatement in the untested balance. Next, we select those locations that have a higher risk of material misstatement. Factors to consider when evaluating the risk of material misstatement include the following:

• Risk assessment procedures performed to date
• Design and operating effectiveness of controls (where applicable)
• Significance/volatility of book to physical adjustments
• Significance/volatility of inventory loss/shrink (including fraud)
• Susceptibility of inventory to deterioration or obsolescence
• Experience level and knowledge of the individuals performing the counts
• History of misstatements resulting from counting errors
• Nature of inventory (e.g., hard-to-count, unusual measurement techniques)

As noted earlier in this topic, for an entity or component that has a large number of similarly sized locations, we apply professional judgment, and in applying this judgment, we may analogize to accept-reject sample sizes to determine the number of locations to visit. When determining the number of locations to visit in this situation, we consider not only the number of similarly sized locations but also the similarity or commonality among locations by considering factors such as:

• Underlying inventory systems
• Counting processes (i.e., cycle count vs wall-to-wall)
• Nature of inventory
• Type of location (e.g., manufacturing facility vs. sales facility vs. distribution center)

We would typically identify fewer locations when there is more commonality among the locations. For example, assume that 50% of an entity’s inventory is located in three distribution centers subject to annual counts at period-end and the remaining 50% of the inventory is located across 110 sales facilities subject to periodic cycle counts. The sales facilities hold similar inventory for sale to customers, use the same inventory management system and utilize the same cycle count program which is monitored centrally. In this situation, we may plan to observe inventory at the three distribution centers (which provide monetary coverage) as well as 10 of the sales facilities, assuming a low level of desired evidence based on the accept-reject sample size table in OAG Audit 7043.1.

Our conclusion of whether we have done enough is impacted by the risk profile of the locations not selected for testing. In making this determination, we consider various factors, including:

• Risk assessment analytics performed over the locations not subject to testing.
• Other risk assessment procedures performed over locations not subject to testing (e.g., reviewing the results of internal audit’s work for testing inventory existence or reviewing the results of management’s counts, including counts performed by a third party count service).
• Entity level or transactional controls in place to monitor inventory levels or count procedures across the locations not subject to testing.
• Consistency of counting procedures among the untested locations as compared to the locations selected for testing.
• Nature of the inventory financial statement line item—the greater the risk associated with the inventory for that entity, the more evidence is needed related to that financial statement line item.
• Multiples of performance materiality represented by the untested balance—the greater the multiples, the greater pressure on the judgment of sufficiency of evidence.
• Composition of untested balance—the greater the concentration of the untested balance, including the number of locations not observed with balances greater than performance materiality, the greater the pressure on the judgment of sufficiency of evidence.

The following chart summarizes the relevant considerations noted above:

OAG Guidance

Due to the real-time nature of our physical inventory observation, understand, in advance of the start of the physical inventory, the nature of the inventory to be observed as well as the entity’s count procedures and controls. Consider the nature and extent of the audit procedures to perform in all key areas, e.g., number of test counts and how they will be spread across different types of inventory, testing the entity’s tag or count sheet control, the entity’s identification of obsolete inventory, how to handle difficult to count inventory, how to deal with count differences, what entity documentation to retain (e.g., we ordinarily maintain a copy of the tag or count sheet control listing and may retain copies of some or all inventory tags or count sheets, whether prepared manually or system generated), and when to call a more experienced person on the engagement team. The Physical Inventory Observation Checklist template is available to facilitate documentation of our observation.

Understand what to communicate within the team, whether they are on or off site, about those issues that might arise in the course of the observation. Issues may require immediate resolution with the engagement leader and/or team manager. For example, we generally discuss in advance what level of differences in test counts in different areas might not be considered significant vs. requiring recounting by the entity. As issues may arise during the inventory observation that require immediate resolution with the engagement leader and/or team manager, consider if appropriate plans have been made to communicate and resolve issues that may arise during the physical observation procedures with appropriate engagement team members.

Documentation of the resolution of such issues needs to be completed during the inventory observation or as soon thereafter as possible.

OAG Guidance

Proper documentation of work performed during our observation of the physical inventory is essential. For example, documented details of the last serial numbers of goods received and shipped and records of movements during the physical inventory counting may be used to subsequently test cut-off. After the inventory counting, follow up on the matters recorded in our workpapers at the time of the count, including apparent instances of obsolete or deteriorating inventory.

When the entity operates a perpetual inventory system which is used to determine the period end balance, evaluate, through the performance of additional procedures, whether the reasons for any significant differences between the physical count and the perpetual inventory records are understood and the records are properly adjusted.

The Physical Inventory Observation Checklist template is available to facilitate documentation of our observation.