Inventory in one of the most important and difficult verification problems with which the auditor is faced. It is commonly the single greatest current asset and is often the largest asset in the entire Balance Sheet. An error in inventory affects the net income directly.
Problems of various types are going to be faced in the verification of Inventory. Some such problems are as under:
a) Physical existence and ownership of Inventory;
b) The quantities included in making inventory extensions;
c) The prices used in making inventory extensions;
d) The arithmetical accuracy of extension, footings, forwarding, and final totals.
The most difficult problem is that of Pricing.
Essentials of Verification
1) To determine physical existence and to test quantities:
A) Be present when physical inventory is taken by company representative.
a) Observe existence of inventory;
b) Observe inventory taking procedure including the efficiency with which the members of the inventory crews perform their tasks.
c) Make and record test counts of inventory counts;
d) Inventory completeness of count by checking areas and divisions of inventory from tags or other evidence of count.
B) Trace test counts into inventory listings to discover whether quantities counted are properly listed;
C) Trace some of company’s inventory counts into inventory listing to discover whether counts are properly listed;
D) Account for all inventory tags or tickets;
E) Review purchases and sales cut-off and make tests to discover accuracy or inventory count with respect to shipments close to the balance sheet date.
2) To determine reasonableness of pricing:
A) Test specific prices used by the company by comparing them with recent invoice or quoted prices;
B) Review method of pricing with intention of determining a generally accepted pricing policy has been followed:
a) Determine and evaluate general pricing practice;
b) Review composition and application of burden rate;
c) Investigate balances of any standard cost variation accounts of the disposition thereof;
C) To determine the quality and grade as reasonable:
a) During observation of physical inventory, determine by observation and inquiry whether inventory is in merchantable condition;
b) Review detail inventory records for slow moving and obsolete items;
c) Refer to purchase invoices for major inventory items to determine whether that grade or quality is handled in the quantities indicated.
3) To discover the degree of clerical accuracy in the inventory complication:
a) Test inventory extensions and footings by re-computation;
b) Trace all page total and sub-total into summaries and into the final inventory amounts.
4. To review accuracy of inventory amount in general:
A) Obtain an inventory representation from company officers or employees:
a) Enquire as to any merchandise held on consignment held for others, or otherwise on hand but not the property of the Co under examination, and any property belonging to the Co but not available for count;
b) Inquire as to method of determining all quantities and prices used in compiling inventory total.
B) Apply gross profits test for its equivalent;
C) Review any production record available and relate beginning inventory, production sales, and ending inventory on a quantity basis, if possible.
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