Definition of Inventory Audit
Inventory audit as the name itself 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 inventory audit is performed by the external auditors 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.
Inventories generally form a significant part of the total asset, especially in manufacturing companies. Inventories include manufactured goods available for sale in a normal course of the business, work in progress goods, supplies, goods used in the production of goods and services. Since inventory is such important for every business, therefore, inventory audit is important as well. The process involves verifying whether the value of inventory appearing in the entity’s books is actually present with the entity or not.
There are some points that the company should keep in mind while performing inventory audits internally or getting it 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 its physical count. Financial records are maintained internally, therefore there is a chance that they are incorrect due to error, omission or maybe they are intentionally manipulated to serve personal benefits which is considered as fraud.
Inventory audit ensures that these mistakes are prevented and audit is conducted properly to provide a true and fair view of the inventory status in the organization. Inventory audit does not only verify or cross-check the count of the inventory but also its quality or condition of the inventory which is not included in its financial records.
Objectives of Inventory Audit
The objective of the inventory audits are as follows:
- Verifying Physical Existence: As mentioned in several instances that the main objective of the inventory audit is to verify the financial records with physical counts.While performing inventory audit auditors oversee the process of inventory counting and check for the fact that whether they are efficiently done or not. They pick a sample of goods to check whether the physical counts match with its financial records and vice-versa.
- Examining the Accuracy of The Process: An auditor examines whether the inventory counting system is being done with accuracy; they use a statistical sampling method for this.
- Ownership Rights: The objective of the inventory audit is also to determine whether the inventory recorded by the company is actually owned by it or not.
- 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 auditor checks that if they are recorded at realizable value or not.
Inventory Audit Procedures
Below listed are some most commonly used inventory audit procedures:
- ABC Analysis: In this process inventories are grouped separately according to the value and volume. That is high-value, mid-value items, and low-value items all are grouped, stored, and tracked separately.
- Analytical Procedures: It involves an analysis of inventories through financial ratios like gross margin, days inventory remain 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, physically counting the inventory simply to avoid mistakes.
- Cost of Finished Goods Analysis: If a major portion of the inventory is comprised of the finished goods, the auditors will go for this method in which they will 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 put more focus on high-value inventory items, which is whether they are correctly recorded and valued.
- Review Freight Costs: Auditors check whether freight cost treatment is consistent in the financial books of records or not i.e. freight cost can either be included in the cost of the inventory or can be charged to the profit and loss account, but the treatment should be consistent.
- Overhead Analysis: If the company is including the overhead cost in the cost of the inventory, auditors will check which general ledger account is used for this and if it is the consistent account or not. They will also focus on any abnormal cost which should be charged as an expense but are included in the cost of the inventory.
Examples of Inventory Audit Procedures
ABC audit firm was appointed to perform an inventory audit in XYZ Ltd, a manufacturing company that purchases raw material 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 count of inventory matches with records at each operation level.
- They will check for the consistency of treatment of freight charges.
They will also employ other techniques like focusing on high-value items, error-prone items, overhead analysis, etc. to check whether the inventory is valued correctly and represented fairly in the books of accounts or not.
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 is it will require more strategic solution to perform the audit.
- Inventory audit hinders or sometimes halts a particular part of the operation until the audit is completed.
Importance of Inventory Audit
- Inventory audits help in the confirmation of the correct valuation of the inventory and thus calculation of the 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 in finding loopholes or inefficiencies where the company can work upon in the future.
Advantages of the inventory audit are as follows:
- 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 in the reduction and elimination of gaps in the inventory management system.
Disadvantages of the inventory audit are as follows:
- It is a tedious and time-consuming task.
- It involves a lot of manual efforts, therefore,there is a lot of scope of manual error or intentional manipulation.
- In a big organization, inventory audits take place frequently which leads to an increase in the cost.
Inventory audit is an important audit process which includes different audit procedure as per the requirement of the company. The process is tedious and requires a lot of manual effort, but plays a pivotal role in determining the accuracy and efficiency of the inventory management system and other aspects of the inventories and thus complete audit process.
This is a guide to Inventory Audit. Here we also discuss the definition and purpose of inventory audit along with advantages and disadvantages. You may also have a look at the following articles to learn more –