ACCOUNTING FOR AND AUDIT OF INVENTORIES

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1 ACCOUNTING FOR AND AUDIT OF INVENTORIES PRESENTED BY MICHEAL AGHWANA MANAGER: PEAK PROFESSIONAL SERVICES IN HOUSE SEMINAR SERIES NO 3 PEAK PROFESSIONAL SERVICES (CHARTERED ACCOUNTANTS) NIGERIA A member of Kreston International A global network of independent accounting firms

2 INTRODUCTION Stock (otherwise referred to as inventories) are items of value held for use or for resale by an enterprise and usually comprise, raw materials and supplies used in production, work in progress and finished goods. Depending on the nature of an enterprise, the value of stock may be substantial, surpassing or only second to that of property, plant and equipment. Appropriate classification and accurate determination of the quantity and cost of stock are necessary for proper determination of the result of the operation of an enterprise and for the presentation of current asset in the balance sheet. There are several methods of valuing stocks which give rise to wide difference in the result of the operation of an enterprise. It is therefore important to have an understanding of these methods and know when they can be applied. This paper covers the accounting for and auditing of stock and work in progress. It is hoped that at the end of the presentation members of staff will appreciate the importance and different application of stock accounting and apply the procedure required for the audit of stock and work in progress. The topics covered in this paper are as follows: Relevant Accounting standard for stock and WIP Important definitions Measurement of inventories Valuation of inventory Valuation of WIP Accounting for WIP Accounting for Inventory Introduction to Auditing inventory Audit of Inventory Cut off procedure Disclosure requirement Understanding the company s inventory system ACCOUNTING STANDARDS In Nigeria stock are accounted for using the statement of accounting standard (SAS 4). This position is expected to change from this year (2013) when companies with significant public interest are expected to convert from using the SAS to International Financial Reporting Standard (IFRS).Most of the big clients (with turnover of over #500, 000,000)are in this category. In this paper we shall be limiting our work to Stocks. Work in Progress will be treated under a separate cover. IAS 2 - Inventories and short term WIP IAS 2 WAS REVERSED IN DECEMBER Members of staff are strongly advised to familiarize themselves with the provisions of the relevant standards.

3 Measurement of inventories The standard states that inventories should be measured at the lower of cost and net realizable value Cost of inventories The cost of inventories will consist of all costs of: Purchase Cost of conversion Other cost incurred in bringing the inventories to their present location and condition. Cost of purchase The standard lists the following as comprising the costs of purchase of inventories: Purchase price plus import duties and other taxes plus Transport handling and any other cost directly attributed to the acquisition of finished goods, Services and material less Trade discounts, rebates and other similar amounts Costs of conversion Costs of conversion of inventories consist of two main parts. a) Costs directly related to the units of production, e.g. direct material, direct labor b) Fixed and variable production overheads that are incurred in converting materials into finished Goods, allocated on a systematic basis Other costs Any other costs should only be recognized if they are incurred in bringing the inventories to their present location and condition ACCOUNTING FOR INVENTORY The purpose of an Inventory System in Financial Accounting is to account for resources and to match costs to their related sales as closely as possible. There are two systems used to account for Inventory, the Periodic System and the Perpetual System. Each has its own accounting methods. Periodic Inventory System - Assumes Entity Owns Inventory until Sale: The first system is the Periodic Inventory System. Under this system, purchases of inventory are debited to the Income Statement Account Purchases. At the end of the year, the Balance Sheet Account Inventory is adjusted when the available inventory is counted and valued. Entry for purchases throughout the year Example: Purchase of Goods for 10,000 would be posted as follows:

