7064 Cycle counts

Jun-2021

OAG Guidance

Testing cycle counts of physical inventory is ordinarily considered a test of controls, as the focus is on testing the entity’s controls throughout the year over inventory when we intend to rely on such controls. While designed as a test of controls, we also obtain substantive evidence from our attendance at the inventory counts. We begin by evaluating if the entity’s program is designed for operational purposes or for financial reporting purposes. Some entities have implemented cycle count programs to validate quantities for operational purposes, which may not be designed to support the quantities reflected in the period-end financial statements. For example, operational cycle counts (a) may not be designed with an appropriate frequency to conclude accounting records are accurate and timely adjusted, (b) may not subject all inventory to counting or (c) may not result in any adjustments to the quantities in the perpetual inventory records. Effective cycle counting depends on effective controls related to inventory quantities and timely recording throughout the production process.

In conjunction with testing cycle count controls, understand and evaluate controls over perpetual inventory quantity activity by understanding controls and evaluating whether they are implemented and by obtaining audit evidence of operating effectiveness as appropriate.

When understanding the overall process of the entity, we need to consider the following areas:

• Cycle count process of the entity.

• Gain an understanding of the entity’s cycle count procedures by reviewing appropriate manuals, inquiring of entity personnel and reviewing prior years’ workpapers to understand:

  • Whether all locations (the entity’s own locations and/or third party warehouses) and types of inventory (e.g., raw material, work in progress, finished goods) subject to cycle counting procedures are included.

  • The determination of items to be counted once or more times a year (manually determined or system-based).

  • The frequency of cycle counts (see additional considerations below).

  • How the entity resolves counting differences (are these followed up, recounted, corrected in the inventory records).

• Evaluate the design of the cycle count process:

  • Does the process operate throughout the year?

  • Is the process appropriately designed as to completeness such that all inventory items are selected for counting at least once a year?

  • Does management monitor the cycle counting process including the frequency and magnitude of differences identified, evaluation of the reasons for differences (i.e. systematic or isolated) and appropriate approval of adjustments to the inventory records and the general ledger?

  • Consider the design of the cycle count process and the organization and execution of the cycle count procedure and, if implemented, test operating effectiveness of the controls over the cycle count process.

  • Organization and carrying out of the cycle count procedures.

• Obtain the current year log (or equivalent report generated by the system) of cycle counts completed and planned that describes

  • date(s) of counts;

  • location(s) of counts

  • description (e.g., part numbers) of items;

  • by reference to the log, select counts that have been completed and determine that they were performed as scheduled and the results communicated to the accounting / finance department and resulting adjustments to perpetual inventory records and general ledger were posted.

• Select the date(s) and location(s) to observe entity cycle counting procedures to test the operating effectiveness of the cycle count control. When inventory is situated in several locations, consider at which locations attendance is appropriate, taking into account the materiality of the inventory and the assessment of risk of material misstatement at different locations. If an auditor’s expert is used to verify quantities or to identify the nature and condition of the inventory, document the work of the expert in the audit file.

• Determine that the written cycle counting instructions are adequate and clear and have been reviewed and approved by appropriate management personnel.

• Determine that cycle count teams are familiar with the entity’s cycle counting procedures.

• Determine number of locations and types of inventory (e.g., raw materials, work in progress, finished goods) subject to cycle counting procedures.

• Check that established procedures are adequate to control the use of inventory tags or count sheets by the cycle count teams (e.g., by using pre-numbered tags or count sheets and accounting for all such tags or count sheets, including used, unused, and voided) and consider the segregation of duties between persons responsible for tag or count sheet control, counting inventory, and inputting completed inventory tags or count sheets to inventory records.

• Consider the impact of IT on the completeness and accuracy of the cycle count program and related reports.

OAG Guidance

Generally, an entity uses cycle count procedures in order to have all inventory items counted at least once a year and some items counted more frequently. These procedures may be performed by the entity with one or several cycle-count teams and it may be performed on a daily basis or with some other frequency.

Our tests of the entity’s cycle count procedures are tests of a manual control. Apply the guidance set out in OAG Audit 6053 in determining the number of cycle counts to test. For example, if the entity conducted cycle counts at its single location on a daily basis, the number of daily cycle counts to test would generally be either 10 or 20 (days) for moderate or high assurance. We do not have to attend the cycle counts for all days selected, but may vary the nature of our testing between observation/reperformance (i.e., attending a few counts) and examination/inspection of entity documentation relating to the cycle counts. The number of days to attend the cycle counts is a matter of professional judgment; however, do not rely solely on examination / inspection of entity documentation for all cycle counts. In order to obtain sufficient audit evidence in the situation where an entity has inventory in only a few locations, we generally attend a few counts at each count location. However, the more locations an entity has, and thus the more count locations we observe, the fewer days we would generally need to observe at each location because we are accumulating sufficient audit evidence. The number of cycle counts we observe in the aggregate is considered in determining whether we have met the objective set forth in the CASs. For example, if there are only two locations and we observe both locations, we may conclude that observing more than three counts in total is reasonable and observe 3-5 days. In contrast, if we observe at 50 locations, we obtain more cumulative audit evidence, and we exercise our professional judgment as to how many counts in total to observe.

