7069.2 Inventory Cut-Off Testing

Jun-2020

OAG Guidance

This subsection provides guidance on testing the cut-off of inventory at period end and organizes the related procedures that we may perform into the following steps:

• Obtain an understanding of purchase and sales arrangements and related contract terms;

• Obtain an understanding of the entity’s process, data and systems used to track and record inventory transactions in the correct period; and

• Plan and perform tests over inventory receiving and shipping cut-off.

This subsection does not address our procedures regarding cut-off of inventory at a location for purposes of inventory count procedures. For that guidance refer to OAG Audit 7063.

OAG Guidance

To identify risks of material misstatement and develop an appropriate audit approach, we obtain an understanding of the various purchase and sales arrangements and the related contract terms. An entity may enter into several types of purchase and sales arrangements with vendors and customers, each of which dictates when ownership changes or control over the inventory transfers between the parties to the arrangement. Understanding the terms of these arrangements enables an accurate determination of when an entity is the owner or has control of the inventory.

Under inventory consignment arrangements for goods for sale, the entity physically transfers inventory into the custody of a third party, but maintains control until the goods are sold or used by the third party. An entity may also be the consignee in such an arrangement, in which case the entity has physical possession of a third party’s inventory, but legal ownership or control does not transfer to the entity until the inventory is sold or used by the entity.

Third party logistics providers provide services to companies such as pick and pack, warehousing, freight consolidation, import broker and distribution. We understand these types of arrangements to determine the completeness of inventory controlled by the entity in the possession of third parties as of period end.

Drop shipping arrangements

A drop shipping arrangement is a supply chain management technique in which an entity does not keep goods in stock, but instead transfers customer orders and shipment details to either the manufacturer, another retailer, or a wholesaler, who then ships the goods directly to the customer. In a drop shipping arrangement, goods are not physically received by the selling entity prior to revenue being recognized for the sale of the goods. The terms of the arrangements with the supplier and end customer determine control of the inventory as of period end. Drop shipping arrangements also create unique cut‑off considerations as an entity may record the sale of inventory when it receives an invoice from the supplier indicating the inventory item has been shipped to the customer but there is often a lag between the time when the criteria for revenue recognition have been met and when the entity receives the invoice/ notification of the shipment from the supplier. To account for this lag, management may obtain information directly from the supplier to understand the status of all outstanding orders or they may estimate the amount of sales to record based on the average historical lag time between delivery to the customer and receipt of the invoice from the supplier. There are also cut-off considerations when the entity we are auditing is acting as the manufacturer, retailer or wholesaler who drop ships the goods directly to the customer at the direction of another entity.

OAG Guidance

To identify risks of material misstatement and develop an appropriate audit approach, we obtain an understanding of the entity’s process and related controls for determining inventory transactions are recorded in the correct period. When obtaining an understanding of the various points within the end-to-end process where the cut-off of inventory transactions is relevant, we consider the following:

• The entity’s process for reviewing new or modified contractual arrangements for accounting implications

• The entity’s process for reconciling inventory reports (i.e., the subledger) to the general ledger

• The entity’s process for recording inventory transactions at the point in the process when there is a change in the owner of the inventory for each type of inventory (e.g., inventory held on entity premises, inventory held by a third party (including inventory in-transit), inventory on consignment, inventory held by a third party warehouse provider)

• The entity’s process for developing estimates as of period end to record inventory transactions in the correct period

We understand management’s process for recording inventory receipts. We understand whether receiving documents are generated using unique sequential numbers for all locations or whether receiving numbers are not sequential across multiple docks and/or warehouses where inventory is received. Controls over sequential numbering is a consideration when determining the testing approach (e.g., accept-reject versus targeted testing). Testing the accuracy of the inventory receipt date may be coordinated with our testing of inventory purchases in which we agree the dates in the purchases journal to supporting evidence (e.g., receiving document) to provide evidence over the accuracy of the receipt dates within the system.

We understand management’s process for recording the relief of inventory upon sale to a customer based on shipping terms and relevant terms of the arrangement. For example, management may recognize revenue on all sales at the time of shipment, then either:

• Perform an analysis as of period end to identify those sales with FOB destination point terms and reverse the revenue (and re-recognize the inventory) for these items on a specific-identification basis, or

• Perform an analysis at period end to estimate the average delivery time for sales with FOB destination point terms and reverse the revenue (and re-establish the inventory cost) for shipments made within the average delivery period immediately prior to period end.

