Inventory observation is a process typically carried out by auditors during a physical inventory count. It is a method of verifying the existence and condition of the inventory items reported in a company’s financial statements.
During an inventory observation, the auditor will:
- Witness the Count: The auditor observes company employees as they count the physical inventory. The purpose is to ensure that the count is being done accurately and in accordance with established procedures.
- Conduct Test Counts: The auditor will select a sample of inventory items and count them independently to compare the results with the company’s count.
- Inspect Inventory: The auditor will physically inspect inventory items to verify their condition. For example, they might look for obsolete or damaged items.
- Review Procedures: The auditor reviews the company’s procedures for counting and valuing inventory, to ensure they are in accordance with accounting principles.
- Cut-off Analysis: The auditor will review transactions that occurred near the time of the physical count (both before and after) to ensure that they are recorded in the correct accounting period. This is called a cut-off test.
- Reconciliation: Finally, the auditor reconciles the physical count to the company’s inventory records and financial statements, to ensure that the amount reported in the financial statements is accurate.
Inventory observation is an essential part of the audit process, as it provides auditors with direct evidence about the existence and state of the inventory, which is a significant account in the financial statements of many companies.
Example of Inventory Observation
Let’s consider a practical example involving a company named XYZ Corp. which manufactures and sells industrial machinery. XYZ Corp. has an auditor, ABC Auditing, to review their year-end financial statements.
Here’s how ABC Auditing would conduct an inventory observation at XYZ Corp:
- Witness the Count: The auditors from ABC Auditing arrive at XYZ Corp’s warehouse on the day of the physical inventory count. They observe the counting process carried out by XYZ Corp’s employees to ensure it’s done accurately. They note if the count procedures are followed, like whether items are counted systematically, and if count tags are used properly.
- Conduct Test Counts: ABC Auditing selects a random sample of items and conducts independent counts. For instance, if XYZ Corp’s employees counted 50 units of a particular machine part, the auditors independently count the same part. If their count matches XYZ Corp’s, it increases their confidence in the inventory count process’s accuracy.
- Inspect Inventory: The auditors inspect the condition of the inventory items. For instance, they might check if the machine parts in the warehouse match their descriptions and if they’re in good condition (i.e., not obsolete or damaged).
- Review Procedures: ABC Auditing reviews XYZ Corp’s inventory count and valuation procedures. This includes reviewing policies and procedures related to the physical count, and how XYZ Corp accounts for issues like obsolescence or lower of cost or market considerations.
- Cut-off Analysis: The auditors inspect XYZ Corp’s documents related to recent purchases and sales. For example, if a batch of machine parts was received a day after the inventory count, it should not be included in the year-end inventory.
- Reconciliation: Finally, ABC Auditing reconciles the results of the physical inventory count to XYZ Corp’s inventory records and the reported inventory amount in their draft financial statements. If there are any discrepancies, they will investigate further to identify the reason and ensure the financial statements are accurate.
Through this process, ABC Auditing can gather evidence regarding the accuracy and existence of the inventory reported in XYZ Corp’s financial statements.