Question

A company can choose to use a variety of inventory valuation methods under GAAP. Would the use of one certain method require more testing of controls than another method? Why or why not?

Answer 1

There are various inventory valuation methods like FIFO, LIFO, weighted average method, retail method, etc. The inventory method adopted by the company directly affects the net income presented and inventory values in Balance sheet. If these amounts are affected, the ratios calculated like, current ratio, total assets ratio, net profit ratio, etc. are affected. Overstatement of closing inventory results in higher net income, higher amount of assets. Understatement results in lower net income and lower amount of assets.

While conducting the audit, the basic checks that auditor should perform remain same irrespective of the method used by the management. The tests of controls to be performed by the auditor include verifying physical inventory, ascertaining the inventory valuation method, re-performing the valuation methodologies, assessing the suitability of method, comparison with peers, etc. If the company has changed its method of valuation, the auditor should ascertain the necessity and justifications for the same. Hence, irrespective of method used, tests of controls remain the same.

The auditor might modify some procedures to suit the new inventory method. However, overall, the tests of controls do not increase or decrease with the change of method.