 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. First a word from our sponsor. Well actually these are just items that we picked from the YouTube shopping affiliate program but that's actually good for you because these aren't things that were just given to us from some large corporation which we don't even use in exchange for us selling them to you these are things that we actually researched purchased and used ourselves. 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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 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 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 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 risk 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 market up and sell it of course and then when we when we make it we're going to put it up in there in some kind of valuation on the 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 were typically we're typically on the you know 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 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 obviously if your inventory is something like diamonds or something like that then that's going to be more of a 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 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 auditor 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 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 an 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 less controls rely on them less but we were 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 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 control 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 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 is sold giving some some portion of that sale back to the original owner of the inventory so with regards to completeness we want to we want to consider the proper allocation of the inventory to the records then we have the authorization we're going to review authorized production schedules we want to basically review the authorization process review and test procedures related to developing inventory levels and those used to control them then we have the assertion of accuracy so we're considering the assertion of accuracy review and test procedures related to taking physical inventory so they should be taking a physical inventory of course this is one of the major things with regards to audit that will kind of consider many of the new auditors will will go out and the company will actually do a physical inventory typically towards the end of the year and the auditors get to go out there and count you know the inventory and the physical inventory which is always a exciting time and then we have the review and test procedures to develop standard costs so we'll review and test the procedures that develop those standard costs that's kind of like estimated costs and this would be in like a production type of process review and test variance reports so the difference between the standards and what actually happened again more of a something that would happen if we're making the inventory producing inventory as opposed to purchasing and selling it review and test procedures for detecting obsolete slow moving and excess quantities so we want to see the procedures for that because if something's obviously obsolete or slow moving or if we have excess quantities it might well be the case that we're overvaluing the inventory given the fact that some of it is old and note that within the audit process this could be a real problem for us because we as the auditor may not be experts in valuing inventory so when it comes to the question of well is this piece of inventory now below what the cost is should we write it down you know we don't really have the expertise to do that we might need experts to come in if we're valuing something like clothing or something like that or carpets or something like if it's old inventory how do we know how how uh what the value of the inventory has will be is it still valued correctly if it's been there for a long time we may need some expert help in order to value some inventory that might be slow moving inventory review the reconciliation of perpetual inventory to the general ledger control control account so you'll recall the perpetual inventory system if we're talking about a publicly traded company they're probably recording the inventory as sales happen we want to be comparing the perpetual inventory system to the gl the general ledger the controlling account then we have the cutoff the assertion of the cutoff testing and that's going to be the end of the year you'll recall the end of the year type of of information what are the controls related to it to make sure things are recorded in the proper time period review review and test procedures related to processing inventory that is on receiving reports into the perpetual records so again the perpetual records those records that we would be tracking on a perpetual basis with relation to inventory so we want to consider then the receiving reports and then how they're going to relate to the perpetual records why because when should be we be recorded the inventory into the system at that point in time that we have received it oftentimes so the receiving reports then often being the triggering point and we want to make sure that there's the proper controls over those again you might think this sounds like something we did in the purchasing process you're right because there's going to be overlap within the purchasing process and the inventory the inventory process because many of the things that we purchase quite possibly be one of the major things we purchase being of course inventory review and test procedures for removing inventory from the perpetual records because of shipment of goods so then of course the other side of things when we make sales we have the review of the perpetual inventory records going down because of the shipment so again we want to test the thing that should be triggering the inventory to be decreasing when should it be decreasing when we completed the work in accordance with revenue recognition when we no longer have ownership of the inventory when does that typically happen when with the shipping happens when the inventory leaves that's when we did the job and therefore that's what we want to tie out to the cutoff testing to make sure that the inventory going out lines up in the proper time period and then we have the assertion of classification review the procedures and forms for inventory classification next we have presentation review inventory reports general ledger and chart of accounts for proper proper aggregation and disaggregation we're going to review procedures and forms used to create inventory disclosures so how are they going to make those inventory disclosures and then we're going to review disclosure checklist and related disclosures for reliance on completeness so you'll note again that as we think about these controls some of them are budding up against some of the other controls we have tested as we consider other processes those being the purchasing process in particular as well as the sales process as part and possibly human resources and payroll to some degree as well so as we consider these individually note