Special Note: Physical Inventory Observation

1. Special Note: Physical Inventory Observation Importance of Inventory • Major component of current assets on the balance sheet. • Significant effect on net income. • Valuation is usually very subjective. • Potential obsolescence • Goods have not been sold, so marketability may be uncertain.

2. Special Note: Physical Inventory Observation • AICPA Professional Standards specifically address the need to observe the client's inventory counting procedures: "it will always be necessary for the auditor to make, or observe, some physical counts of the inventory and apply appropriate tests of intervening transactions" (AU 331.12). • If the client is on a perpetual system, the auditor may make test counts at a time other than year-end. • If inventory is observed on a date other than fiscal year-end, the auditor must be able to rely on the client's internal controls in order to roll-forward (or back) inventory quantities to fiscal year-end balances.

3. Special Note: Physical Inventory Observation • If possible, try to stop flow of goods on inventory date • Make TEST COUNTS • From INVENTORY LISTING, choose sample of items to count (Existence) • From WAREHOUSE FLOOR, choose sample of items to count to TRACE to final INVENTORY LISTING (Completeness) • Record all counts in working papers

4. Special Note: Physical Inventory Observation • Use tags to indicate whether all items have been counted • Be wary of "Hollow squares" and "empty boxes” • Tour shipping and receiving areas • Watch for OBSOLETE and SLOW-MOVING inventory (Valuation) • Inventory on CONSIGNMENT and at other locations should be CONFIRMED (Rights and obligations) • For Specialty Inventory, consider the use of SPECIALISTS • Inventory in transit must be confirmed.

5. Inventory Cost Testing • Valuation (Price Tests) • VENDOR INVOICE or cost records (include cost of inventory, freight, and other costs) • Consider COST FLOW ASSUMPTION • Evaluate LOWER OF COST OR MARKET for inventory • Check Extensions and Footings of INVENTORY LISTING and agree to PERPETUAL INVENTORY RECORDS.

6. Purchase Cutoffs • Verify CUT-OFFs for purchases • Examine Receiving Reports and Vendor Sales Invoices occurring around year-end to ensure inventory received is included in the appropriate period.

7. Analytic Procedures • Verify REASONABLENESS of COGS • Calculate Gross Profit Margin • Compare to prior year, industry averages • Verify REASONABLENESS of ending inventory • Days Sales in Inventory - provides evidence concerning management's assertion about valuation. • Inventory Turnover - provides evidence concerning management's assertion about valuation.