Inventory is often the largest asset on a manufacturer's or distributor's balance sheet. It is counted by the client, priced by the client and reserved by the client, so the auditor needs evidence over each of those steps. The physical count is the foundation, and GAAS expects the auditor to be there.
This guide covers AU-C 501, Audit Evidence: Specific Considerations for Selected Items, as it applies to inventory, along with test counts, cutoff, interim counts, third-party inventory, pricing and the inventory reserve under ASC 330. It paraphrases the standards, which are in AICPA Professional Standards and the FASB Codification.
What AU-C 501 requires for inventory
When inventory is material to the financial statements, AU-C 501 requires the auditor to obtain sufficient appropriate evidence about its existence and condition by attending the physical inventory count, unless attendance is impracticable, and by performing audit procedures on the entity's final inventory records to determine whether they accurately reflect actual count results.
Attendance at the count has four parts:
- Evaluate management's instructions and procedures for recording and controlling the count.
- Observe the performance of management's count procedures.
- Inspect the inventory.
- Perform test counts.
If the count happens at a date other than the financial statement date, the auditor also performs procedures to obtain evidence about whether changes between the count date and year end are properly recorded.
Before the count: planning the observation
Plan the observation before the count date.
- Get the count instructions early and review them. Look for clear count teams, tag or sheet control, treatment of damaged and slow-moving goods, cutoff procedures, and a freeze on movement during the count or controlled movement if operations continue.
- Understand the locations. List every site with inventory, including warehouses, consigned goods at customers and goods held by third parties. Decide which locations to attend based on materiality and risk.
- Understand the inventory. Know what the products look like, how they are measured and whether specialized knowledge is needed (for example, grain, chemicals, precious metals or work in process). AU-C 620 applies if the auditor uses an auditor's specialist.
- Pull prior-year results and any count issues noted last year.
- Prepare cutoff requests. Plan to record the last receiving and shipping document numbers.
During the count: what the observer does
Evaluate and observe
Walk the floor before counting starts. Check that areas are organized, that counted items are marked, that goods not owned (consigned in, customer-owned) are segregated, and that obsolete or damaged items are identified. During the count, watch whether count teams follow the instructions: two-person teams, blind counts where used, tags controlled, recounts of discrepancies.
Inspect
Look at the condition of inventory. Dust, damage, expired dates and old packaging are evidence for the obsolescence reserve as much as for existence. Note specific items and quantities so you can follow them into the reserve analysis later.
Test counts
Test counts work in two directions, matching the assertions they address:
| Direction | What you do | Assertion |
|---|---|---|
| Floor to sheet | Select items on the floor, count them, and agree to the count tag or sheet | Completeness |
| Sheet to floor | Select items from the count sheets or tags, find them, and count them | Existence |
Select test counts with a bias toward high-value items, items that are hard to count and locations with weaker controls. Record each test count with enough detail to trace it to the final inventory listing later: tag number, item number, description, location, unit of measure and quantity.
Tag and sheet control
Record the range of tags or count sheets used, voided and unused. That record lets you confirm later that the final listing includes every tag issued and nothing was added after the count.
Cutoff information
Record the last receiving report and last shipping document before the count, and the first after. Note goods on the dock and whether they were counted. This is the information needed to test that purchases and sales are recorded in the same period as the inventory movement.
After the count: testing the final inventory records
Attendance is only half the requirement. The auditor must determine that the final priced inventory listing reflects the count results.
- Trace test counts to the final listing and agree quantities.
- Check tag control: all used tags are included, voided and unused tags are excluded, and no tags appear that were not issued.
- Agree the listing total to the general ledger.
- Test pricing (below).
- Test cutoff using the documents recorded at the count.
- Investigate book-to-physical adjustments. A large adjustment from the perpetual records to the count is both a misstatement risk and a control signal.
Counts at a date other than year end
Many clients count before year end, or use cycle counting through the year. AU-C 501 allows this, but the auditor needs evidence about the intervening period. Typical procedures:
- Evaluate controls over inventory movements between the count date and year end.
- Roll forward from the count date to year end: count quantity plus purchases less cost of sales, and compare with the year-end balance.
- Perform analytics on gross margin and inventory levels for the rollforward period.
- For cycle counts, understand the program, test that it covers all items over the year, review the results and observe cycle counts on a test basis.
The longer the gap, and the weaker the controls, the less a rollforward is worth.
When attendance is impracticable
If attending the count is impracticable, for example because of the nature or location of the inventory, AU-C 501 requires the auditor to perform alternative procedures to obtain evidence about existence and condition. If that is not possible, the auditor modifies the opinion under AU-C 705. Inconvenience is not impracticability.
A common case is a first-year audit where the auditor was engaged after the prior year-end count. Evidence over opening inventory then comes from procedures under AU-C 510, such as reviewing the predecessor's workpapers, testing subsequent transactions and gross profit analysis. If that evidence is not sufficient, the opinion on the income statement may need to be modified.
Inventory held by third parties
When inventory under the custody and control of a third party is material, AU-C 501 requires the auditor to obtain evidence about its existence and condition by one or both of:
- requesting confirmation from the third party of the quantities and condition held on the entity's behalf, and
- performing inspection or other audit procedures appropriate in the circumstances.
Other procedures can include attending the third party's count, obtaining a service auditor's report on the warehouse's controls, or inspecting warehouse receipts. See audit confirmations under AU-C 505 for how to run the confirmation itself.
