a. Reasons Why Closing Inventory is Important to the Auditor:

1. Impact on Profit Measurement: Closing inventory directly affects the cost of goods sold (COGS) and, consequently, the reported profit for the period. An accurate valuation is crucial for true profit representation.
2. Balance Sheet Valuation: Inventory is a significant asset on the balance sheet, and its valuation impacts the overall financial position of the company. Auditors need to ensure that it is valued correctly to provide reliable financial information.
3. Compliance with Accounting Standards: IAS 2 requires inventory to be valued at the lower of cost and net realizable value. The auditor must confirm compliance with this standard to ensure accurate reporting.
4. Assessment of Management Estimates: Closing inventory often involves management estimates (e.g., obsolescence, net realizable value). Auditors must evaluate these estimates to determine if they are reasonable and consistently applied.
5. Risk of Misstatement: Inventory is susceptible to misstatement due to its complexity, valuation methods, and management’s influence. Auditors must scrutinize this area to detect potential errors or fraud.
6. Internal Controls Evaluation: Inventory management is a key area for internal controls. Auditors assess the effectiveness of controls related to inventory to ensure proper recording and valuation.

b. Principal Risks of Misstatement Associated with Closing Inventory:

1. Valuation Risks: Inventory may be overvalued if management does not accurately assess the net realizable value or fails to recognize slow-moving or obsolete stock.
2. Existence Risks: There is a risk that inventory recorded does not exist. This can arise from errors or fraudulent activities, leading to inflated asset values.
3. Cut-off Errors: Incorrect cut-off procedures can result in inventory being recorded in the wrong accounting period, impacting the accuracy of both inventory and COGS.
4. Costing Errors: Miscalculations in determining the cost of inventory, including misapplication of inventory valuation methods (e.g., FIFO, LIFO, weighted average), can lead to misstatements in financial statements.
5. Incomplete Inventory Records: Failure to record all inventory transactions can lead to an understatement of inventory, affecting both the balance sheet and income statement.

c. Constituents of Cost and Net Realizable Value in an Inventory Valuation Exercise:

Cost of Inventory:

1. Purchase Price: The actual cost incurred to acquire the inventory, including any discounts received.
2. Import Duties: Non-refundable taxes and duties that are directly attributable to bringing the inventory to its location and condition for sale.
3. Transportation Costs: Any direct costs related to transporting the inventory to its location, such as freight and handling charges.
4. Production Costs: For manufactured goods, the costs of direct materials, labor, and overhead incurred in the production process.

Net Realizable Value (NRV):

1. Estimated Selling Price: The expected selling price of the inventory in the ordinary course of business.
2. Estimated Costs to Sell: Costs directly attributable to the sale of the inventory, including marketing, sales commissions, and any other selling costs.