Physical verification of inventories is the responsibility of the management of the entity. However, where the inventories are material and the auditor is placing reliance upon the physical count the management, it may be appropriate for the auditor to attend the stock-taking. The extent of auditor’s attendance at stock-taking would depend upon his assessment of the efficacy of relevant internal control procedures, and the results of his examination of the stock records maintained the entity and of the analytical review procedures. The procedures concerning the auditor’s attendance at stock-taking depend upon the method of stock-taking followed the entity. There are two principal methods of stock-taking : periodic stock-taking and continuous stock-taking. Under the first method, physical verification of inventories is carried out at a single point of time, usually at the year-end. Under the second method, physical verification is carried out throughout the year, with different items of inventory being physically verified at different points of time. However, the verification programme is normally so designed that each material item is physically verified at least once in a year and more often in appropriate cases. The continuous stock-taking method is effective when a perpetual inventory system of record-keeping is also in existence. Some entities use continuous stock-taking methods for certain stocks and carry out a full count of other stocks at a selected date. The auditor is expected to examine the adequacy of the methods and procedures of physical verification followed the entity. Before commencement of verification, the management should issue appropriate instructions to stock-taking personnel. Such instructions should cover all phases of physical verification and preferably be in writing. It would be useful if the instructions are formulated the entity in consultation with the auditor. The auditor should examine these instructions to assess their efficacy. Where the auditor is present at the time of stock-taking, he should observe the procedure of physical verification adopted the stocktaking personnel to ensure that the instructions issued in this behalf are being actually followed.
The auditor should also perform test-counts to satisfy himself about the effectiveness of the count procedures. In carrying out the test counts, the auditor should give particular consideration to those stocks which have a high value either individually or as a category of stocks. Proper attention should also be paid to the physical condition of inventories. Ideally, there should be no movement of stocks when the physical verification is being carried out. On occasions, however, it may be necessary for the entity to continue the production, receiving, or despatch operations during physical verification. In such circumstances, it is essential that the entity has the procedures to identify and record such movement. The auditor should review the procedures adopted the entity to account for the movement of inventories from one location to another within the entity during stock-taking (e.g. issues from stores to
production departments). The auditor should also examine whether the entity has instituted appropriate ‘cut-off procedures’ to ensure that –
- goods purchased but not received have been included in the inventories and the liability has been provided for;
- goods sold but not despatched have been excluded from the inventories and credit has been taken for the sales.
The auditor may examine a sample of documents evidencing the movement of stocks into and out of stores, including documents pertaining to period shortly before and shortly after the cut-off date, and check whether the stocks represented those documents were included or excluded, as appropriate, during the stock-taking. The auditor should review the original physical verification sheets and trace selected items – including the more valuable ones – into the final inventories. He should also compare the final inventories with stock records and other corroborative evidence, e.g., stock statements submitted to banks. The auditor should examine whether the discrepancies noticed on physical verification have been investigated and properly accounted for. Where continuous stock-taking methods are being used the entity, the auditor should pay greater attention to ascertaining whether the management :
- maintains adequate stock records that are kept up-to-date;
- has satisfactory procedures for physical verifications of inventories, so that in the normal circumstances the programme of physical verification will cover all material items of inventories at least once during the year; and
- investigates and corrects all material differences between the book records and the physical counts.
The auditor should determine whether the procedures for identifying defective, damaged, obsolete, excess and slow-moving items of inventory are well-designed and operate properly.