4 5050 Purchases #10, Accounts Payable #10,000 *In the entry above, the credit entry could be cash, I chose Accounts Payable because it will be the most common account used in this situation. At the end of the year, when inventory is counted and valued, adjusting entries would be made to the Balance Sheet and Income Statement Accounts. This entry assumes prior entries and the following account balances at the end of the year: Beginning Inventory of #5,000, Purchases of #60,000 and Ending Inventory of #6,000. Entry to transfer balances to Cost of Goods Sold and adjust the Inventory Account to equal the ending balance valuation Cost of Goods Sold #65, Inventory #5, Purchases #60, Inventory #6, Cost of Goods Sold #6,000 When working with accounts like Inventory under the Periodic Inventory system, I prefer to remove the entire account balance and make the adjusting entry equal to the new ending balance. This strategy makes future auditing of the account more clear. Companies using the Periodic Inventory System provide more detail for Cost of Goods Sold on the Income Statement and expand the entry to include the Cost of Goods Sold calculation/statement. The format for the Cost of Goods Sold Statement is: + Beginning Inventory + Net Purchases (Inventory Purchases - Returns) + Freight In Charges - Ending Inventory Cost of Goods Sold Perpetual Inventory System - Assumes Entity Owns Inventory until Sale:

5 Using this system, inventory purchases are debited to a Balance Sheet Inventory account rather than an Income Statement Purchase account. Under the perpetual system, products that are purchased as finished goods are accounted for in one inventory account but products that will be manufactured use three inventory accounts, raw materials, work in progress and finished goods. For the purposes of this entry, I will use one Cost of Goods Accounts (5000), three Inventory Accounts (in the 1300 range) and one Revenue Account ( Sales). The Account Numbers are not important to the concept, they are used here to provide easy identification. The important concept is the difference between Cost of Goods which is an Income Statement Item and Inventory which is a Balance Sheet Item. In the case of retail, where products are purchased as finished goods and then resold, products are owned by the seller until sold. An example of the initial cost entry is: 1375 Inventory #1, Accounts Payable #1,500 There are two entries to make when Products (Inventory) are sold: Record the Sale: 1200 Accounts Receivable #3, Sales #3,000 And then transfer the Cost of the products that were sold from Inventory to Cost of Goods: 5000 Cost of Goods Sold #1, Inventory #1,500 In the case of Value Added or Manufacturing, all costs related to purchasing materials and preparing them for sale are included in their value. When a company purchases Raw Materials well in advance a Raw Materials Inventory Account is used. In cases where the company is manufacturing or constructing a product for sale but only purchases inventory as it is required, the Raw Materials Inventory Account is skipped and the Purchases are debited directly into the Work in Progress Inventory Account. Purchase of Raw Materials In Advance:

6 1300 Inventory - Raw Materials # Accounts Payable #500 To Record the purchase of Raw Materials that will be put to immediate use: Inventory - Work in Progress 1325 #500 (Materials) 2000 Accounts Payable #500 Or, to transfer the cost of the Raw Materials that are in the process of Manufacturing to Work in Progress. Inventory - Work in Progress 1325 #500 (Materials) 1300 Inventory - Raw Materials #500 To Record Direct Labor: Inventory - Work in Progress 1325 #500 (Labor) 2000 Operating Account #500 To Transfer the Cost of the Value Added or Manufactured Goods that are completed to Finished Goods: 1375 Inventory - Finished Goods #1, Inventory - Work in Progress #1,500 Sales/Revenue Entries There are two entries to make when Products (Inventory) are sold: Record the Sale: 1200 Accounts Receivable #3, Sales #3,000

7 And then transfer the Cost of the products that were sold from Inventory to Cost of Goods: 5000 Cost of Goods Sold #1, Inventory #1,500 INTRODUCTION TO AUDITING INVENTORY Audit of inventory is concerned with the auditor expressing an opinion on the inventory figure included in the financial statements which he has been given to audit. When we are presented with an inventory figure in our Financial Statements, it is important to look at three aspects: namely 1 Existence 2 Valuation 3 Pricing Your job as an auditor is to design procedures that will help you to verify these three aspects of inventory. The audit of inventories Why is it important? Easiest assets to manipulate Misstatement affect reported profit: misstatement of inventory balances has a direct effect on reported profit. Inventories identification: some inventories can be very difficult for an auditor to identify stock of gas reserve. Need an expert to estimate the quantity- ISA 620 using the work of an expert. Inventories difficult to establish: the quantities of inventory held at a specific given moment may be difficult to establish. It may not be possible to cease inventory movements during the inventory count and cut off may be hard to establish with precision. Valuation: difficult for certain products e.g. antiques-no active markets, hospital which is 24/24 hours. Inventory losses: from pilferage, wastage, obsolescence, damage, dormant stock. Inventories may be intangible: some very significant work in progress balances may be intangible in nature. Risks associated with inventory Inadequate or inappropriate inventory held: to meet the demands of sales and production e.g. Stock out High inventory levels resulting in poor cash flow and financial loss. Inaccurate or incomplete record of inventory movements resulting in lack of awareness of the

