Inventory: observation, test counts, costing and NRV

• Apply the AU-C 501.12 requirements for attending the physical count
• Perform test counts from floor to sheet and sheet to floor
• Roll counts forward under AU-C 501.13 and handle inventory held by third parties
• Test costing and the lower of cost and net realizable value under ASC 330

The observation requirement

AU-C 501.12 says that if inventory is material, the auditor should obtain sufficient appropriate evidence about its existence and condition by attending the physical count, unless impracticable, to evaluate management's count instructions, observe the count, inspect the inventory and perform test counts. The auditor also performs procedures over the final inventory records to determine whether they reflect the actual count results.

Related paragraphs fill the gaps:

• AU-C 501.13: if the count is at a date other than period-end, perform procedures on changes between the count date and period-end.
• AU-C 501.14: if you cannot attend because of unforeseen circumstances, make or observe some counts on an alternative date and test intervening transactions.
• AU-C 501.15: if attendance is impracticable, perform alternative procedures; if that is not possible, modify the opinion under AU-C 705.
• AU-C 501.16: for material inventory held by a third party, request confirmation of quantities and condition, perform inspection or other procedures, or both.

"Impracticable" is narrow. Inconvenience or cost is not impracticability.

At the count

Read the count instructions before the day. Look for tag or sheet control, how damaged or slow-moving goods are flagged, cutoff of receiving and shipping, and whether counters are independent of the custodians.

On the floor:

• Floor to sheet tests completeness: count items you pick and confirm they are on the count records.
• Sheet to floor tests existence: pick recorded items and count them.
• Record your test counts with location and tag number so you can trace them to the final listing later.
• Note the last receiving report and shipping document numbers for cutoff.
• Look at condition. Dust, damage and obsolete packaging bear on valuation.
• Record the tag range used and unused, so tags cannot be added later.

After the count, trace your test counts and the cutoff documents into the final priced listing. Many files stop at the observation memo and never do this step, which AU-C 501.12b requires.

Count before year-end

When the count is at an interim date, roll the quantities or values forward: count date balance plus purchases, less cost of sales, to period-end. Test the rollforward activity, compare gross margin for the gap period with the rest of the year, and review cutoff at both dates. The interim count rollforward guide gives the layout.

Costing and valuation

Existence is half of it. ASC 330 measures inventory at the lower of cost and net realizable value for most cost methods, including FIFO and average cost. Inventory measured using LIFO or the retail inventory method stays at lower of cost or market.

Price testing:

1. Agree unit costs for a sample to vendor invoices, using the invoices consistent with the cost flow method.
2. For manufacturers, test the build-up of material, labor and overhead, and confirm overhead is allocated on normal capacity.
3. Test NRV: compare cost with selling prices after year-end, less costs to complete and sell. Focus on slow-moving items.
4. Recalculate the obsolescence reserve and compare last year's reserve with what actually happened.

Use the inventory price testing guide and the lower of cost or NRV test.

Common file findings

• Observation memo with no test counts traced to the final listing.
• Inventory at a third-party warehouse with no confirmation or inspection.
• No rollforward when the count was weeks before year-end.
• Price testing against the most recent invoice when the client uses average cost.

Test counts and NRV at Bluewater Marine Parts, Inc.