INTERNAL CONTROL AND TESTS OF CONTROL FOR INVENTORY AND

PRODUCTION CYCLE

Assessment of (Inherent) Risk of Material Misstatement of Inventory at Assertion Level for

Valuation

 Inventories should be stated as lower of cost and NRV. When the inventories’ NRV is
lower than the cost, the company has to write down the value of inventory.
 The amount to be written down is subject to management’s estimation.
 The risk of material misstatement of the inventory at assertion level for valuation
should be high, for example, if a company has many inventories piled up and the
economy was under recession, making the saleable value hard to be determined.
 However, it should be low if a company maintains an appropriate level of inventories
and the saleable value is easy to be determined.

Source: Chapter12 Inventory Cycle (yolasite.com)

Risk of Material Misstatement for Inventory

Risk of material misstatement for inventory is the probability that there is a material
misstatement in inventory, but the internal control cannot prevent or detect such misstatement.

It is the combination of inherent risk and control risk that could occur in the inventory
account. The inherent risk here is the risk that inventory account is susceptible to misstatement
where control risk is the risk that is due to having no internal control procedures to prevent or
detect such misstatement or the internal control procedures are not properly executed.

In this case, the level of risk of material misstatement will entirely depend on the
susceptibility of inventory account to misstatement and the internal control that is put in place to
eliminate or minimize such susceptibility.

Risk of material misstatement is directly related to the substantive procedures that

auditors will perform in the audit process. Hence, if the risk of material misstatement for
inventory is low, auditors can reduce the substantive procedures required on such account or
balance.
 Inherent Risk of Inventory

Inherent risk is the risk of material misstatement on financial statements before

considering any control in place. It is the susceptibility of the account or balance to
misstatement.

In this case, inherent risk of inventory is its susceptibility to misstatement. It is directly

related to nature, size and complexity of the inventory transactions. Usually, the bigger and more
complex they are, the higher the inherent risk is.

In most cases, the inventory is an inherently risky asset. This is due to the inventory is
usually the material item on the balance sheet, especially for companies that are in the production
or trading industry. In this case, the level of inherent risk of inventory tends to be high.

Examples of inherent risk of inventory may include:

 Inventory may be misstated due to its complication of valuation.
 Inventory may be intentionally overstated to increase profit (i.e. overstatement of
inventory leads to an understatement of cost of goods sold).
 There may be an overstatement of inventory to disguise unauthorized removal of valuable
products.
 There may be an inventory thief due to it is easily concealed and stolen, especially for the
small inventory with high value.
 The company may change accounting policy regarding inventory valuation, e.g. from
LIFO to FIFO.
 Inventory counts may be falsified to overstate ending inventory and understate the cost of
goods sold.
 Inventory may be misappropriated by the company’s employees, e.g. employees may
take home the legitimate inventory.
 The company may not write down obsolete or damaged merchandise.
 There may be an unreasonable net realizable value of inventory.
 There may be a misstatement of inventory due to the complexity of working in progress,
e.g. complex valuation of the quantity and type of raw materials, labor hours invested in
each semi-assembled product, and allocation of manufacturing overhead, etc.
 There may be a misstatement in inventory valuation carrying from the previous period.
 Inventory inspected by auditors may be held on consignment, etc.
 Control Risk of Inventory

Control risk is the risk that financial statements contain the material misstatement but the
internal control cannot prevent or detect that misstatement. Likewise, such misstatement can
happen due to error or fraud. In this case, control risk of inventory is the risk that the company’s
internal control cannot prevent or detect a material misstatement that occurs in the inventory
accounts.

Auditors usually evaluate the control risk with their assessment of inherent risk in
inventory so that they can make an overall assessment of the risk of material misstatement for
inventory. For example, if the inherent risk of inventory is high and the control risk is low, it
means that the client’s internal control can reduce the risk of material misstatement to some
extent. In this case, auditors can rely on the client’s internal control to reduce some of their
substantive procedures.

However, auditors need to perform the test of controls to obtain audit evidence to support
their assessment that the control risk is low before relying on the client’s internal control.

On the other hand, if the control risk is high, auditors do not need to perform the test of
controls. There is no need to prove that internal control is weak. In this case, auditors usually
ignore the test of controls and go directly to substantive tests (e.g. by performing more works).

