Question

1. What are the risks that can arise in auditing inventory accounts?
2. State internal controls that can be applied by the company to prevent fraud that occurs in the company's inventory!
3. Make a case about inventory problems and how the audit procedures should be carried out on the case you made.

Answer 1

1. Answer

• Auditing inventory is the process of cross-checking financial records with physical inventory and records. It can be completed by auditors and other parties.
• An auditing inventory can be as simple as just taking a physical count of stock and inventory to match the records with physical stock.

Auditing Explained

• Auditing is the process of verifying that the financial records of an entity are accurate and fairly represented. Transactions in financial records must fairly represent the entity’s financial positioning and actual operating activities.

• Since financial documentation and records are produced internally, there is a high risk that records can be manipulated by inside parties. Insiders can make mistakes or intentionally alter information while preparing financial records, which is considered fraudulent behavior. Auditing ensures that these mistakes are prevented.

• Audits also ensure that entities are complying with relevant accounting standards such as the International Financial Reporting Standards (IFRS), Generally Accepted Accounting Principles (GAAP), and other relevant accounting standards.

Evidence in Auditing

• Evidence is needed to determine whether financial statements or records have been prepared in accordance with standards and free from material error. It is also required to promote the accuracy, transparency, and independence of audit reports.

• Evidence is required by auditors to verify the validity of financial records. It can either verify or provide support for the financial information that is presented. On the other hand, the evidence can contradict the financial information, which indicates errors or fraudulent behavior.

Importance of Auditing Inventory

• Observation of inventory is a generally accepted auditing procedure, where an independent auditor issues an opinion on whether the financial records of inventory accurately represent the actual inventory being carried.

• Auditing inventory is an important aspect of gathering evidence, especially for manufacturing or retail-based businesses. It can represent a large balance of assets or capital.

• Auditing inventory must verify not only the amount of inventory but also its quality and condition to see whether the value of the inventory is fairly represented in financial records and statements.

Auditing Inventory Procedures

• Some common auditing inventory procedures are:

1. ABC analysis

An ABC analysis includes grouping different value and volume inventory. For example, high-value inventory, mid-value, and low-value products can be grouped separately. The items can be tracked and stored in their separate value groups as well.

2. Analytical procedures

Analytical procedures include analyzing inventory based on financial metrics such as gross margins, days inventory on hand, inventory turnover ratio, and costs of inventory historically.

3. Cut-off analysis

The cut-off analysis includes pausing operations such as receiving and shipping of inventory while making a physical count to avoid mistakes.

4. Finished goods cost analysis

Finished goods cost analysis applies to manufacturers and includes valuing finished inventory during an accounting period.

5. Freight cost analysis

Freight cost analysis includes determining the shipping or freight costs for transporting inventory to different locations. Generally, freight costs are included in the value of inventory, so it is important to track the freight costs as well.

6. Matching

Matching involves matching the number of items and the cost of inventory shipped with financial records. Auditors may conduct matching to verify that the right amounts were charged at the right time.

7. Overhead analysis

Overhead analysis includes analyzing the indirect costs of the business and overhead costs that may be included in the costs of inventory. Rent, utilities, and other costs can be recorded as part of inventory costs in some cases.

8. Reconciliation

Reconciliation includes solving discrepancies that are found in an auditing inventory. Errors may be re-checked and reconciled on financial record.

3. Answer

What is an Inventory Audit?

Inventory Audit refers to the process of checking the inventory methods used by the company to record the inventory using the different analytical procedures to ensure that the proper record of the inventory is maintained in the book of accounts of the company and the same matches with the physical inventory count available.

Inventory Audit Example 1

• For example company, A ltd purchases the raw material from the vendor processes it and converts it into the finished goods. It appoints Mr. B to conduct the inventory audit.
• Mr. B, after getting appointed for conducting the inventory audit in the company A LTD. follows the different procedures to complete the audit. He performs the counting of the physical inventory where every piece of the inventory is counted. It is then matched and reconciled with the inventory count available in the books of accounts of the company, cut off analysis.
• Consistency of charging the freight cost in all the periods, either as the expense or include in the inventory cost. Conducting the direct labor cost analysis, conducting the overhead cost analysis, testing of the work in progress, conducting the analysis of the cost of the finished goods; inventory allowances in case of the obsolete inventory, testing that the inventory is valued as per the method required by the law, etc. It is an example of the inventory audit conducted in the company by the auditor appointed for that purpose.

