Application and Other Explanatory Material
Attendance at Physical Inventory Counting (Ref: Para. 4(a))
A1. Management ordinarily establishes procedures under which inventory is physically counted at least once a year to serve as a basis for the preparation of the financial statements and, if applicable, to ascertain the reliability of the entity’s perpetual inventory system.
A2. Attendance at physical inventory counting involves:
Inspecting the inventory to ascertain its existence and evaluate its
condition, and performing test counts;
Observing compliance with management’s instructions and the
performance of procedures for recording and controlling the results of the physical inventory count; and
Obtaining audit evidence as to the reliability of management’s count
procedures. These procedures may serve as test of controls or substantive procedures depending on the auditor’s risk assessment, planned approach and the specific procedures carried out.
A3. Matters relevant in planning attendance at physical inventory counting (or in designing and performing audit procedures pursuant to paragraphs 4-8 of this SA) include, for example: Nature of inventory. Stages of completion of work in progress. The risks of material misstatement related to inventory. The nature of the internal control related to inventory.
Whether adequate procedures are expected to be established and proper
instructions issued for physical inventory counting. The timing of physical inventory counting. Whether the entity maintains a perpetual inventory system. The locations at which inventory is held, including the materiality of the inventory and the risks of material misstatement at different locations, in deciding at which locations attendance is appropriate. SA 600, “Using the Work of Another Auditor” deals with the involvement of other auditors and accordingly may be relevant if such involvement is with regards to attendance of physical inventory counting at a remote location. Whether the assistance of an auditor’s expert is needed. SA 6204 deals with the use of an auditor’s expert to assist the auditor to obtain sufficient appropriate audit evidence.
Evaluate Management’s Instructions and Procedures (Ref: Para. 4(a)(i))
A4. Matters relevant in evaluating management’s instructions and procedures for recording and controlling the physical inventory counting include whether they address, for example: The application of appropriate control activities, for example, collection of used physical inventory count records, accounting for unused physical inventory count records, and count and re-count procedures. The accurate identification of the stage of completion of work in progress, of slow moving, obsolete or damaged items and of inventory owned by a third party, for example, on consignment. The procedures used to estimate physical quantities, where applicable, such as may be needed in estimating the physical quantity of a coal pile. Control over the movement of inventory between areas and the shipping and receipt of inventory before and after the cut off date. Observe the Performance of Management’s Count Procedures (Ref: Para. 4(a)(ii))
A5. Observing the performance of management’s count procedures, for example those relating to control over the movement of inventory before, during and after the count, assists the auditor in obtaining audit evidence that management’s instructions and count procedures are adequately designed and implemented. In addition, the auditor may obtain copies of cut off information, 4 SA 620, “Using the Work of an Auditor’s Expert”. such as details of the movement of inventory, to assist the auditor in performing audit procedures over the accounting for such movements at a later date.
Inspect the Inventory (Ref: Para. 4(a)(iii))
A6. Inspecting inventory when attending physical inventory counting assists the auditor in ascertaining the existence of the inventory (though not necessarily its ownership), and in identifying, for example, obsolete, damaged or ageing inventory.
Perform Test Counts (Ref: Para. 4(a)(iv))
A7. Performing test counts, for example by tracing items selected from management’s count records to the physical inventory and tracing items selected from the physical inventory to management’s count records, provides audit evidence about the completeness and the accuracy of those records.
A8. In addition to recording the auditor’s test counts, obtaining copies of management’s completed physical inventory count records assists the auditor in performing subsequent audit procedures to determine whether the entity’s final inventory records accurately reflect actual inventory count results. Physical Inventory Counting Conducted Other than At the Date of the
Financial Statements (Ref: Para. 5)
A9. For practical reasons, the physical inventory counting may be conducted at a date, or dates, other than the date of the financial statements. This may be done irrespective of whether management determines inventory quantities by an annual physical inventory counting or maintains a perpetual inventory system. In either case, the effectiveness of the design, implementation and maintenance of controls over changes in inventory determines whether the conduct of physical inventory counting at a date, or dates, other than the date of the financial statements is appropriate for audit purposes. SA 330 establishes requirements and provides guidance on substantive procedures performed at an interim date5.
A10. Where a perpetual inventory system is maintained, management may perform physical counts or other tests to ascertain the reliability of inventory quantity information included in the entity’s perpetual inventory records. In some cases, management or the auditor may identify differences between the perpetual inventory records and actual physical inventory quantities on hand; this may indicate that the controls over changes in inventory are not operating effectively.
