Updated June 17, 2023
Definition of Inventory Audit
Inventory audit, as the name suggests, is the audit for the inventory in the organization. The audit procedure for inventory audit involves confirming or cross-checking the financial records of inventory with its physical count. The external auditors perform the inventory audit, or internal parties in the company, and the auditors apply different types of audit procedures while performing an inventory audit which we will discuss in detail.
Explanation
Inventories generally form a significant part of the total asset, especially in manufacturing companies. Inventories include manufactured goods available for sale in the normal course of the business, work-in-progress goods, supplies, and goods used in producing goods and services. Since inventory is important for every business, an inventory audit is also important. The process involves verifying whether the value of inventory appearing in the entity’s books is present with the entity or not.
There are some points that the company should keep in mind while performing inventory audits internally or getting them done through external auditors. These considerations include whether the company’s inventory is physically countable by hand, are the inventory stored in the company’s warehouse or third-party facility, and if the time is appropriate for conducting the audit. These points will help in deciding the audit procedure and its timing.
Purpose of Inventory Audit
The purpose of the inventory audit is to check and match the financial records of the inventories to their physical count. Financial records are maintained internally; therefore, there is a chance that they are incorrect due to error or omission, or maybe they are intentionally manipulated to serve personal benefits, which is considered fraud.
An inventory audit ensures that these mistakes are prevented and the audit is conducted properly to provide a true and fair view of the inventory status in the organization. An inventory audit does not only verify or cross-check the inventory count but also the quality or condition of the inventory, which is not included in its financial records.
Objectives of Inventory Audit
The objective of the inventory audits is as follows:
- Verifying Physical Existence: As mentioned in several instances, the main objective of the inventory audit is to verify the financial records with physical counts. While performing inventory audits, auditors oversee the inventory counting process and check whether they are efficiently done. They pick a sample of goods to check whether the physical counts match their financial records and vice-versa.
- Examining the Accuracy of The Process: An auditor uses a statistical sampling method to examine whether the inventory counting system is being done accurately.
- Ownership Rights: The objective of the inventory audit is also to determine whether the inventory recorded by the company is owned by it.
- Evaluation of Realizable Value: One of the objectives of the inventory audit is to check whether the inventories are recorded at the correct value in the general ledger. For damaged and low-quality condition goods, the auditor checks if they are recorded at realizable value.
Inventory Audit Procedures
Below listed are some most commonly used inventory audit procedures:
- ABC Analysis: In this process, inventories are grouped according to value and volume. That is, high-value, mid-value and low-value items are all grouped, stored, and tracked separately.
- Analytical Procedures: It involves an analysis of inventories through financial ratios like gross margin, days inventory remains in hand, inventory turnover ratio, etc.
- Cut-Off Analysis: In this process, inventory is examined by halting or pausing different operations, like after the receipt of the shipment, and physically counting the inventory simply to avoid mistakes.
- Cost of Finished Goods Analysis: If a major portion of the inventory comprises finished goods, the auditors will go for this method to check whether the bill of material depicts the correct components of the finished goods and whether they are valued correctly.
- Test High-Value Items: In this technique, auditors will focus more on high-value inventory items, whether they are correctly recorded and valued.
- Review Freight Costs: Auditors check whether freight cost treatment is consistent in the financial books of records, i.e. freight cost can either be included in the inventory cost or can be charged to the profit and loss account, but the treatment should be consistent.
- Overhead Analysis: If the company includes the overhead cost in the inventory cost, auditors will check which general ledger account is used for this and whether it is consistent. They will also actively identify abnormal costs that should be charged as expenses but included in the inventory cost.
Examples of Inventory Audit Procedures
ABC audit firm has been appointed to perform an inventory audit on XYZ Ltd, a manufacturing company that purchases raw materials and produces finished goods.
ABC audit firm will apply the following audit procedures to complete the audit:
- The matching of financial records with the physical count of the inventory items.
- Cut-off analysis to check whether the inventory count matches records at each operation level.
- They will check for the consistency of the treatment of freight charges.
They will employ other techniques, such as focusing on high-value items, error-prone items, conducting overhead analysis, etc., to actively check whether the inventory is correctly valued and fairly represented in the books of accounts.
Challenges of Inventory Audit
- An Inventory audit is a very time-consuming procedure.
- Inventory audits are difficult to scale; the bigger the volume of inventory it will require, the more strategic solution to perform the audit.
- An inventory audit can hinder or sometimes halt a particular part of the operation until the completion of the audit.
Importance of Inventory Audit
- Inventory audits help confirm the correct valuation of the inventory and, thus, the calculation of accurate profits.
- Inventory audits by confirming the correct status of the inventory in the organization help in budgeting and planning for the next steps.
- Inventory audits help find loopholes or inefficiencies that the company can work on in the future.
Advantages
- It helps in identifying slow-moving, damaged, and obsolete inventory items.
- It helps in the prevention of fraud and errors.
- It provides the correct status of the companies’ inventory.
- It helps in determining the correct value of the inventory.
- It helps reduce and eliminate gaps in the inventory management system.
Disadvantages
- It is a tedious and time-consuming task.
- It involves a lot of manual effort; therefore, there is a lot of scope for manual error or intentional manipulation.
- In a big organization, inventory audits occur frequently, leading to an increase in cost.
Conclusion
An inventory audit is an important process that includes different procedures per the company’s requirements. The process is tedious and requires a lot of manual effort. Still, it plays a pivotal role in determining the accuracy and efficiency of the inventory management system and other aspects of the inventories and thus completes the audit process.
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