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Inventory Audit Procedures

the auditors
will be conducting an audit of your inventory. Given the massive size of some

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they are comfortable that the valuation you have stated for the inventory asset is
reasonable.

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inventories, they may engage in quite a large number of inventory audit procedures before

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If your company records its inventory as an asset, and it undergoes an annual audit, then

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Here are some of the inventory audit procedures that they may follow:
Cutoff analysis. The auditors will examine your procedures for halting any further
receiving into the warehouse or shipments from it at the time of the physical inventory
count,
so that extraneous inventory items are excluded. They typically test the last few
receiving and shipping transactions prior to the physical count, as well as transactions
immediately following it, to see if you are properly accounting for them.
Observe the physical inventory count. The auditors want to be comfortable with the
procedures you use to count the inventory. This means that they will discuss the
counting procedure with you, observe counts as they are being done, test count some
of the inventory themselves and trace their counts to the amounts recorded by the

company's counters, and verify that all inventory count tags were accounted for. If you
have multiple inventory storage locations, they may test the inventory in those
locations where there are significant amounts of inventory. They may also ask for
confirmations of inventory from the custodian of any public warehouse where the
company is storing inventory.
Reconcile the inventory count to the general ledger. They will trace the valuation
compiled from the physical inventory count to the company's general ledger, to verify
that the counted balance was carried forward into the company's accounting records.
Test high-value items. If there are items in the inventory that are of unusually high
value, the auditors will likely spend extra time counting them in inventory, ensuring that
they are valued correctly, and tracing them into the valuation report that carries

forward into the inventory balance in the general ledger.

Test error-prone items. If the auditors have noticed an error trend in prior years for
specific inventory items, they will be more likely to test these items again.
Test inventory in transit. There is a risk that you have inventory in transit from one
storage location to another at the time of
the physical count. Auditors test for this by
reviewing your transfer documentation.
Test item costs. The auditors need to know where purchased costs in your accounting
records come from, so they will compare the amounts in recent supplier invoices to the
costs listed in your inventory valuation.
Review freight costs. You can either include freight costs in inventory or charge it to
expense in the period incurred, but you need to be consistent in your treatment - so the
auditors will trace a selection of freight invoices through your accounting system to see
how they are handled.
Test for lower of cost or market. The auditors must follow the lower of cost or market
rule, and will do so by comparing a selection of market prices to their recorded costs.

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Finished goods cost analysis. If a significant proportion of the inventory valuation is
comprised of finished goods, then the auditors will want to review the bill of materials
for a selection of finished goods items, and test them to see if they show an accurate
compilation of the components in the finished goods items, as well as correct costs.
Direct labor analysis. If direct labor
is included in the cost of inventory, then the auditors
will want to trace the labor charged during production on time cards or labor routings to
the cost of the inventory. They will also investigate whether the labor costs listed in the
valuation are supported by payroll
records.
Overhead analysis. If you apply overhead
costs to the inventory valuation, then the
auditors will verify that you are consistently using the same general ledger accounts as
the source for your overhead costs, whether overhead includes any abnormal costs
(which should be charged to expense as incurred), and test the validity and consistency
of the method you use to apply overhead costs to inventory.
Work-in-process testing. If you have a significant amount of work-in-process (WIP)
inventory, the auditors will test how you determine a percentage of completion for WIP
items.
Inventory allowances. The auditors will determine whether the amounts you have
recorded as allowances for obsolete inventory or scrap are adequate, based on your
procedures for doing so, historical patterns, "where used" reports, and reports of
inventory usage (as well as by physical observation during the physical count). If you
do not have such allowances, they may require you to create them.
Inventory ownership. The auditors will review purchase records to ensure that the
inventory in your warehouse is actually owned
by the company (as opposed to
customer-owned inventory or inventory on consignment from suppliers).
Inventory layers. If you are using a FIFO or LIFO inventory valuation system, the
auditors will test the inventory layers that you have recorded to verify that they are
valid.
If the company uses cycle counts
instead of a physical count, the auditors can still use the
procedures related to a physical count. They simply do so during one or more cycle counts,
and can do so at any time; there is no need to only observe a cycle count that occurs at the
end of the reporting period. Their tests may also evaluate the frequency of cycle counts, as
well as the quality of the investigations conducted by counters into any variances found.
The extent of the procedures employed will decline if inventory constitutes a relatively small
proportion of the assets listed on a company's balance sheet.
Related Topics
How do I ensure a proper inventory cutoff?
How do I improve inventory record accuracy?
How do I reconcile inventory?
Inventory internal controls
Types of inventory errors

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