they are interrelated in some degrees and we're going to be testing the controls of one in some to some degree to some component as we do the other we want to take that into consideration when we do the planning process now we're going to be considering inventory transactions looking first at the assertion of occurrence so the primary worry of the auditor is that every record recorded inventory transaction actually occurred so that we're thinking about the inventory transactions if the inventory transaction was recorded we're worried that it was that it actually happened that the actual occurrence happened that was recorded so the thing we're thinking about with occurrences well what if they just made a transaction that didn't actually happen did it actually occurs there's something behind the transaction that should have caused the transaction the auditor will also be worried that goods may be stolen it's another concern within occurrence the primary tests of controls then will be review and observation those are the primary tests of controls used to test the control for procedures now we're going to test inventory transactions with the assertion of completeness with regards to completeness the main control procedures relate to the the recording inventory that has been received so when we're considering completeness have we recorded the inventory that has been received because now we're considering of course with regards to completeness the end thing that we have that in financial statements we can consider are they including all that they should be including with regards to inventory in other words are there inventory that's not being recorded in in terms of the transaction or isn't being a transaction that's not being processed within the end procedure now this is going to be something that's going to be closely related to the purchasing process so something that we're probably going to be testing within the purchasing processing can basically review the procedures within the purchasing process with regards to the assertion of completeness and the receiving of the inventory and recording the receiving of the inventory then we have authorization of inventory transactions we're considering authorization with regards to inventory transaction primary worry here is the unauthorized purchase of product of production activity that may cause excess levels of certain types of finished goods the next assertion with regards to inventory's transaction is accuracy inventory transactions not properly recorded can result in misstatements that directly affect the amounts reported on the financial statements so when we're considering the assertion of accuracy with regards to inventory it's really important of course because the inventory in and of itself is generally something that's going to be material and if something is inaccurately reported there's going to be a direct effect on the financial statements and of course we are here to give an opinion on the accuracy of the financial statements inventory purchases need to be recorded at the correct price and the actual quantity received so we need to make sure that the inventory that's that's going into the process is recorded one at the correct price and the correct quantity inventory shipped must be correctly recorded in cost of goods sold and the related revenue recognized so when we ship the inventory recall of course that's the point in time that we would ship it out because we sold it there's going to be two components to that when when we have the sales process happening right that the sale we have the revenue component revenue is going up and then we have accounts receivable or cash that would be going up as well then we have the inventory area that we're kind of thinking about here inventory of course would then be going down inventory would go down and revenue should be recognized typically at this at the point in time when the work is completed when we and on the expense side and the cost of goods sold when we have used the expense in order to help us to generate revenue matching principal expense recognition revenues recognized when we did the work in order to generate the revenue both those should be happening at the point in time when we ship the inventory typically cost of goods sold the expense being recorded inventory going down at that point in time then we have the inventory transactions uh assertion of cutoff so the cutoff into the year cutoff inventory transactions that are recorded in the wrong period may affect many different accounts such as or like inventory purchases cost of goods sold so it's quite possible that if the cutoff is wrong if we have transactions at the end of the year that are being applied to the wrong place then that's going to affect inventory that's going to affect cost of goods sold that could affect purchases so that could have a substantial impact on on the financials and that's something that we're going to basically want to be considering as of the end of the year looking at those types of transactions considering and testing whether or not the transactions are being recorded in the proper time period also note if there was going to be something such as fraud or some kind of deception and like say someone wanted to look good if a manager for whatever reason wanted to possibly get their bonus or something like that and they needed to increase sales or something then they they could do they could try to manipulate the numbers by adjusting the cutoff by taking sales possibly out of the next period and pulling them into this period so you want to be careful we need to be careful with the cutoff and the reporting of cutoff because of course inventory can be significant those could be factors that could cause a significant impact on the financial statements then we have the assertion of classification the entity needs to have control procedures to make sure inventory is classified correctly as either raw materials working process finished goods again if if they're not making the inventory it's more straightforward inventory it's going to be the inventory if they're producing the inventory making the inventory we have the added complexity of breaking out that inventory between the inventory accounts those of raw materials working process finished goods we need to allocate through there through understanding which manufacturing department holds the inventory the order is able to classify it by type so we'll basically be able to know who's in who's holding it and that'll help us through that classification process in other words we need to know as the inventory flows through how it flows through the manufacturing process of course the manufacturing process is going to be more complex for us to to be auditing inventory and then we need to get an understanding of you know where the inventory is at with regards to where it should be classified raw materials working process or the finished product presentation of inventory so within the presentation assertion tests of controls regarding management's use of a chart of accounts proper codes for recording inventory transactions and the financial reporting process including the use of a disclosure checklist controls over the aggregation or disaggregation of transactions are needed to properly allocate costs to the correct classes of inventory