4.9 Substantive Procedures for Inventory & Cost of Sales
Key Takeaways
- Where inventory is material, the auditor attends the physical count to observe management's procedures, perform test counts in both directions and note the condition of the goods.
- Test counting from the count sheet to the floor tests existence; test counting from the floor to the count sheet tests completeness.
- Inventory is measured at the lower of cost and net realisable value, so the auditor tests both the build-up of cost and the evidence that goods can be sold above that cost.
- Net realisable value falls below cost through falling selling prices, physical deterioration and obsolescence, each of which is evidenced differently.
- Cut-off for inventory is tested using the last goods received notes and goods dispatch notes before the year end, ensuring purchases, sales and inventory are recorded in the same period.
Substantive Procedures for Inventory & Cost of Sales
Inventory is examined heavily because it sits on both the statement of financial position and, through cost of sales, the income statement — an error in inventory misstates both profit and net assets by the same amount. It also involves a physical asset, which means the auditor must attend a count.
1. Attendance at the physical inventory count
Where inventory is material to the financial statements, the auditor attends the count unless attendance is impracticable. The work divides into three stages.
Before the count
- Obtain and review management's count instructions: are they clear, do they cover zoning of the warehouse, identification of damaged and third-party goods, control of movements during the count, and use of pre-numbered count sheets or tags?
- Assess the effectiveness of the instructions; deficiencies noted here become management letter points.
- Plan which locations to attend where there are several, and decide the sample of items to test count, including high-value lines.
- Review the prior year's count for problems.
During the count
| Procedure | Purpose |
|---|---|
| Observe whether count teams follow the instructions | Evaluates the reliability of the count as a whole |
| Test count from count sheet to physical goods | Tests existence — that recorded items are really there |
| Test count from physical goods to count sheet | Tests completeness — that everything present has been recorded |
| Note the condition of goods: damaged, rusted, dusty, water-marked, unlabelled | Feeds the net realisable value and obsolescence assessment |
| Record details of the last GRNs and GDNs before the count | Provides the basis for cut-off testing |
| Confirm movements are frozen, or that any movements are separately recorded | Prevents double counting or omission |
| Identify goods held for third parties and goods held at third parties | Tests rights and obligations |
| Retain copies of, or details from, the count sheets | Allows later agreement to the final inventory listing |
The two-directional test count is a standard examination point. One direction alone tests only one assertion.
After the count
- Agree the test counts recorded on the day to the final inventory listing.
- Agree the sequence of count sheets or tags used, investigating any missing.
- Test the arithmetic of the final listing and agree the total to the general ledger and financial statements.
- Follow up on all items noted as damaged or slow-moving.
2. Valuation: the lower of cost and net realisable value
Inventory is measured at the lower of cost and net realisable value (NRV), compared line by line rather than in total.
Testing cost
| Inventory type | Evidence of cost |
|---|---|
| Raw materials and bought-in goods | Recent purchase invoices, agreeing to the costing method applied (FIFO or weighted average) |
| Work in progress and finished goods | Test the build-up: material usage records, labour rates and hours, and the basis for absorbing production overheads |
| Overhead absorption | Confirm only production overheads are absorbed, on the basis of normal capacity; selling and general administrative costs must be excluded |
A frequent misstatement is absorbing administrative or selling costs into inventory, or absorbing fixed overheads over actual rather than normal production levels in a period of low output.
Testing net realisable value
NRV is the estimated selling price less the estimated costs of completion and the estimated costs necessary to make the sale. It falls below cost for three reasons the syllabus expects candidates to name:
- A fall in selling price — evidenced by after-date sales invoices below carrying value, price lists, and buyer correspondence.
- Physical deterioration — evidenced by count observations, damage reports and insurance claims.
- Obsolescence — evidenced by aged inventory analysis, slow-moving reports, discontinued product lists and superseded specifications.
The strongest NRV procedure is comparing carrying value to actual selling prices achieved after the year end, item by item for the lines that matter.
3. Other assertions
| Assertion | Procedures |
|---|---|
| Rights and obligations | Confirm goods held on consignment or on sale-or-return are excluded; obtain confirmation from third parties holding the entity's inventory; inspect agreements for retention of title clauses |
| Completeness | Reconcile the final listing to the perpetual records and investigate differences; include goods in transit where the entity bears the risk |
| Cut-off | Using the last GRN and GDN numbers recorded at the count, verify that goods received before the year end are in both inventory and payables, and that goods dispatched before the year end are excluded from inventory and included in revenue |
| Presentation | Check the disclosure of the accounting policy, the classification between raw materials, work in progress and finished goods, and any write-down recognised |
4. Continuous (perpetual) counting
Some entities count continuously through the year instead of holding a single year-end count. This is acceptable where:
- the perpetual records are well maintained and updated promptly;
- every line is counted at least once a year, and high-value or high-risk lines more often;
- differences between counts and records are investigated, corrected and, importantly, the causes are addressed; and
- the auditor attends at least one of the counts during the year and tests the reconciliation from the count date to the year end.
5. Worked application
A pharmaceutical distributor holds inventory of BDT 240 million. The auditor's count attendance notes three pallets in a corner with 2024 expiry dates and dust on the shrink-wrap.
The response: obtain the aged inventory analysis and identify all lines with expiry dates within twelve months; check whether the client's provisioning policy captures them; obtain after-date sales invoices for those lines to establish actual realisable value; inspect any destruction certificates; recalculate the write-down required; and, because expired pharmaceutical stock also carries regulatory consequences, consider whether the matter indicates a wider compliance issue requiring escalation.
During an inventory count an auditor selects items physically present on the warehouse floor and traces them to the client's count sheets. Which assertion does this direction of test counting address?
A manufacturer absorbs its selling and distribution costs into the cost of finished goods inventory. What is the effect and the correct treatment?
Which procedure provides the most persuasive evidence that inventory is correctly stated at the lower of cost and net realisable value?