 In this presentation, we will take a look at inherent risk and control risk with relation to the audit of inventory, the inventory management process. Recalling our procedures here, when we think about the auditing of inventory, we're going to take a look at inventory, we're going to assess the inherent risk, we're going to assess the control risk, and then we're going to use those for the detection risk process that's going to be related to us. So remember that the inherent risk, control risk, in essence, you can think of those basically outside of the auditor's control. Those are things that are kind of managed or decided on in some way or the other by the company. And then we are going to take those risks and determine the detection risk, which is what we do have control over through the amount of testing that we will do. So we have to consider these two risk factors inherent risk, control risk, and then consider them with relation to detection risk. So first we will consider inherent risk. Now inherent risk, you'll recall, is going to be the risk that it's just inherent within the process. So if we were to basically remove the controls altogether, then you would think that's the inherent risk that's just inherently risky. Now note, the business doesn't have a lot of control over the inherent risk other than the fact that they chose to be in that business and chose to take on whatever inherent risks are in relation to it. And then they look at those inherent risks, they put in place the internal controls related to them that are supposed to mitigate those inherent risks for things that should mitigate the risk of material misstatement as well. The thing we're concerned with as our job for the auditor. So we're going to be wanting to depend on the internal controls as well. So we need to have an understanding of these things. So we have the inherent risk items. The auditor will need to think about industry related factors and operating engagement characteristics while analyzing the possibility of material misstatement with regards to inventory. And of course, that's going to be our main goal here. We're thinking about material misstatement with regards to inventory in the financial statement in this section. When there is a lot of industry competition, so if we're happened to be in an industry that has a lot of competition, there are often problems with the correct valuation of inventory. So there's more inherent risks. So if we happen to be in an industry where there's a lot of competition, how do we know what the value of the inventory is? It's tough to say because it's volatile given the nature of the industry that we are in. Of course, inventory is going to be a large asset type of account on the books. And we typically think of it as the lower of cost or market type of calculation. In other words, we have to put the inventory on the books. If we purchased it, we typically put it on there at cost, even though we're going to mark it up and sell it, of course. And then when we make it, we're going to put it up in there in some kind of valuation on the purchasing or the production process in terms of the valuation. But it's quite possible that if there's a lot of volatility in the market, that the value of that inventory can decline to possibly below what the cost is that we either we paid for it or produced it for. In that case, we as the auditors are concerned because we don't want to overvalue the inventory because remember, we're typically on the conservative side in terms of valuation. We'd rather, in other words, possibly undervalue than overvalue because that would normally be a safer position in terms of the auditing type of process. So volatility is a problem for us or a type of inherent risk that we'll have to look into. Technology can also result in material misstatement as a result of obsolescence. So notice if you're in a type of industry that uses technology that needs to be updated a lot in order to kind of track this type of information. If the technology then becomes obsolete, if you're using systems that become old, then that could be a problem as well in terms of valuation. Small products of high value are more susceptible to theft. So notice if you're obviously if you're inventory or something like diamonds or something like that, then that's going to be more of a break. If you're selling something like forklifts, it's kind of not likely that your inventory of forklifts are going to be someone's going to come in and steal the forklifts possibly it can happen, but not nearly as likely if you sell diamonds. So if you have diamonds or something like that, then of course we would consider the diamonds to be more inherently risky in that they're more subject to possible theft. And obviously the the company would be well aware of that inherent risk as well and probably have safeguards in place for that. Auditors should understand related party transactions related to acquiring raw materials and selling finished products. Whenever we consider inventory related party transactions, remember those transactions that are with people that are related or entities related such as subsidiaries to the company are suspect transactions because we're relating to someone that doesn't isn't a market factor. We don't have the same market forces. So if we have related party transactions, we need to look into them see if they're material and see whether or not they have been recorded properly or what the valuations are with regards to those transactions. Prior year misstatements are good indicators of potential misstatements in the current year. And so of course the standard audit practice of look at what happened last year and try to use that to figure out what to do this year applies to the inventory. If there's a problem last year, we're more skeptical about the situation of course this year as well that will increase then the inherent risk factors. So we have the inventory control risk. Now we're moving to control risk and recall that the control risk is going to be something that of course the auditor knowing the inherent risks of the industry that they are in puts in the controls into place in order to basically mitigate the type of inherent risks. We as the auditor want to also depend on the controls because we believe that the controls will mitigate the ability of or the fact or the likelihood of a material misstatement. So we want to see what controls are in place. We have an understanding of the process and understanding of the company. We've assessed what the inherent risks are. Then we want to think about the internal controls that have been put in place and whether or not we can rely on them. So we want to understand and document the inventory management process based on a reliant strategy. So what is the process of inventory? We need to understand it and then we can plan and perform tests of controls on inventory transactions. So then we want to basically understand what you know the controls are within the organization. Then we think about how we can test for those controls. Our goal of course is to hopefully be able to test for controls if it's a large company we pretty much have to. If it's a small company we may have less controls and we rely on them less but we're hoping we can rely on the controls test the controls which will be less testing than if we had to do all the testing and get all of our audit assurance all of our evidence from the substantive testing. So we're going to test the actual controls the safeguards within the organization. Then we're going to set and document the control risk for the inventory management process. So then we could set what the control risk would be. Once we set the control risk of course we can then consider the detection risk. Once we have the inherent risk the control risk we consider the detection risk the thing we have kind of control over through the amount of testing we do typically with regards to substantive testing the more detailed testing going out to the client you know doing things pulling out inventory files watching looking at the inventory observing and watching processes those kind of things. So now we're going to look at the control activities and tests. We have the assertion of occurrence. So with regards to occurrence we're going to observe and evaluate good segregation of duties and as we go through these remember when we think about controls we want to first think you know are these controls do we have the controls set up to the controls look good in terms of what kind of controls are set up in plan and theory and then whether or not they've actually been implemented. Those are two completely different things you can have good controls and then bad implementation of the controls because they can be take more time. So we want to go and make sure that there is actual occurrence of the controls as well how we can observe and evaluate good separation of duties. So segregation of duties is one of those things they can actually take more time but can be a safeguard against problems that will be happening. So we want to make sure we can observe to see that those are indeed in place and then we can look at review and test procedures for transfer of inventory. We can review and test procedures for issuing materials to the manufacturing department. So we're going to look at these controls these type these are the key components the transaction components things are moving within the inventory system we want to test the controls relation to them review and test entity procedures related to a count number sequence of material requisitions. So we have the material requisitions forms which should be have a pre numbered or number sequence to them and then we're going to observe physical safeguards over the inventory. Then we have the assertion of completeness with regards to completeness review and test entities procedures related to consignment goods. So when we're thinking about completeness we're often thinking about the idea of the concept of consignment because you'll recall when we're thinking about inventory we're often thinking that if the if the entity is going to make an error on inventory or if they were to do something on purpose to misstate inventory they'd probably overstate the inventory because that would make them look better if they overstate the inventory but when we consider completeness there could be an error with regards to completeness with regards to consignments because consignments can be kind of confusing that would be basically the people who physically have the inventory aren't actually the owners of the inventory so one company would be providing the inventory to another even though they still own the inventory the other company then possibly facilitating a sale and then once the inventory sold giving some some portion of that sale back to