8 actual inventory position and difficulties in meeting customer needs. Lack of security over inventory resulting in loss, theft or misappropriation. Obsolete inventory held or incorrectly supplied to customers, resulting in financial loss and damage to reputation. Physical inventory counts The 2 methods of carrying out inventory counts are: 1. Periodical: made at or close to the year end. 2. Perpetual: counting on a continuous basis over the whole year. Each item is physically inspected at least once a year, and more frequently in the case of items liable to loss. Adequate records are kept up to date. The records are amended and signed as a result of physical inspection and that there are appropriate reports and investigation procedures for discrepancies. Organization of counting- client procedures It is the responsibility of management to count inventory. 1. Permanent organization of the stores: Location and records of goods: goods are kept in bins or on racks, with complete description of each item stated in the bin cards.(in and out) Goods are protected against deterioration. Restriction of access to stores: to avoid misappropriation. Goods held for third parties, and slow moving, obsolete inventories, etc are indentified and separated. Stores area should be tidy. 2. Instructions for counting Comprehensive stocktaking instructions are laid down for the undertaking of the stock take. Management should implement the following controls when carrying out an inventory count: All stocktaking staff must be fully familiar with stock to enable them to identify damaged or sub- standard goods. Areas of responsibilities. A responsible officer must be responsible for the issue and collection of all stock sheets. Stock sheets should be sequentially numbered. All stock sheets must be signed by the stock taker. Any changes on the stock sheets must be initialled by stock taker. No stock movement during the stock take, keep a special bay for dispatch/receipts during stocktake. Staff should record the condition of the items in stock.

9 Staff should count the stock in a systematic way. The stocktake must be supervised by senior official within the organization. Assistance of internal auditor. Those staff involved in the stocktake must not be responsible for the day to day custody of the items. Proper procedures for reconciliation of the physical stocktake with the stock records. The auditor and the inventory count Auditor s attendance at counting ISA 501: when inventory is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its existence and condition by the attendance at physical inventory counting unless impracticable.

10 Attendance enables the auditor to: Inspect inventory. Observe compliance to proper stock count procedures in order to provide evidence as to the reliability of the stock count exercise. Where the count is not attended on the date planned due to unforeseen circumstances the auditor should take or observe some physical counts on an alternative date if possible. Note: it is client responsibility to carry out the stock count where the auditor can perform test counts on sample basis. AUDITORS RESPONSIBILTIES AND DUTIES FOR A STOCK COUNT 1. Before the count: planning Review and planning: review prior year s working papers, familiarize themselves with the nature volume and location of inventories, consider the controlling and recording procedures over inventory and the timing of the count. Problem identification and reliance: identify problem areas in relation to the system of internal control and decide whether reliance can be placed on internal auditors. Risk and materiality: assess inherent, control and detection risks and establish materiality. Inventory held by third parties: arrange third party confirmation of inventories held by third parties- depending on materiality, the auditors should also consider the integrity and independence of the third party and whether it is necessary to arrange for other auditors to observe the count or whether it is sufficient to obtain another auditor s report on the adequate of the third party s systems or merely to inspect relevant documentation held at client place. Expert assistance: if the nature of the inventories is specialized then the auditor will need to arrange expert help. Counting instructions: examine the client s counting instructions: if found to be inadequate, the matter should be discussed with the client with a view to improving them prior to the inventory count. 2. During the counting When the auditor attends stocktake, he will carry out the following: Observation that the controls within the stocktaking instructions are being adhered to. Stock is counted systematically by client s staff. Ensure that there is no movement of stock to be counted by the stock count teams. If stock is recorded by weight, weight a sample. If stock is in sealed boxes, the auditor must open a sample of boxes to confirm the quantity in each box. Inspection of goods to make notes of damaged or obsolete stock. The gathering of cut off details such as goods received notes and delivery notes numbers to be followed up after stock take Ensure exclusion of third party

