Auditing inventory is cross-checking financial records with physical inventory and records. Auditors and other parties can complete it. An auditing inventory can be as simple as just taking a physical count of stock and inventory to match the records with physical stock.
Auditing is the process of verifying that the financial records of an entity are accurate and fairly represented. Transactions in financial records must fairly represent the entity’s financial positioning and actual operating activities.
Since financial documentation and records are produced internally, there is a high risk that inside parties can manipulate records. Insiders can make mistakes or intentionally alter information while preparing financial records, which is considered fraudulent behavior. Auditing ensures that these mistakes are prevented.
Audits also ensure that entities comply with relevant accounting standards such as the International Financial Reporting Standards (IFRS), Generally Accepted Accounting Principles (GAAP), and other relevant accounting standards.
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.
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. 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 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 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 inventory cost, auditors will check which general ledger account is used for this and if it is a consistent account. They will also focus on any abnormal costs that should be charged as an expense but are included in the inventory cost.
Examples of Inventory Audit Procedures
ABC audit firm was 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 inventory count matches records at each operation level.
- They will check for the consistency of the 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.
Challenges of Inventory Audit
- An Inventory audit is a very time-consuming procedure.
- Inventory audits are difficult to scale. The bigger the inventory volume, the more strategic the solution to perform the audit.
- An inventory audit hinders or sometimes halts a particular part of the operation until the audit is completed.
Importance of Inventory Audit
- An inventory audit is also required to match the actual quantity of items in stock against the accounting records while adjusting for differences and allowing for shrinkage so that the ledger reflects accurate values.
- An inventory audit can reveal which physical goods or products are over or under-stocked. This will allow you to properly and effectively stock your business, thus helping maximize profit.
- An inventory audit is necessary to reduce unnecessary investment in stocks and to ensure that you have a proper line balancing in the process.
- An inventory audit is needed to compare actual physical counts and match them to business records: When this count is conducted accurately, an inventory audit will be able to disclose the true picture of what you hold as compared to the recorded stocks, which, in turn, will give you an understanding of the financial health of the company. Misstatement of inventory balances often tends to affect reported profit directly.
- An inventory audit is imperative to account for losses resulting from wastage, pilferage, damage, obsolescence, and dormant stock.
- An inventory audit will also help determine the effectiveness of your warehouse procedures and help reveal any issues within your organization’s warehouse procedures, whether at the receiving dock or during the actual packaging. This could help highlight any potential inefficiencies in the process, such as the disorganization of the warehouse and slow retrieving methods.
- An inventory audit will help reveal any failure owing to a lack of security, resulting in loss, theft, or misappropriation.
- High stock levels generally result in unnecessary overstocking, thus resulting in poor cash flows and financial loss. An inventory audit at timely intervals will help remedy that issue. Similarly, it helps determine any obsolete inventory in stock or orders incorrectly supplied to customers, which could not only lead to financial loss but also result in irreparable damage to the organization’s reputation.
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 completing the audit process.