A11. Relevant matters for consideration when designing audit procedures to obtain audit evidence about whether changes in inventory amounts between the 5 SA 330, paragraphs 22-23. count date, or dates, and the final inventory records are properly recorded include: Whether the perpetual inventory records are properly adjusted. Reliability of the entity’s perpetual inventory records. Reasons for significant differences between the information obtained during the physical count and the perpetual inventory records. Attendance at Physical Inventory Counting Is Impracticable (Ref: Para. 7)
A12. In some cases, attendance at physical inventory counting may be impracticable. This may be due to factors such as the nature and location of the inventory, for example, where inventory is held in a location that may pose threats to the safety of the auditor. The matter of general inconvenience to the auditor, however, is not sufficient to support a decision by the auditor that attendance is impracticable. Further, as explained in SA 2006, the matter of difficulty, time, or cost involved is not in itself a valid basis for the auditor to omit an audit procedure for which there is no alternative or to be satisfied with audit evidence that is less than persuasive.
A13. In some cases where attendance is impracticable, alternative audit procedures, for example inspection of documentation of the subsequent sale of specific inventory items acquired or purchased prior to the physical inventory counting, may provide sufficient appropriate audit evidence about the existence and condition of inventory.
A14. In other cases, however, it may not be possible to obtain sufficient appropriate audit evidence regarding the existence and condition of inventory by performing alternative audit procedures. In such cases, SA 705(Revised) requires the auditor to modify the opinion in the auditor’s report as a result of the scope limitation7.
Inventory under the Custody and Control of a Third Party
Confirmation (Ref: Para. 8(a))
A15. SA 5058 establishes requirements and provides guidance for performing external confirmation procedures.
Other Audit Procedures (Ref: Para. 8(b))
A16. Depending on the circumstances, for example where information is obtained that raises doubt about the integrity and objectivity of the third party, the 6 SA 200, “Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Standards on Auditing”, paragraph A48. 7 SA 705(Revised), paragraph 13. 8 SA 505, “External Confirmations”. auditor may consider it appropriate to perform other audit procedures instead of, or in addition to, confirmation with the third party. Examples of other audit procedures include: Attending, or arranging for another auditor to attend, the third party’s physical counting of inventory, if practicable. Obtaining another auditor’s report, or a service auditor’s report, on the adequacy of the third party’s internal control for ensuring that inventory is properly counted and adequately safeguarded. Inspecting documentation regarding inventory held by third parties, for example, warehouse receipts.
Requesting confirmation from other parties when inventory has been
Completeness of Litigations and Claims (Ref: Para. 9)
A17. Litigation and claims involving the entity may have a material effect on the financial statements and thus may be required to be disclosed or accounted for in the financial statements.
A18. In addition to the procedures identified in paragraph 9, other relevant procedures include, for example, using information obtained through risk assessment procedures carried out as part of obtaining an understanding of the entity and its environment to assist the auditor to become aware of litigation and claims involving the entity.
A19. Audit evidence obtained for purposes of identifying litigation and claims that may give rise to a risk of material misstatement also may provide audit evidence regarding other relevant considerations, such as valuation or measurement, regarding litigation and claims. SA 5409 establishes requirements and provides guidance relevant to the auditor’s consideration of litigation and claims requiring accounting estimates or related disclosures in the financial statements.
Reviewing Legal Expense Accounts (Ref: Para. 9(c))
A20. Depending on the circumstances, the auditor may judge it appropriate to examine related source documents, such as invoices for legal expenses, as part of the auditor’s review of legal expense accounts. 9 SA 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures”. Communication with the Entity’s External Legal Counsel (Ref: Para. 10-11)
A21. Direct communication with the entity’s external legal counsel assists the auditor in obtaining sufficient appropriate audit evidence as to whether potentially material litigation and claims are known and management’s estimates of the financial implications, including costs, are reasonable.
A22. In some cases, the auditor may seek direct communication with the entity’s external legal counsel through a letter of general inquiry. For this purpose, a letter of general inquiry requests the entity’s external legal counsel to inform the auditor of any litigation and claims that the counsel is aware of, together with an assessment of the outcome of the litigation and claims, and an estimate of the financial implications, including costs involved.
A23. If it is considered unlikely that the entity’s external legal counsel will respond appropriately to a letter of general inquiry, for example if the professional body to which the external legal counsel belongs prohibits response to such a letter, the auditor may seek direct communication through a letter of specific inquiry. For this purpose, a letter of specific inquiry includes:
