Is a detailed perpetual inventory master file maintained for raw materials inventory

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The COVID-19 outbreak has resulted in the introduction of exceptional measures including the mandatory closure of many businesses and restrictions of movement in countries around the world, including the UK.

COVID-19 may have made attending inventory counts impractical or difficult for auditors in many jurisdictions, including the UK, due to government restrictions and concerns about the safety of staff. Some inventory counts have been delayed or cancelled. In 2021, some auditors may be facing their second year of alternative audit procedures. 

ISA 501 requires auditors to attend inventory counts where inventory is material, unless impractical, to provide audit evidence relating to existence and condition. Alternative procedures are otherwise required, and where a count is conducted at a date other than the year end, additional procedures are required to cover the intervening period. 

The FRC has issued a December 2020 COVID-19 specific bulletin for auditors which discusses alternative procedures, such as gathering evidence through remote means. It notes that in some cases, verification through other means than physical verification may be appropriate, although materiality should be considered. 

Even when inventory counts are performed by management, auditors may not be able, willing or permitted to attend. In these situations, auditors should seek to perform alternative audit procedures. If this is not possible, there may be no alternative to a limitation of scope in the audit opinion.

In some cases, a disclaimer of the audit opinion may be necessary if impact is both material and pervasive. We would expect qualifications arising from a limitation of scope of the audit to be more likely to be issued than disclaimers of opinion, which are relatively rarely issued.

This guide explores these issues further, as well as answers some of common questions raised by auditors in the UK and elsewhere on alternative audit procedures to testing inventory.

Common questions

Management has cancelled the inventory count and intends to use a book value or estimate instead. What should I do?

If management has cancelled the inventory count, you should consider the impact on your risk assessment, your audit approach, and the balance of substantive procedures and tests of controls. The inventory count represents an important control in many cases. The risk of theft remaining undetected, for example, might increase in such cases. All of the alternative procedures set out elsewhere in this document may be considered in such cases. Enhanced basic procedures such as analytical procedures and testing after the year end may also be appropriate, but it may be difficult to obtain sufficient appropriate audit evidence relating to the existence and condition of inventory at the balance sheet date.

This is the second year the inventory count has required alternative procedures, what should I do?

Some businesses had to delay or undertake alternative procedures for inventory counts in 2020. For some, 2021 represents the second year of modified procedures for inventory counts. In these cases, it may be helpful to consider the following questions:

• What was your audit opinion last year? If you were able to obtain sufficient, appropriate audit evidence last year, consider whether any circumstances have changed in the past year that may impact you this year.
• If you were unable to obtain sufficient, appropriate audit evidence last year, consider the impact on opening balances, and whether there may need to be a restatement in the accounts.
• Where your opinion was modified previously, what will you be able to do differently this year?
• Are there any lessons to take from other audits and/or different procedures that can be implemented? Have you been able to do any interim work?
• Has management potentially installed additional inventory controls and/or inventory management and monitoring systems?

Where possible, it will be helpful to engage early with management to discuss potential problem areas, as well as alternative procedures.

Can management change the entity's year end to move their inventory count?

There is no reason in principle why a year end should not be changed to facilitate an inventory count, but changing a year end often has tax, filing and other implications, which management should consider. Furthermore, as with delays to inventory counts, it is possible that conditions may worsen or remain the same, which could limit any benefit, although a longer delay may increase the possibility that conditions may improve.

There may be restrictions to changing your year end and/or or eligibility requirements which may need to be met. In the UK, you should be aware of restrictions in lengthening your accounting period if you have done so before in the past five years. Entities are permitted to shorten accounting periods in the UK as many times as desired.  

I don't feel comfortable sending my staff to do an inventory audit, given the risk to their health. Should I suggest that management delays the inventory count for a number of months?

Auditors should review government health guidelines and any restrictions in the applicable jurisdiction prior to any inventory audit. When social distancing guidelines and/or lockdown restrictions apply, you may need to consider cancelling or delaying attendance at inventory counts to safeguard the wellbeing of your staff, the staff of the reporting entity and others.

Any audit work should take into account social distancing advice. If management intends to conduct an inventory count, it will be helpful to consider if they will take any alternative procedures, either due to local requirements or by choice, and whether these procedures are likely to be effective.