Similar to inventory receipts, we also understand whether shipping documents are generated using unique sequential numbers for all locations. If each facility has unique sequential numbering, then we test the completeness and accuracy of the listing of inventory shipments for each facility, even if we consider the shipping documents from different facilities to be one testing population.

We understand how management tracks and records inventory in-transit to the entity for which the entity takes ownership before it is received. For example, management may obtain a detailed listing of inventory in-transit from significant suppliers or management may estimate the amount of inventory in-transit based on purchase orders and estimated delivery dates received from the vendor.

For consignment inventory, we understand management’s process for obtaining usage reports from customers holding inventory on their premises. For example, management may request final usage reports within a certain number of days after period end or management may estimate the usage in the current period by considering usage in the immediately preceding period or usage levels in the same period in the prior year (in the case of seasonality).

We understand management’s process for tracking and recording inventory held in third party warehouses. For example, management may perform periodic counts of the inventory themselves or require the third party to perform periodic counts of the inventory and provide management with the results of those counts so they can be reconciled to the entity’s perpetual inventory listing.

In cases where management develops an estimate to record inventory transactions in the correct period, we understand the data, model and assumptions used by management to develop the estimate. We also understand the source of the data, whether it is a report received from a third party or a report sourced from the entity’s system for which we need to test the completeness and accuracy.

After we obtain an understanding of management’s process and controls for recording inventory transactions in the correct period, we design substantive procedures to test inventory cut-off.

OAG Guidance

We design our test of inventory cut-off taking into consideration:

• The terms of the arrangements;

• The point in the process when the entity becomes the owner of the inventory (for purchases) or when the entity’s customer becomes the owner of the inventory (for sales); and

• The related “at-risk” period where there is a risk of material misstatement due to improper cut-off.

Substantive analytical procedures are typically not performed when testing inventory cut-off given the absence of data having a plausible and predictable relationship to the inventory balance sheet account. Therefore, substantive tests of details will generally be the most effective and efficient way to test for proper inventory cut-off.

In some instances, sufficient monetary coverage may be achieved by targeting high value items within the period determined appropriate for testing (i.e., the “at risk” period). Additionally, for entities where we have tested the controls over sequential numbering of invoicing and shipping documents and determined they operate effectively we may be able to conclude that the risk of cut-off error is in the last or first shipments of the period, and therefore risk-based targeted testing may be appropriate (e.g., testing the last 10 shipments prior to period end and the first 10 shipments in the period after period end). In assessing controls over sequential numbering of invoicing and shipping documents, we consider whether sequentially numbered shipping documents could represent shipments for which a shipping number is generated but the item(s) has not actually shipped. However, given the nature of inventory purchases and sales (e.g., high volume of relatively similar transactions), targeted testing may not be an efficient approach. In these situations, since it is not appropriate to extrapolate errors across a population when testing an attribute (e.g., cut-off), non-statistical sampling is typically not appropriate for testing cut-off. Given the nature of the test (i.e., testing an attribute or characteristic versus an account balance), accept-reject testing is typically applied when performing substantive tests of details over inventory cut‑off.

We may test inventory purchases in other areas of the audit (e.g., inventory cost testing, testing purchases in the intervening period when inventory counts are performed at a date other than period end). We may develop a holistic testing strategy (i.e., design procedures to achieve several test objectives at the same time) rather than perform separate tests and make separate selections for each test. A holistic approach may be more efficient, as a selection of purchases made for other audit tests may be leveraged for testing inventory receiving cut-off (or vice versa). For example, in a situation where we observe an inventory count two weeks prior to period end, we may design our tests over purchases in the intervening period (i.e., roll-forward procedures) to obtain evidence of when ownership of the inventory transferred to the entity we are auditing.

Similarly, in a situation where our population for testing the cost of purchased materials is purchases during the last month of the year (i.e., the turnover period), we may design our test to obtain evidence of when ownership or control of the inventory transferred to the entity we are auditing. We consider the collective evidence obtained from these other audit procedures and the at-risk period for cut-off in determining the extent of additional procedures necessary to test inventory receiving cut-off.