2. Answer

• Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability, and prevent fraud. Besides complying with laws and regulations and preventing employees from stealing assets or committing fraud, internal controls can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.
• Inventory fraud is one such noncash scheme. It could be as minor as an employee stealing a bottle of soda off the line or as complex as a production manager selling company-owned raw materials to a third party. Unfortunately, the current COVID-19 situation could create new opportunities for inventory fraud. For instance, having fewer employees on-site is likely to reduce the level of oversight, which could make it easier for an employee to commit fraud. Also, remote work arrangements could disrupt processes and, ultimately, internal controls.
• Needless to say, inventory fraud could be devastating to your business, and now is not the time to let down your guard. Here are six ways to prevent it.

1. Practice proper segregation of duties.

• Segregation of duties is one of the most basic fraud-prevention measures you can take. Simply put, “segregation of duties” means you don’t allow one person to be involved in two processes that have a conflict of interest. For example, never put the same employee, no matter how trusted, in charge of both production and shipping.
• If you have employees working from home, however, your segregation of duties practices could become more complicated. Consider evaluating who’s working from home as well as their responsibilities, so you can ensure duties are properly segregated.
• A dispersed staff could also impact how assets, such as sensitive financial documents, travel through your organization. Some assets previously handed off in person must now be transferred electronically. What’s more, these assets may no longer have appropriate chronological documentation or a paper trail. Paying attention to an asset’s “chain of custody”—i.e., the people who have had ownership of an asset—is critical to prevent it from falling into the wrong hands.

2. Implement a formal management reporting process.

• A detailed management reporting package can serve as your canary in the coal mine. Regularly reviewing these with your key managers and department heads can help you spot fraud in its earliest stages.
• Ideally, your management reports should clearly show your company’s key performance indicators (KPIs), which are numeric measures of performance that correlate with your key business objectives. This level of detail allows you to more easily pick out anomalies and variances. It also gives you the opportunity to ask questions if needed. The more light you can shed on the nuances of your operations, the better.

3. Incorporate the element of surprise.

• Incorporating the element of surprise into your internal controls creates a threat of detection—an excellent fraud deterrent. For instance, consider conducting surprise stock counts or doing an unannounced shipping audit. If employees know you could show up at any minute, they will be less likely to engage in fraudulent behavior. What’s more, if fraud were to be in progress, your surprise action could potentially detect it.

4. Automate your processes.

• Eliminating opportunities for product to be manually adjusted can reduce opportunities for fraud. Unfortunately, automating a process is easier said than done. If you’re unable to purchase and/or implement an automated system, consider looking into the capabilities of your current system(s). Could it be doing more for you, or have you outgrown it?

5. Conduct a production yield analysis.

• As I’ve said before, data analytics is a powerful tool for detecting and preventing fraud. Analyzing your production yield—that is, your actual output versus a standard output calculated from standard inputs of materials and labor—can help you see if a discrepancy exists between the two. If it does, and you don’t have an explanation for the variance, it may be worth further investigation.

6. Pay special attention to bill and hold arrangements.

• These types of arrangements, in which a company recognizes revenue prior to the delivery of purchased goods, can be easily abused by fraudsters. If you use bill and hold transactions, it’s important to be diligent about the accounting involved, especially given the current economic climate. It’s likely you could end up holding onto inventory items longer than expected.
• Don’t let inventory fraud impact your business.

In a real figure

• One final thought: The 2020 ACFE report I referenced above found that noncash fraud schemes last, on average, for 13 months. This is plenty of time for a fraudster to cause lasting damage—and a good reason to start implementing these six fraud prevention practices as soon as possible. The sooner you can detect fraud, the better. If you’d like to explore your options for preventing and detecting inventory fraud in your business, contact us today.

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