Conditions can and have changed rapidly around the world, with outbreaks often occurring in waves. Restrictions have fluctuated accordingly. If conditions worsen, or restrictions remain in place, delaying inventory counts may not improve the ability of management or auditors to perform appropriate procedures. You may need to ultimately limit the scope of your audit opinion in any case.

If management does decide to perform a count after the year end, and you are able, willing and permitted to attend, you may be able to perform roll-back testing procedures after the year end. This would involve auditing management’s reconciliation of the inventory counted with the year end inventory. A long time lag may provide the opportunity for conditions to improve, but the longer the delay, the less likely it is that a reconciliation will be possible. This however, will depend on the extent of inventory movements, which may be limited due to restrictions or reduced trading in certain industries.

You should consider whether inventory will be accessible during the intervening period, i.e. whether warehouses and other relevant premises are likely to remain open. You should plan how you will reconcile movements in the light of the accounting system, type of inventory and volume of transactions, and how you will assess the condition of inventory at the year end, which will depend on the typical life of the inventory. You may need to consider how often inventory turns over - a high volume of transactions may make a roll-back difficult and the reconciliation may be more complicated for manufacturers with raw materials and WIP, as well as finished goods.

The number of Covid-19 infections is currently quite low in my country – should I suggest that management counts inventory prior to the year end to avoid future restrictions?

In jurisdictions where the spread of the virus is at present more limited and there are no significant restrictions on movement, management might arrange for a count to be performed before the year end. You may then be able to perform testing procedures afterwards and audit the intervening period, reconciling the inventory counted with the year end inventory (i.e. a roll-forward).

As with a roll-back, you will need to consider how the accounting system records movements in inventory, management's reconciliation of the intervening period, the speed of inventory turnover and how you will assess the condition of the inventory at the year end.

You should also consider whether it is safe for your staff to attend, despite the lack of formal restrictions on movement. Consider whether the visit can be conducted in such a way as to protect your staff, and the company's staff.

Management has closed its warehouse over the year end; what issues should I consider when it reopens?

If the warehouse was closed prior to the year end and remained closed over that year end, management might decide to perform a physical inventory count before trading begins.

The extent to which this provides sufficient appropriate audit evidence relating to inventory held at the year end depends on whether, for example, evidence exists to demonstrate that no inventory has been removed or added over the period. This would include physical controls, such as security systems to prevent theft of inventory, and CCTV footage. 

As with a roll-back or roll-forward, evidence will be needed relating to the condition of the inventory at the year end.

As with a roll-back or roll-forward, it may not be possible to obtain sufficient appropriate audit evidence in these cases.

Management only performs inventory counts once a year, but has asked me not to attend due to safety concerns for their employees. What should I do?

If management does not wish you to attend, you should not insist on attending, and management might want to consider counting at a later date in such cases and performing a roll-back.

Arranging to visit the site to conduct your tests when the relevant premises are closed and no staff are present will not provide audit evidence relating to inventory counting procedures, and the substantive evidence based on sampling procedures it would provide relating to the existence and condition of inventory would be very limited. You may need to limit the scope of your audit opinion in such cases.

Can I use technology, such as video conferencing or use of robotics, to attend the inventory count remotely?

New technology, such as drones or remotely controlled robotics, might help with your inventory testing in some cases, but you should consider legal restrictions on the use of such technology in close proximity to people. If you do decide to use such technology, you should consider the following limitations:

• Who will be controlling the device(s), and how and where are the cameras directed? If you are not in control, there is a risk that the video footage may be manipulated.
• How will you obtain evidence regarding completeness? Do cameras allow you to see all of the inventory at any point in time? There is a risk that things are hidden out of frame or that items are moved in and out of frame.
• Can the condition of the inventory be assessed? If videos lack resolution, you may not be able to see indications of damage. Video footage may not be appropriate for assessing the condition of all inventory.
• How will you select samples for testing, and will you increase their size to reflect the increased risk? If communicated prior to the count, this could allow for manipulation. Unpredictability, and only selecting on the call items to be counted, from both floor to sheet, and sheet to floor, will help to reduce this risk.
• Do you need to adjust your sample sizes, given these issues?
• How experienced are your staff who are involved with the count? Given the technology limitations, you will likely want to use staff with prior experience of inventory counts. You may also find it helpful to have more than one member of staff involved or to take recordings which can be reviewed by multiple members of the team.