11 3. After the counting There are 3 objectives after stocktake: Existence Valuation Analytical review Explanations of the above objectives are all included in our standard file divider. Cut off procedures Cut off highlights the fact that the balance sheet date divides two accounting periods, and the purpose of the correct cut off procedures is to ensure the correct allocation of all transaction to the period to which they relate. Cut off tests- stocktake at year end. Sales cut off Select sales invoices before the yearend ensuring that the number sequence was complete. Match these sales invoices to the corresponding dispatch notes before the year end. If a sales invoice has been issued but no dispatch note has been raised, the stock must be excluded from the stocktake and treated as third party stock. Accordingly, the sales account and debtors ledger must be updated as well as the stock record. Similarly a sample of dispatch notes should be matched to corresponding sales invoices and the sales record to detect cases of understatement. The above tests will be repeated for sales just after the year end. Purchases cut off Select a sample of GRN and ensure completeness of population by checking sequential numbering. Ensure that the GRN can be matched with an invoice and that the purchase ledger and purchases account has been updated. If not, a provision for accrual should be made. Ensure that the stock record has been updated accordingly. Similarly the purchase invoices will be matched with GRN to detect cases where goods have not yet been received. The above tests will be repeated for goods received after the year end to ensure that they have not been included in the year end stocktake and that the corresponding invoice has been included in the following year results. Cut off tests- stocktake before year end ( two cut off dates)

12 If the stocktake is to be performed before the year end, the auditor will have to perform two separate sets of cut off tests. The above tests will be repeated for sales just after the year end. Purchases cut off Select a sample of GRN and ensure completeness of population by checking sequential numbering. Ensure that the GRN can be matched with an invoice and that the purchase ledger and purchases account has been updated. If not, a provision for accrual should be made. Ensure that the stock record has been updated accordingly. Similarly the purchase invoices will be matched with GRN to detect cases where goods have not yet been received. The above tests will be repeated for goods received after the year end to ensure that they have not been included in the year end stocktake and that the corresponding invoice has been included in the following year results. Cut off tests- stocktake before year end ( two cut off dates) If the stocktake is to be performed before the year end, the auditor will have to perform two separate sets of cut off tests. Ensuring physical cut off to the stock records. Check purchase accruals and debtors to be performed at the year end. Purchases cut off Select a sample of sequentially numbered GRN before the stocktake date and ensure a like entry has been made in the stock records. Select some sequentially numbered GRN after the stocktake to ensure that these deliveries were not entered into the stock records until after the stocktake date. Sales cut off Select a sample of sequentially numbered DN before the stocktake date and ensure that a corresponding entry had been made in the stock records. Similarly, the test will be repeated for despatches after the stock date. Inventory valuation procedures Raw materials and consumables Ascertain what elements of cost are included e.g. carriage in, duties. Etc If standard costs are used, enquire into basis of standards, how theses compare with actual costs and how variances are treated. Test check cost prices used with purchase invoices received in the month(s) prior to counting.

13 Follow up valuation of all damaged or obsolete inventories noted during observance of physical counting with a view to establishing a net realizable value. Work in progress Ascertain how the various stages of process are measured and if estimates are made, on what basis they are made. Ascertain what elements of cost are included. If overheads are included, ascertain the basis on which they are included and review this basis with the available costing and financial information. Ensure that any material costs exclude any abnormal wastage factors. Finished goods and goods for resale. Enquire into what costs are included, how these have been established and ensure that the overhead included is based on normal costs and is reasonable in relation to the information disclosed by the draft FS. Test check prices on inventory lists with official sales price list, bearing in mind any trade discount which are normally granted off the list prices. Ensure that inventories are valued at net realizable value if this is less than cost. For any such items, also check back and see if the relevant partly processed inventories and raw materials have also been written down. Follow up any items which is obsolete, damaged, slow moving ascertain the possible realizable value of such items. Follow up any inventories which at time of observance of physical counting were noted as being demaged or obsolete. We would now use our standard file divider for the other procedures. STOCKS AND WORK IN PROGRESS Initial W/P Ref. 1. Obtain all available Stock Sheets and get and check or prepare a Stock Summary per Balance Sheet, showing separately raw materials, goods in transit, Work-In-Progress and Finished Goods and indicting location thereof and basis of valuation. 2. Plan all your audit checks to establish (a) Does the stock exist, and how much is there? (b) What is it worth? and with this in mind:- EXISTENCE AND QUANTITY