Our inventory shipping cut-off testing is typically performed in conjunction with sales/accounts receivable cut-off testing. When we use this approach, we verify the inventory release is incorporated into the testing either by testing each transaction’s release from inventory, or more commonly, testing that the system automatically releases inventory upon the recording of a sale. Further, in order to design an effective and efficient cut-off test, we obtain a thorough understanding of contract terms with customers so we first understand when control transfers from the entity to their customer.

We may identify revenue cut-off as a significant risk of fraud and therefore need to perform substantive tests of details. The designation of revenue cut-off as a significant risk does NOT always require inventory shipping cut-off to also be considered a significant risk. Therefore, the nature and extent of audit work necessary may differ between the test for revenue cut-off and the test for inventory shipping cut-off.

OAG Guidance

We define a period before and after period end for which each class of inventory receipts and shipments may be subject to testing for proper inclusion/exclusion from the inventory balance. The period selected, referred to as the “at-risk” period, is a matter of professional judgment, and we document our judgment in determining the appropriate period of time to consider as the population for cut-off tests. Factors to consider include, but are not limited to:

• Details surrounding the terms of vendor and customer arrangements, including shipping terms, shipping method (e.g., barge, truck, rail), logistical information (e.g., proximity of the supplier base to the entity’s premises) and average transit times.

• The volume of activity in the last few days before period end and the first few days after period end, including how long it takes for trucks to leave the docks after being loaded.

• Whether there are any days surrounding period end where goods were not received or shipped.

• How receipts and shipments are processed - are they scanned when received/loaded on the truck or is there a manual input of documents?

• Whether the controls surrounding the automated sequencing of receiving or shipping documents are designed and operating effectively surrounding period end.

• History of cut-off exceptions.

The at-risk period for shipping cut-off does not have to be the same as the at-risk period for receiving cut-off. In fact, the at‑risk periods will often be different given differences in the factors to consider as outlined above.

OAG Guidance

As explained in OAG Audit 7011, ordinarily we need to design and perform one or more substantive procedures for each relevant assertion for all material classes of transactions, account balances and disclosures, regardless of our expected level of controls reliance. In the majority of our audits, cut-off is considered a relevant assertion, and thus, some level of substantive testing is performed. Note: This topic assumes control transfers upon shipment for inventory sold. If control transfers at a different point in time or over time, we would need to tailor our audit procedures accordingly.

We determine the population(s) subject to our cut-off testing by taking into account the risk of material misstatement for each type of inventory. If total inventory receipts or total inventory shipments for a type of inventory during the at-risk period is less than performance materiality, the risk of misstatement due to cut-off errors associated with these transactions would not present a risk of material misstatement. In this case, after verifying the appropriateness of the at-risk period, testing the completeness and accuracy of the listing of inventory receipts/shipments during the at-risk period and performing risk assessment procedures to identify any significant or unusual receipts or shipments, we may be able to determine there is no risk of material misstatement and no additional substantive cut-off testing procedures are necessary.

We define at least four separate populations for testing:

• Inventory receipts before period end;
• Inventory shipments before period end;
• Inventory receipts after period end; and
• Inventory shipments after period end.

Combining the before period end population and the after period end population into a single population is not appropriate as the objectives of the tests differ. The before period end population tests for proper cut-off of transactions recorded (e.g., recorded inventory is properly included in the current period), and therefore, addresses the assertions of existence and cut‑off. The after period end population tests the completeness of the transactions that should have been recorded in the current year (e.g., inventory that should have been recorded in the current period was recorded in the current period and not the subsequent period), and therefore, addresses the completeness and cut-off assertions.

To illustrate this approach, assume each population has greater than 200 items. Using accept-reject testing, a desired moderate level of assurance and tolerating no exceptions, we would select:

• 30 transactions from the detailed listing of receipts before period end;
• 30 transactions from the detailed listing of shipments before period end;
• 30 transactions from the detailed listing of receipts after period end; and
• 30 transactions from the detailed listing of shipments after period end.

The sample size of 30 in this example is in accordance with accept-reject testing guidelines for testing populations over 200 in OAG Audit 7043.1.