Once we determine how many days we are going to observe and inspect in total, we then select which days to observe and which days to inspect. We obtain evidence to demonstrate the effectiveness of the control throughout the period under audit. As a result, we do not obtain all of our inspection or observation evidence from one period during the year but instead obtain evidence throughout the year. Because observation/reperformance provides a higher level of evidence, we need to plan to observe/reperform at least one cycle count close to the year end.

The number of test counts to be conducted at each cycle count observed is a matter of judgment. We would generally expect small populations for cycle counts. Although the number of items counted at each cycle count is likely to be less than 200 items (especially when the cycle counts are performed daily), the number of items counted can be higher if cycle counting is performed weekly or monthly. For the number of test counts follow the guidance in OAG Audit 7063. The determined approach and number of items to count per cycle count and for the total of all count procedures needs to be sufficient to determine the accuracy of the entity’s cycle count process. Consider whether the items subjected to cycle counting at the selected location are representative of all inventory items at that location. If some types of inventory are not subject to the cycle count such as items with specific risk characteristics, determine whether additional visits to that location may be necessary.

During test counts, consider the following:

• Select and recount some of the entity’s cycle counts (“tag to floor”). Testing from “tag to floor” provides audit evidence regarding the entity’s assertions of existence of the inventory and accuracy of the counts.

• Selecting and counting inventory items by performing independent counts and comparing them to the entity’s cycle counts (“floor to tag”) is generally not necessary for cycle counts, because our completeness testing procedures would be different from those applied on a year-end observation (as explained below).

• Select and test recounts and review variances posted to the perpetual inventory records.

For count differences identified, see ‘Evaluating count differences during a physical inventory observation’ block in OAG Audit 7063.

Design procedures over the completeness assertion by understanding and testing how management determines that all inventory on hand is both included in the perpetual inventory system and subject to the cycle inventory counts each year. Note that we would ordinarily perform completeness procedures that are different from those applied on a year-end observation. For cycle counting we need to consider factors such as timing of cycle counts, cycle counts system changes (if any), assessed risk of material misstatement, effectiveness of related controls, consistency of inventory types. We would also need to obtain evidence that

• the cycle count program is appropriately designed and operating effectively as to completeness such that all inventory items are selected for counting one or more times a year depending on the frequency deemed appropriate (e.g., by testing related automated controls and/or considering effectiveness of ITGCs); and

• the perpetual inventory system, which provides the underlying data used in the entity’s cycle count process, is reliable as to completeness (e.g., by selecting on an accept reject basis, inventory or stock keeping units (SKUs) item number from the floor and tracing the SKU item number (not quantity) to the perpetual inventory listing to see that the selected inventory items or SKUs are included in the perpetual). Consider the need to perform these procedures at each observation based on the factors above.

Cycle Counts Not Observed

For those cycle counts that we do not observe, we consider materiality and the level of inherent risk of error to determine procedures we will perform to assess the effectiveness of the entity’s cycle counting process.  These procedures may include inspection of documentation prepared as part of the entity’s cycle counting procedures. When we inspect entity documentation, we obtain evidence to conclude whether the entity performed the cycle counts and provided the results for review by a responsible official on a timely basis. To identify the population for selecting our sample, we may obtain the current period log of cycle counts completed and planned at the selected count location. This log may include dates of counts, locations of counts and/or description (e.g., part numbers) of items counted. Using this log, we select counts that have been completed and perform the following procedures:

• Obtain support from management to determine that the selected counts were performed as scheduled (i.e., test count workpapers that demonstrate what items were counted and the results of those counts, including any differences noted and approval/resolution of differences with supporting documentation).

• Determine whether the entity has compared the results of the selected cycle counts with the perpetual inventory records and whether the results were communicated to the accounting/finance department and whether the results were accurately summarized in information used by management to monitor the results and effectiveness of its cycle counting process.

• Where the cycle counts identify variances, determine that the entity has investigated and resolved them on a timely basis.

• Verify that management has approved any adjustments and recorded them in the perpetual inventory listing. We may set our sample size for tracing adjustments into the perpetual inventory records using the tables in OAG Audit 7043.1. However, we use judgment in making our selection, and it may be appropriate to test all adjustments in the case of only a few adjustments. We also evaluate the implications of significant adjustments.