Examples of the internal control procedures that can reduce the risk of material misstatement
for inventory may include:
 Regularly inventory count
 Properly inventory tagging
 Physical safeguard of inventory
 Inventory only be accessible to authorized personnel
 Proper authorization in inventory requisition and payment procedures
 Proper segregation of duties in inventory management, in which no single individual
handles all or most aspects of the inventory transaction including authorization,
preparation, and payment.
 Those who have physical access to inventory should not have access to the accounting
records, such as the inventory records, cost accounting records, or the general ledger.
 Those who work in the inventory department should not have the authority to request for
inventory items, etc.
 Source: https://accountinguide.com/risk-of-material-misstatement-for-inventory/
Internal Controls and Tests of Control

Examples of internal control procedures and test of control for inventory and production
cycle are as follows:
Internal Control
Assertions Test of control
Procedures
 Observe and
1. Existence  Proper segregation of evaluate proper
In the audit of inventory, duties and physical segregation of duties and
existence or occurrence assertion safeguards of inventory to test procedures for
tests whether the inventory on prevent fictitious transfer and issuing
balance sheet actual exists and inventory. inventory.
whether inventory transactions  Use prenumbered  Review authorized
actually took place. and/or properly approved production schedules
Example: test of existence in receiving reports and and test procedures for
physical inventory count materials requisitions for establishing inventory
procedure. inventory transfers levels and inventory
control.
2. Rights and Obligations
All inventory reported on
 Recorded inventory is  Check recorded
financial statements as at the
supported by suppliers’ inventory against
reporting date really belongs to
invoices and goods suppliers’ invoices and
the company.
received notes. goods received notes.
Example: test of rights and
obligations
3. Completeness  Purchase requisition,  Check sequential
Completeness assertion in the purchase order, receiving controls over purchase
audit of inventory tests whether report and vouchers are requisition, purchase
the entire inventory at year-end is prenumbered and order, receiving report and
included in the balance sheet and accounted for vouchers.
all purchases and sales of  Procedures to include  Test the control
inventory are recorded. One high goods out on consignment procedures for the
risk of inventory is that the and exclude goods led on consignment goods.
company bought the inventory but consignment.
the purchases were not recorded
into the inventory account. This
could be the result of intentional
fraud or unintentional error, in
which they both lead to an
understatement of inventory.
Example: test of completeness
 Check dates of
4. Cut-off receiving reports and
 All receiving reports
The assertion is that all delivery notes to dates to
and delivery notes should
transactions were recorded within record the inventory
be processed daily.
the correct reporting period. movements in perpetual
inventory records.
 Review of cost  Examine and test
5. Accuracy
accumulation, standard procedures for taking
The assertion is that the full
costs, and variance reports physical inventory,
amounts of all transactions were
by person of appropriate accumulating costs, and
recorded, without error.
level. developing standard cost.
6. Valuation and Allocation  Inventory management  Discuss with
Valuation assertion tests whether personnel review inventory management and test
the inventory figures in the for obsolete, slow-moving, procedures for
client’s account are correct and or excess quantities. identifying obsolete and
the evaluation method used by the  Periodic or annual slow-moving items.
client in determining the cost of comparison of goods on
various items for inventory hand with perpetual
valuation is appropriate. inventory record.
One important rule that always
applies to the inventory valuation
is that the value of the inventory is
measured at the lower of cost and
net realizable value. As the
auditors, we need to confirm that
the client correctly follows the
above rule or the misstatement
might occur.
More likely than not, the
overstatement statement tends to
happen in this case as the client
sometimes determines the value
by cost on all of the inventory
including obsolete inventory
which their net realizable value is
usually lower than the cost.
One more important aspect of the
inventory valuation is whether the
overhead allocation made by the
client is appropriate. We usually
meet this case when testing the
working-in-progress and finished
goods of the client’s
manufacturing products.
Example: test of valuation
 Check that the
7. Classification  Material requisitions
classification of inventory
The assertion is that all and production data used
is in compliance with
transactions have been recorded to classify inventory into
accounting standard and
within the correct accounts in the raw materials, WIP, and
company accounting
general ledger. finished goods.
policies.
 Review inventory
8. Presentation and Disclosure
 Inventory is properly items are properly
Inventory is properly classified
classified, disclosed and classified, disclosed and
and sufficiently disclosed in the
presented at fair value. presented at fair value in
notes to financial statements.
the financial statements.

Internal Control Affects the Level of Substantive Tests for Inventory

How internal control affects the level of substantive tests for inventory:
(a) If the auditor assesses the level of control risk to be at the maximum, the auditor may
carry out the substantive approach and rely on substantive tests only.
(b) On the other hand, if the auditor can rely on internal controls, he or she will carry out
tests of controls and consider the effects of the results on further substantive
procedures.
(c) If the results of the tests of controls support the assessed level of control risk, the auditor
can conduct substantive tests of inventory accounts at the planned level.
(d) However, if the auditor judges the control risk to be higher than expected, then he or she
will set the detection risk at a lower level and extend the substantive tests.

Source: Chapter12 Inventory Cycle (yolasite.com)