Auditing Inventory
Inventory is a critical asset for many businesses, and its audit is often a key focus in the Auditing and Attestation (AUD) section of the U.S. CPA exam. Inventory is susceptible to misstatements due to theft, obsolescence, and clerical errors, among other factors. Understanding the core procedures to audit inventory—Physical Inventory Count, Obsolescence Review, and Cut-off Testing—is essential for CPA candidates.
Physical Inventory Count
One of the most direct ways to verify the existence and condition of inventory is through a Physical Inventory Count. During this procedure, auditors physically count the inventory items and often reconcile them to the client's inventory records. This is a critical process to assess the existence assertion and is generally conducted at or near the balance sheet date. CPA candidates should know that auditors can either perform a full count at once or use cycle counting where inventory is counted periodically throughout the year.
Example: Imagine you’re auditing a clothing retailer, and their ledger indicates 500 units of a particular shirt in stock. During the physical inventory count, you find only 475 units. This discrepancy of 25 units warrants further investigation. It could be due to theft, misplacement, or errors in record-keeping.
Obsolescence Review
Another vital aspect of auditing inventory is Obsolescence Review. Here, the auditor evaluates the potential decrease in the value of inventory items due to factors like age, changes in market demand, or wear and tear. An obsolete inventory item may require writing down its market value, affecting both the balance sheet and income statement. On the CPA exam, you may encounter questions that require you to calculate the write-down or identify the accounting entries for obsolescence.
Example: Still at the clothing retailer, you notice a pile of jackets that have not sold for two seasons. After reviewing market trends and talking with the management, you conclude these jackets are obsolete. If the jackets are on the books for $10,000 but are now worth only $3,000, a write-down of $7,000 is necessary to accurately represent their value.
Cut-off Testing
Cut-off Testing is crucial for ensuring that inventory transactions are recorded in the correct accounting period. This involves verifying that goods received or sold near the balance sheet date are included in the correct period's inventory and cost of goods sold. This type of testing is prevalent on the CPA exam, where candidates may have to determine the correct accounting period for inventory transactions.
Example: The clothing retailer’s year-end is December 31. During your audit, you notice that a shipment of 100 shirts arrived on December 30 but was recorded as inventory on January 2 of the next year. This mistake could lead to an understatement of the current year’s inventory and an overstatement of the next year's starting inventory, affecting several financial metrics and ratios.
