The audit of a manufacturer is nearly identical to the audit of any other enterprise, except for the additional procedures around the company's inventory balances. Auditors need to obtain reasonable assurance that a company’s financial statements are free of material misstatement if caused by error or fraud. The auditors design specific procedures to test inventory balances for manufacturers.
Manufacturing companies face a wide range of dangerous situation which can result in serious injury to employees and significant financial liability to the company. By understanding some of the common procedures will help manufacturers for the audit.
Inventory Observation – Auditors are required to accept auditing standards to physically observe the company’s inventory count procedures and make their own independent tests of the physical count of inventory. The requirement is in response to the multitude of accounting frauds that perpetuates through false entry of inventory records. When the inventory count is tested by the auditor they will make use of a technique known as “Floor-to-sheet” and “sheet-to-floor.” When the auditor select items from the inventory warehouse and makes sure to include it on the count sheet it is known as floor-to-sheet. This shows that the count sheet is completed. The auditor then selects the items from the count sheets and checks that they are available in the warehouse and this enables the existence of inventory.
Price Testing – The Company’s financial statements depend on the inventory balance and are a function of the quantity of inventory on hand and the value of the inventory. The quantity is known by the inventory observation tests and the cost of the inventory is depended on price testing tests. The accounting standards require that inventory is held in the financial statements at low cost or market price. The verification of price testing is done by the cost that the company paid for the materials, labor and overhead that goes into the production inventory. The auditor will prefer items from the company’s inventory on a test basis to perform price testing. This is verified through the analysis of original documentation like invoices and time cards, that the inventory’s cost is carried out exactly as per the company’s financial records.
Control Testing – When auditing a manufacturer, the auditor will test the internal controls around the inventory cycle. The extent of control testing depends on the materiality of the inventory balance, the auditor wishes to rely on controls to reduce audit testing and various other risk factors involved in the cycle. As per the auditing standards it is needed that the auditors should have basic understanding of the internal controls in relation to the inventory accounting system. This knowledge should be used to plan and perform the audit.
Inventory Reserve Testing – Inventory reserve testing can be an important part of the manufacturer’s audit for companies that hold inventory that may spoil. Due to low cost or market assumption that the accounting principles prescribe, testing must be conducted to ensure that the market value of the inventory does not increase the cost verified during price testing. The risk of obsolete inventory will be assessed by auditors while testing of internal controls. Besides an inventory count observation, the spoiled food or boxes of dust may cause auditors to check the area more sharply and cleanly.
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