Depending on the nature of the inventory, virtual reviews may be inappropriate or unreliable. If alternative procedures cannot be performed, you may need to limit the scope of your opinion.

If certain types of inventory are more easily reviewed - such as finished goods rather than raw materials or WIP - comfort might be obtained in some cases on part of the inventory balance, with other procedures undertaken to test the remaining items.

This is unlikely to constitute sufficient appropriate audit evidence in its own right and therefore, will most likely need to form part of a package of alternative procedures. You should inform management that the remote review may not be sufficient by itself. If possible, consider doing a count at a later date.

You should understand and assess the risks of conducting inventory tests remotely. Processes should be documented clearly on the audit file.

Management are limiting non-employee visits to their sites. Could I ask the internal auditors to attend on my behalf?

ISA 610 Using the Work of Internal Auditors sets out requirements and guidance for external auditors where local laws or regulation allow them to use the work of internal auditors. UK auditors should note that the FRC prohibits the use of internal auditors by external auditors for audits conducted in accordance with ISAs UK. However, it may be permitted elsewhere. You should check local requirements before proceeding.

When considering relying on internal auditors, you should consider:

• Are there any threats to the independence of the internal auditors, actual or perceived?
• Are the internal auditors competent to do this work? It is possible that staff absences will reduce their resources?
• How systematic and disciplined has their work been in the past? It may not be appropriate to rely on internal auditors in certain cases.

You should also consider the safety of those you ask to work on your behalf. If management are not already planning on sending internal audit staff to attend, it would not be appropriate for you to ask them to attend in your absence.

The entity's inventories are held by a third party who sends confirmations. Do I need to do anything more on this?

You should consider whether third party confirmations remain reliable. COVID-19 closures may impact the reliability of controls at such organisations due to staff absences or other issues. If controls are less reliable, you may need to consider whether any of the additional alternative procedures mentioned previously are suitable for third party confirmations.

The entity has a perpetual inventory counting system – what does that mean for my testing?

Some businesses count their inventory on a rolling basis throughout the year. All inventory is counted at least once a year and records are kept up to date at all times (‘perpetual counting and recording systems’). Where such systems are in place, they represent important controls over inventory and inventory records. A year end count may or may not be performed in conjunction with this type of system. Other businesses may count all or part of their inventory on a periodic or cyclical basis but do not maintain perpetual records.

If you and management have tested the operation of perpetual counting and recording systems during the year, controls are found to be effective, and substantive tests have also been performed, only a limited level of testing may be required at the year end. The inability to attend a full or partial year end count will be less of an obstacle to obtaining sufficient appropriate audit evidence than would be the case were such a system not in place. However, you should consider whether controls have been operating effectively and if controls reliance is appropriate. It is possible that staff absences or warehouse closures will have impacted how controls operate, making it inappropriate to rely on controls.

Assessing the results of alternative procedures

There may be other relevant considerations. Each individual engagement will need to be assessed on a case by case basis to determine what more, if anything, may be appropriate.

You should consider whether alternative procedures have fulfilled the requirements of ISA 501 and in particular whether sufficient appropriate evidence has been obtained. If, despite using alternative procedures, the requirements of ISA 501 are not met, you will need to modify the audit opinion under ISA 705. 

If you have additional questions or concerns not covered by current ICAEW guidance, let us know by emailing the Audit and Assurance Faculty at . We will continue to review and update these FAQs as the situation evolves.

The Audit and Assurance Faculty has prepared guides which provide advice when preparing a modified audit opinion which may help. If in doubt, ICAEW members should contact the Technical Advisory Service on +44 (0)1908 248 250 or via webchat.

Our thoughts are with everyone affected at this challenging time. We encourage all parties to stay up to date with the latest public health advice in their country.

This guidance is published by the ICAEW Audit and Assurance Faculty which is recognised internationally as a leading authority and source of expertise and know-how on audit and assurance matters. The Faculty has over 7,500 members drawn from practising firms and organisations of all sizes in the private and public sectors. To connect with like-minded professionals within this community and, to gain access to the full suite of exclusive resources, visit icaew.com/joinaaf

Who should maintain perpetual inventory master files?

Why is it important to periodically take a physical inventory when using a perpetual inventory system?

Which of the following procedures carried out at an inventory count by an auditor is a test primarily for overstatement of inventory?

Which of the following is a significant audit concern related to the transfer of inventory?