We also consider the appropriate level of disaggregation of the population based on the nature and source of the inventory and similarities in the processes, systems and controls used to record and track inventory in the correct period. For example, we may identify the arrangements for inventory purchased for resale and raw materials purchased for use in production are two separate populations if the entity’s processes and controls for recording and tracking these types of inventory differ. Similarly, we may test shipping cut-off for consignment sales separately from non-consignment sales due to the distinct cut-off risks associated with each arrangement and the different processes used for recording sales under each of these types of sales arrangements.

We also evaluate whether items received into/shipped from different facilities can be treated as one population. If processes, systems or controls differ across facilities, the facilities are likely not sufficiently homogeneous to permit testing as one population. Conversely, if processes and systems are the same across facilities, including common oversight to monitor the consistent operation of the processes across all facilities (e.g., all facilities report to a common supply change manager who has direct oversight over receiving activity, management performs a periodic review to monitor the consistent application of policies and procedures), it may be appropriate to treat the facilities as one testing population. In this case we perform one test of transactions before period end across all facilities and one test of transactions after period end across all facilities, separately for both inventory receipts and inventory shipments. If we treat multiple facilities as one population, we document the factors contributing to this conclusion in the audit file. When assessing the homogeneity of a substantive testing population, we consider whether the nature of the underlying transactions and their corresponding accounting models suggest the population is homogeneous and whether an identified error is indicative of potential errors across all transactions in the population.

If each facility has unique sequential numbering, then we test the completeness and accuracy of the listing of inventory receipts (or shipments) for each facility, even if we consider appropriate to treat receipts (or shipments) from different facilities as one testing.

We typically align the populations for testing inventory shipping cut-off with the populations used in our revenue testing approach.

OAG Guidance

Once the appropriate at-risk period for each population is defined and documented, we identify this as the relevant population for testing and obtain a detailed listing of inventory receipts and shipments during this period before and subsequent to period end. For example, when testing inventory receipts, if we determine based on consideration of average transit times and supplier shipping terms that the risk of improper cut-off before and after period end is concentrated in a 2 week period, then we obtain a listing of all inventory receipts in the last 2 weeks of the year and a separate listing of inventory receipts in the first 2 weeks of the subsequent year. We test the completeness and accuracy of the listings used to make our selections for testing. Refer to OAG Audit 4028.4 for considerations when testing the completeness and accuracy of relevant reports.

For each transaction selected for testing, we obtain receiving/shipping documents (e.g., bills of lading) as well as other necessary documentation to understand the shipping terms applicable to the particular transaction (e.g., invoice, consignment agreement or other contractual support). We examine the underlying supporting documentation for the ship date (FOB shipping point) or receipt date (FOB destination) to determine whether the inventory was added to or relieved from the inventory records in the appropriate period.

OAG Guidance

Entities often agree to varying shipping terms among customers. In some cases, they may record all sales upon shipment and then record an adjustment at period end to reverse the sales transactions where the product did not arrive at the customer’s location and control transfer for revenue recognition was not met until the following period. The adjustment also establishes the inventory and credits the related cost of goods sold. Depending on the volume of transactions and the entity’s accounting systems and processes, the entity may record this adjustment based on specific identification of transactions, or the entity may develop an estimate of the sales transactions to be reversed at period end. The entity’s process for developing the estimate typically includes identification of the population of transactions where control of the inventory transfers upon delivery and development of assumptions such as estimated transit times and margins.

In the case where sales are recorded upon shipment and a separate adjustment is recorded at period end to reverse those specifically identified sales transactions where the product did not arrive at the customer’s location and the criteria for revenue recognition were not met until the following period, audit procedures include tests to address the accuracy and completeness of the adjustment. To test the accuracy of the adjustment, we perform substantive tests of details on the transactions included in the reserve balance to verify if the timing of control transfer and the timing of receipt by the customer supports deferral of the transaction to the following period. Completeness of the adjustment is tested by verifying those transactions, as identified in the traditional cut-off testing described in the section Examine Supporting Documentation above, are properly included in the adjustment.

Alternatively, if the entity records an adjustment for shipments where control of the inventory transfers upon delivery based on an estimate, in addition to performing the traditional cut-off testing described in the section Examine Supporting Documentation above, we perform procedures to determine the appropriateness of the model (including appropriate application of the relevant financial reporting framework), assess the reasonableness of the assumption(s), test the completeness and accuracy of the underlying data and test the proper calculation of the adjustment.