Testing inventory pricing
Pricing tests address valuation. The approach depends on the cost method:
- Purchased goods: agree unit costs to recent vendor invoices, considering the cost flow assumption (FIFO, weighted average, specific identification, LIFO).
- Manufactured goods: test the standard cost buildup for materials, labor and overhead, compare standards to actual costs, and review the treatment of variances. Under ASC 330, fixed production overhead is allocated based on normal capacity, and abnormal costs such as idle facility expense are expensed, not capitalized.
- Recalculation: recalculate extended values (quantity times unit cost) for a sample and foot the listing.
The inventory reserve
Measurement rules under ASC 330
US GAAP has two subsequent measurement models, depending on the cost method:
| Cost method | Measurement |
|---|---|
| FIFO, average cost and other methods except LIFO and retail | Lower of cost and net realizable value (NRV), as amended by ASU 2015-11 |
| LIFO or the retail inventory method | Lower of cost or market |
NRV is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation.
Under US GAAP, a write-down of inventory establishes a new cost basis. It is not reversed in a later annual period if the value recovers, which differs from IFRS. (Interim reporting under ASC 270 has a narrow exception for recoveries within the same fiscal year.) Many clients still call the write-down an "inventory reserve" or "obsolescence reserve," and track it as a contra account, but the accounting effect is a reduced carrying amount.
Auditing the reserve
The reserve is an accounting estimate, so AU-C 540 applies: understand the method, test the data, evaluate the assumptions and consider management bias. Common procedures:
- Understand the method. Many clients use an aged or slow-moving analysis (for example, items with no sales in a set number of months reserved at a set percentage) plus specific reserves for known problems.
- Test the data. Test the aging or last-sale dates in the inventory system, because a reserve built on wrong dates is wrong regardless of the percentages.
- Compare to what you saw at the count. Damaged or obsolete items noted during the observation should be reserved or written off.
- Test NRV. Compare carrying cost to selling prices after year end for a sample of items, less selling costs. Items selling below cost need a write-down.
- Look back. Compare last year's reserve to what actually happened (write-offs, sales below cost). A retrospective review is one of the clearest ways to assess management bias.
- Check consistency. A reserve percentage that falls in a year when earnings are under pressure deserves a question.
Worked example: NRV test (illustrative)
An illustrative distributor carries Product X at a FIFO cost of $48 per unit, 2,000 units, $96,000 total. After year end, the client sold units at $52, with sales commissions and freight of $7 per unit.
- NRV = $52 − $7 = $45 per unit
- Write-down = ($48 − $45) × 2,000 = $6,000
If the client has not recorded it, the $6,000 is a misstatement to evaluate under AU-C 450. If the sale price evidence covers only part of the quantity, consider whether the remaining units face the same conditions.
Inventory cutoff
Cutoff errors move inventory, cost of sales and revenue between periods. Using the document numbers recorded at the count, test receipts and shipments on either side of the count date and year end:
- Goods received before year end should be in inventory with a recorded payable.
- Goods shipped before year end should be out of inventory, with revenue and cost of sales recorded if control transferred under ASC 606.
- Review shipping terms, because the point of transfer can differ from the physical movement.
Also consider goods in transit, consigned goods (in and out) and bill-and-hold arrangements.
Documenting inventory work
Under AU-C 230, the file should include the count instructions and the auditor's evaluation, an observation memo describing what was observed at each location, test count details, tag control records, cutoff information, the tie of test counts and tags to the final listing, pricing tests, the reserve evaluation and the conclusion. Sample sizes for pricing tests can be planned with AU-C 530 and the audit sample size calculator. The financial ratio calculator helps with inventory turnover and days inventory analytics.
Frequently asked questions
Is the auditor required to observe the physical inventory count?
When inventory is material, AU-C 501 requires the auditor to attend the count unless attendance is impracticable. If it is impracticable, the auditor performs alternative procedures, and if those cannot provide sufficient evidence, the opinion is modified.
What is the difference between floor-to-sheet and sheet-to-floor test counts?
Floor-to-sheet counts start with items on the floor and agree them to the count records, testing completeness. Sheet-to-floor counts start with the count records and find the items, testing existence.
Can a client count inventory before year end?
Yes. The auditor then performs procedures over the period between the count and year end, such as a rollforward of quantities and analytics, and evaluates controls over inventory movements in that period.
Is lower of cost and net realizable value used for all inventory?
No. Lower of cost and net realizable value applies to inventory measured using FIFO, average cost and similar methods. Inventory measured using LIFO or the retail method continues to use lower of cost or market.
Can an inventory write-down be reversed under US GAAP?
No. A write-down establishes a new cost basis that is not written back up if values recover. This is a difference from IFRS, which permits reversal in some cases.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- AICPA, AU-C Section 501, Audit Evidence: Specific Considerations for Selected Items (inventory attendance, alternative procedures, third-party custody)
- AICPA, AU-C Section 510, Opening Balances: Initial Audit Engagements; AU-C Section 540, Auditing Accounting Estimates; AU-C Section 705; AU-C Section 620; AU-C Section 230
- FASB ASC 330-10 (Inventory, Overall); FASB ASU 2015-11; ASC 270-10 (interim reporting)
- FASB ASC 606 (control transfer for cutoff)
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error