Question

Q3. Explain the importance of observing physical inventory during an audit.

Answer 1

Inventory is a current asset of the business held for sale as part of it's normal course of business. For example, in a furniture store, furniture is the inventory. One of the primary objective behind verifying inventory during audit is to confirm the assertions made by management regarding it's ownership, existence, valuation, accuracy, classification and disclosures.

In these parameters, existence and valuation are two highly challenging aspects that often become the auditor's burden. The generally accepted accounting principles requires inventory to be valued at lower of cost or net realisable value. And when it comes to existence, it needs to be observed and confirmed that the inventory as revealed by the accounting records of an organisation is actually in place.

It is quite normal that an auditor obtaining written confirmations from management about the valuation of inventory. But this doesn't relieve the auditor from his responsibility of verifying and thereby obtaining sufficient and appropriate audit evidence. Moreover, if the value of inventory is material or if there is a significant variation from the previous year figures, the auditor can't take shelter under the reasons of time and cost for not physically verifying them. Reliable and first hand evidence regarding inventory is only possible through physical verification. The auditor may seek the help of an expert or other technologies for the same, but the point here to note is the process should be under his strict supervision.

Physical verification helps to ascertain the true value and existence of inventory, thereby helps to form conclusions on which his audit opinion can be framed.