- 30 Marks
AA – L2 – Q34 – Audit Evidence
Question
(a) Explain why year-end inventory counting is important to the auditors of organisations that do not have perpetual inventory systems.
(b) Describe audit procedures you would perform in order to rely on a perpetual inventory system in a large, dispersed organisation.
(c) Carter Retail is a family-owned company which retails beds, mattresses and other bedroom furniture items. The company’s year-end is 31 December. The only full inventory count takes place at the year end. The company maintains up-to-date computerised inventory records.
Where the company delivers goods to customers, a deposit is taken from the customer and customers are invoiced for the balance after the delivery. Some goods that are in inventory at the year-end have already been paid for in full – customers who collect goods themselves pay by cash or credit card.
Staff at the company’s warehouse and shop will conduct the year end count. The shop and warehouse are open seven days a week except for two important public holidays during the year, one of which is 1 January. The company is very busy in the week prior to the inventory count but the shops will close at 15.00 hours on 31 December and staff will work until 17.00 hours to prepare the inventory for counting. The company has a high turnover of staff. The following inventory counting instructions have been provided to staff at Carter Retail.
(i) The inventory count will take place on 1 January 20X5 commencing at 03/00 hours. No movement of inventory will take place on that day.
(ii) The count will be supervised by Mr Baker, the inventory controller. All staff will be provided with pre-printed, pre-numbered inventory counting sheets that are produced by the computerised system. Mr Baker will ensure that all sheets are issued, and that all are collected at the end of the count.
(iii) Counters will work on their own, because there are insufficient staff for them to work in pairs, but they will be supervised by Mr Baker and Mrs Wilson, an experienced shop manager who will make checks on the work performed by counters. Staff will count inventory with which they are most familiar in order to ensure that the count is completed as quickly and efficiently as possible.
(iv) Any inventory that is known to be old, slow-moving or already sold will be highlighted on the sheets. Staff are required to highlight any inventory that appears to be soiled or damaged.
(v) All inventory items counted will have a piece of paper attached to them that wil show that they have been counted.
(vi) All inventory that has been delivered to customers but that has not yet been paid for in full will be added back to the inventory quantities by Mr Baker.
Required:
Describe the deficiencies in Carter Retail’s inventory counting instructions and explain why these deficiencies are difficult to overcome.
(d) Where inventory is held by third parties auditors will need to obtain external confirmation of such inventory.
Describe the audit evidence provided by such confirmation, the practical difficulties in obtaining it and the alternative audit evidence available when such confirmation is not provided.
Answer
(a) Inventory counting is important to auditors of manufacturers, wholesalers, retailers and many service organisations as inventory counting is the best way to establish quantities for valuation purposes and it assists management in making appropriate allowances against obsolete, slow moving and damaged items.
Inventory counting provides the only direct evidence in relation to the existence of inventory. Performed properly, counting provides evidence on cut-off, certain frauds and on the quality of internal controls over inventory.
Auditors should attend inventory counts where inventory is material to the financial statements (statement of financial position or statement of comprehensive income).
(b) The purpose of a perpetual inventory system in practice is to control inventory. Such a system involves cyclical counting procedures during the year. Such procedures avoid the need for reliance on a year-end count, If auditors wish to rely on the records that than a year-end count for the purposes of the financial statements they must ensure that the cyclical counting procedures are adequate and are being properly and consistently applied, particularly in a large, dispersed organisation.
I would ensure that all inventories have been counted at least once a year and that the records had been kept up to date and were promptly corrected for any discrepancies discovered as a result of counting.
I would assess the risk attaching to the different locations and week to visit those locations where the value or volume of inventory is substantial, and where controls are weak (i.e. where risk is greater).
It may be necessary to involve other offices of my firm, or to engage staff from another firm to attend counts, and to co-operate with internal audit, who may wish to conduct their own counts (on which I may wish to rely), or who may lend staff to my firm.
If using other firms of external auditors, and relying on internal audit work, it is particularly important that I am satisfied with the quality of that work and that my involvement is sufficient for my firm to be able to justify its audit opinion.
My firm may perform visits on a rotational basis throughout the year to ensure adequate coverage of all locations.
(c) Deficiencies in counting instructions and why they are difficult to overcome
| Deficiencies | Why difficult to overcome |
|---|---|
| The date of the count may be inappropriate – staff (and auditors) will not wish to work on a public holiday and given that there is a high level of staff turnover, there is a possibility that staff will not arrive or will complete the work too quickly without properly counting the inventory. This is compounded by the fact that staff are working individually and may make errors or attempt to cover misappropriations. | These problems are difficult to overcome because the shop and warehouse are open seven days a week and because it is expensive and difficult to obtain others (who may not be appropriately experienced) to perform the count. It might be suggested that the count be conducted, say, a week before or a week later and that a roll-forward or roll-back be performed, but this will cause additional staffing problems and problems with the movement of inventory. It may be difficult for the company to change its year-end because of local regulations. Some of the managers might be asked to come and help. |
| There may be insufficient time allowed to prepare the inventory for counting and it is likely that the shop and warehouse will be untidy because the business has been busy. | This is difficult to overcome because the shop and warehouse are open seven days a week and because it is expensive and difficult to obtain others (who may not be appropriately experienced) to perform the count. |
| Too much responsibility is in the hands of Mr Baker (a lack of segregation of duties). He is responsible for the assets (the inventory), the records, the staff and the adjustments to the records. It may be necessary for Mr Baker to be involved with the count but he should be responsible together with another representative of management who is not involved with the day-to-day control of inventory (such as the finance director). It will be too easy for Mr Baker to hide errors or falsifications in the inventory records to cover up errors or misappropriations. It would be particularly easy for him to falsify records in relation to, for example, inventory in inventory but already sold and inventory delivered but not yet paid for. | This is difficult to overcome because family owned companies, (even large ones) often place a substantial amount of trust in valued employees who would be offended if it were suggested that it were necessary to ‘check’ their work in some way. |
(d) External confirmation of inventory held by third parties
Evidence
It is often not possible for auditors to confirm inventory held by third parties by attendance at an inventory count and therefore the only evidence available is confirmation from the third party.
It is particularly important to ensure that the confirmation is genuine because of the possibility of fraudulent collusion between the third party and the client to inflate inventory and profit figures.
Practical difficulties
- The third party may not respond to the confirmation request, or the response may be delayed, impacting audit timelines.
- There may be concerns about the reliability of the third party, especially if they have a close relationship with the client, increasing the risk of collusion.
- The confirmation may not provide sufficient detail (e.g., quantity, condition, or ownership of inventory), requiring additional follow-up.
- Third parties may charge fees or impose administrative burdens for providing confirmations, complicating the process.
Alternative audit evidence
- Review of contracts or agreements between the client and the third party to confirm the terms of inventory storage and ownership.
- Inspection of warehouse receipts or shipping documents to verify the existence and movement of inventory to the third party.
- Analytical procedures, such as comparing inventory levels with sales or production data, to assess reasonableness.
- Obtaining a report from the third party’s auditors, if available, to confirm the existence and condition of inventory.
- Physical inspection of inventory at the third party’s location, if feasible, or arranging for another auditor to attend the count on behalf of the primary auditor.
- Tags: Audit Evidence, Existence, Internal controls, Inventory Counting, Valuation
- Level: Level 2
- Topic: Audit Evidence
- Uploader: Samuel Duah