## **Learning Outcomes**

After studying this article, you will be able to describe why inventory is often an area of high inherent risk, identify key audit assertions and risks linked to inventory, and state the main substantive procedures used to obtain sufficient appropriate audit evidence regarding inventory in the context of a heightened inherent risk for misstatement.

## **ACCA Foundations in Audit (FAU) Syllabus**

For ACCA Foundations in Audit (FAU), you are required to understand substantive audit procedures when inventory is a high-risk area. In this article, you will revise:

- The characteristics of high inherent risk for inventory balances
- The principal audit assertions relating to inventory
- Common sources of misstatement and fraud risk in inventory
- The design and application of substantive procedures to verify existence, completeness, rights, and valuation of inventory
- The interaction of substantive procedures with inventory counts and valuation testing
- The application of professional scepticism and judgement in this area

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which assertion is tested when an auditor checks items physically in the warehouse and traces them to the inventory records?
2. Why is inventory often regarded as a high inherent risk account balance?
3. List two substantive procedures to test the valuation of finished goods.
4. What action should the auditor take if obsolete inventory is identified during an inventory count?

## **Introduction**

Inventory is frequently considered one of the highest risk areas in a financial statement audit, particularly where the nature or scale of inventory creates complex risks. The auditor must address assertions such as existence, completeness, rights and obligations, and, crucially, valuation. Because inventory balances directly affect reported profits and are susceptible to management manipulation or error, robust substantive testing is necessary whenever inherent risk is assessed as high.

## Identifying Inherent Risk Factors for Inventory

Inventory carries a higher risk of material misstatement for several reasons:

- Quantities may be difficult to measure due to large volume or variety
- Inventory may be held in multiple locations, possibly some not under the direct control of the auditee
- Estimates and judgement are heavily involved in assessing net realisable value (NRV), especially for slow-moving or obsolete stock
- Management may have incentives to misstate inventory, as it impacts reported profit

> **Key Term: inherent risk**
> The susceptibility of an account balance or class of transactions to a material misstatement, before considering any related controls.

## Principal Audit Assertions for Inventory

Audit work must address each of the following assertions:

- **Existence:** Inventory recorded actually exists at the period end
- **Completeness:** All inventory owned is recorded in the accounts
- **Rights and Obligations:** Inventory is owned by the entity; goods held on consignment are excluded
- **Valuation:** Inventory is stated at the lower of cost and NRV; obsolete or slow-moving items are written down

> **Key Term: substantive procedures**
> Audit procedures designed specifically to detect material misstatements in financial statement assertions at the account or disclosure level.

## Common Causes of Misstatement in Inventory

Typical risk factors include:

- Unreliable or manipulated inventory records
- Errors during inventory counts, such as double counting or omitting items
- Incorrect allocation of costs or overheads
- Failure to identify and write down obsolete, damaged, or slow-moving inventory
- Goods belonging to third parties included in inventory
- Cut-off errors for goods received or dispatched around the year-end

## Designing Substantive Procedures for Inventory

When controls cannot be relied upon or inherent risk is high, extensive substantive procedures are required. The substantive audit work focuses on the following main areas:

### Substantive Procedures for Existence

- Attend the inventory count, observe procedures, and perform independent test counts; trace counted items to inventory records
- Select recorded items from inventory listings and confirm their physical presence in the warehouse
- Obtain third-party confirmations for inventory not held on the premises

### Substantive Procedures for Completeness

- Select items found physically in the storage location and trace them back to inventory records to identify unrecorded stock
- Review goods received and dispatched around the year-end to verify proper inclusion/exclusion from inventory
- Examine movement records (e.g., delivery/dispatch notes, purchase invoices) and match them against inventory records

### Substantive Procedures for Valuation

- Select samples of inventory items and agree costs to recent purchase invoices (for raw materials or bought-in goods)
- For manufactured goods, recalculate standard costs and check allocation of labour and overheads
- Review post year-end sales invoices to assess NRV and identify obsolete or slow-moving stock
- Discuss with management the basis of any stock provisions; evaluate whether obsolete or slow-moving stock has been written down appropriately

### Substantive Procedures for Rights and Obligations

- Inspect purchase documentation for selected inventory items to confirm title
- Inquire about goods held on consignment and confirm whether such stock is included or excluded appropriately
- Confirm segregation of goods owned by third parties and verify they are excluded from inventory listings

> **Key Term: net realisable value (NRV)**
> The estimated selling price of inventory less the estimated costs of completion and sale.

## The Role of Inventory Counts in High-Risk Situations

The auditor’s attendance at the inventory count is an essential substantive procedure. The auditor must:

- Review and, if necessary, suggest improvements to management’s count instructions before the count
- Observe adherence to count procedures during the count
- Make independent test counts, both from inventory listing to floor (for existence) and floor to records (for completeness)
- Note obsolete, damaged, or slow-moving items for further valuation testing
- Record cut-off information (e.g., last goods received/despatched) to test year-end cut-off

### **Worked Example 1.1**

During an inventory count, you notice that several pallets contain expired products not included in the slow-moving or provision listing. What substantive procedures should you apply, and which assertions are affected?

> **Answer:**
>
> - Inspect and list the expired goods
> - Discuss with management whether these items should be written down to NRV or fully impaired
> - Review subsequent sales or disposal documentation, if available, to confirm actual NRV
> - Assertions affected: **Valuation**, as the correct carrying value may be less than cost; **Completeness**, if obsolete items were omitted from write-down lists

### **Worked Example 1.2**

You identify discrepancies between the quantities recorded on inventory sheets and physical counts performed at one warehouse location. How should you respond?

> **Answer:**
>
> - Investigate the source and cause of the discrepancies (e.g., miscounts, theft, input errors)
> - Expand the sample of test counts at that location
> - Review inventory movement logs for unusual adjustments
> - Consider the need to increase work at other locations
> - Assess the possible impact on the **Existence** and **Completeness** assertions and whether material error may be present

### **Exam Warning**

> Do not assume strong inventory controls mean you can reduce substantive procedures for high-risk inventory. High inherent risk always requires thorough substantive testing—this is often an exam trap!

### **Revision Tip**

> When planning your inventory work, always link each substantive procedure to a specific audit assertion. Clearly stating these links in the exam gains marks.

## **Summary**

Substantive procedures for inventory must be extensive when inherent risk is high. Test counts, tracing inventory records, and reviewing valuation estimates are all critical, especially where there is evidence of past misstatements, complex inventory, or incentive for management bias. Sufficient, appropriate audit evidence is essential to support your opinion on existence, completeness, rights, and valuation.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Inventory is often an area of high inherent risk due to complexity, subjectivity, and misstatement potential
- Risks include physical count errors, valuation errors, omitted/double-counted stock, and fraud risk
- Main relevant assertions: existence, completeness, valuation, rights and obligations
- Substantive procedures include physical count attendance, test counts, tracing between records and physical items, cost and NRV testing, third-party confirmations, and rights checks
- Professional scepticism is required throughout; all high-risk areas demand detailed substantive work
- Always link procedures to assertions when explaining or writing exam answers

## **Key Terms and Concepts**

- inherent risk
- substantive procedures
- net realisable value (NRV)

Substantive procedures - High inherent risk for inventory