14 3. Wherever possible attend the Company s Stock taking to ensure it has been done properly. 4. Indicate in your papers the procedures issued for (a) ensuring a proper cut off (b) counting and recording (c) control and custody of rough stock sheets (d) preparation and pricing of final stock sheets and make sure all stock sheets are kept for our use during the audit. 5. Where we could not attend Company Stock-taking, do a physical test check during the audit to prove existence and state what you have been able to do to relate the quantities then with those at the year end (for example by reference to continuous stock records if kept). 6. Obtain or prepare full analysis of goods in transit and vouch subsequent receipt of goods, noting dates of receipt on schedule. 7. Obtain details of stocks not under client control (e.g. out on consignment or with distributors for sales) and indicate how you have verified existence and quantities. 8. (a) Get and check or prepare a list of all work-inprogress. (b) Explain the nature of the work-in-progress and what you have done to verify tis existence and assess the stage of completion. 9. Prepare and/or check quantity reconciliations where Initial W/P Ref. VALUATION 10. Check arithmetical accuracy of stock sheets. 11. Check prices of all major items of materials and merchandise against current purchase invoices, allowing for duty, etc., and note on schedule all those items checked and all your calculations of prices. 12. Check all major items against checked sales invoices and ensure realizable values are in excess of cost. Note sale prices on schedules. 13. Compare with previous year s prices and enquire

15 into significant difference. 14. Make rough comparison of cost and selling prices per unit (major items) with gross profit percentage per trading account and enquire into any significant difference. 15. In case of manufactured goods state basis of valuation and prepare your own calculations to support unit prices adopted. Do the same for manufacture in progress. 16. Record how you have checked the cut off position at Balance Sheet date. 17. Review contract work-in-progress against state of contract and contract price. 18. Review all stocks for obsolescence, slow turn-over, deterioration, replacement cost, etc., to ascertain if provision necessary and review contract work-in-progress for ultimate loss. 19. Ensure all departmental or other fictitious loadings eliminated. 20. Ensure basis of valuation consistent in all material respects with previous year or consider note if necessary. Get appropriate stock certificates signed. PEAK PROFESSIONAL SERVICES (Chartered Accountants) CLIENT: ADDRESS STOCK CERTIFICATE AS AT 31 ST DECEMBER, (MANUFACTURING COMPANY) I HEREBY CERTIFY that to the best of my knowledge and belief: The whole of the stock on hand wherever situated at the close of business on the above date amounted to N.. as shown by the inventory, and has been valued, item by item, at the lower of cost or replacement price or realizable value. The quantities shown in the inventory have been ascertained either:-

16 By actual count, weight or measurement, or From book stock records, the substantial accuracy of which has been proved by physical stock-taking test during the accounting period ended on the above date; or partly by (a) and partly by (b). Adequate provision has been made against imperfect, also and in active stock. Client s Representative: Name: Sign:.. Date:. Auditors Representative Name: Sign:.. Date:. Financial statement assertion Existence and Occurrence Completeness Rights and Obligations Accuracy, classification and valuation Cut-off Presentation and disclosure Audit objective - Recorded purchases and sales represent inventories bought and sold - Inventory on the statement of financial position physically exist - All purchases and sales are recorded - All inventory at year-end is included on the statement of financial position - The entity has rights to inventory recorded in the period and at year -end - Costs are accurately determined in accordance with accounting standard - Inventory is recorded at year-end at the lower of cost and net realizable value - All purchases and sales of inventories are recorded in the correct period - Inventory is properly classified in the accounts - Disclosure relating to classification and valuation are adequate

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