A significant assumption used in these types of estimated sales adjustments for inventory that has not yet been received by the customer as of period end is the average transit time, or average time it takes for goods to get from an entity’s facilities to the customers’ locations. The assumption is often developed by management using historical actual transit times of shipments. We may test this assumption by 1) concluding the model is reasonable as it is based on historical actual transit times and transit times for shipments around period end are in line with these historical actual transit times, 2) testing the underlying data used in the analysis by selecting a sample of shipments and agreeing the ship date and receipt date back to supporting evidence such as signed bills of lading and 3) recalculating the average transit time. When testing management’s assumption over average transit time, we consider whether management evaluates the reasonableness of the assumption on a periodic basis to account for changes in the business and/or shipping times and whether management performs the analysis at varying, appropriate levels of disaggregation. For example, if an entity ships some product from local warehouses to customers by truck and ships other products by barge, the average transit times for these two types of inventory may indicate a separate assumption of average transit time for each type of inventory. Alternatively, we may develop an independent assumption by taking an independent sample of shipments and obtaining evidence of the ship date and receipt date to calculate an independent average transit time to compare to the assumption calculated by management.

When we test management’s assumption of average transit time by developing an independent assumption, we may leverage the shipments already selected for testing cut-off during the at-risk period rather than selecting a new sample. For example, we use the evidence obtained for those shipments already selected during the at-risk period to determine the ship date and receipt date and calculate an independent average transit time to compare to the assumption calculated by management.

A second assumption used in these types of estimated sales adjustments is the gross margin on the sale. This assumption may be developed by management based on average historical margins or based on the specific identification of transactions subject to the adjustment. We design audit procedures to test the reasonableness of this assumption, including whether the assumption is appropriate for all types of transactions included in the adjustment. For example, if different products have significantly different margins, we evaluate whether management’s model for determining the adjustment uses different margin assumptions based on product type, taking into consideration materiality.

The underlying data used in the estimated sales adjustments is typically the sales data that has been subject to audit procedures; however, we evaluate whether relevant attributes of the data utilized in the estimate were tested in conjunction with revenue testing before deciding no additional work is necessary. For example, the shipping term is a relevant attribute of the underlying data used by management in developing its reserve for shipments where control of the inventory transfers upon delivery. An entity may filter the sales register to obtain the population of sales transactions with FOB destination shipping terms. We test management’s assertion that control transfers upon delivery for all sales with FOB destination shipping terms, as well as the accuracy of the filter. We also separately test the accuracy of the shipping term attribute within the sales register. This test can be performed in conjunction with our sales testing, as invoices or contracts can be examined to determine the shipping term denoted in the sales register is consistent with that agreed to with the customer. Alternatively, a separate accept-reject test can be performed to test the shipping term attribute for all relevant sales from the sales register.

OAG Guidance

Testing shipping cut-off where a third party is involved requires additional considerations. For example, in relation to consignment inventory, if control of the inventory transfers to the third party once the good is used by the consignee, an entity may record sales based upon usage reports received periodically from the consignee. There is often a lag between the time the usage report is received by the entity and when the consignee actually uses the inventory, at which point a sale is recognized and inventory is relieved as control of the inventory is transferred to the consignee/customer. We understand how management accounts for this lag at period end. We consider if management receives the final usage report within a short period of time after period end and records actual usage, or alternatively, if management estimates usage for the last week, month or quarter of the year. If the former, our testing may include obtaining the usage report received from the consignee after period end and agreeing it to the entry recorded to reflect the sale and related relief of inventory. However, if management estimates the usage, we test management’s estimate. We perform procedures to determine the appropriateness of the model (including appropriate application of the financial reporting framework), assess the reasonableness of the assumptions, test the completeness and accuracy of the underlying data and test the proper calculation of the adjustment.

Similarly, in a sell-through revenue recognition model where an entity delivers product to a distributor, the entity is the owner of the inventory until the distributor sells the inventory to the end customer. One of the considerations to be taken is the terms of sale between the distributor and end customer (e.g., FOB shipping point or FOB destination) to determine whether the entity is the owner or has the control of the inventory at period end. In this situation, there is often a lag between the time the delivery report from the distributor is received by the entity and the point at which the entity is no longer the owner or has no control of the inventory. We understand how management accounts for this lag at period end, similar to the discussion above.