AS 1065: PCAOB Standard for Auditing Inventory

Auditing Standard (AS) 2510, Auditing Inventories, is a regulation from the Public Company Accounting Oversight Board (PCAOB). The PCAOB was created by the Sarbanes-Oxley Act of 2002 to oversee public company audits and protect investors. AS 2510 provides the framework that independent auditors must follow when examining inventory, with the objective of gathering evidence to confirm it physically exists and to assess its condition.

The standard outlines the auditor’s responsibilities, focusing on the procedures required to verify inventory quantities and values represented in financial statements. It does not dictate the company’s inventory management system. Following these requirements helps maintain the integrity of financial reporting and provides investors with confidence in the company’s reported assets.

Auditor’s Role in Physical Inventory Counts

AS 2510 requires the auditor’s involvement in the physical inventory count. Before the count begins, the auditor must evaluate the company’s plans by reviewing its written instructions for counting, tagging, and controlling inventory. This includes assessing if the plan minimizes misstatement risks, for example, by having clear cut-off procedures for recording goods received and shipped around the count date.

During the physical count, the auditor’s role is one of observation and testing, not of taking the inventory for the company. The auditor observes the company’s employees to determine if they are following established procedures and if the count is conducted in an orderly manner. This observation helps the auditor gauge the reliability of the company’s methods and the reliance that can be placed on the final count. The auditor also ensures all inventory is included and that measures prevent items from being counted twice.

Another procedure is test counting, where the auditor selects a sample of inventory items and performs an independent count to verify accuracy. This testing is performed in two directions. To test for existence, the auditor selects items from count records and locates them on the warehouse floor. To test for completeness, they select items from the floor and trace them back to the count records.

The auditor must also assess the physical condition of the inventory. While observing the count, the auditor looks for signs of obsolete, slow-moving, or damaged goods. Items that are dusty, stored remotely, or show visible damage may have a lower value than recorded. Identifying these items helps determine if the inventory needs to be written down to its net realizable value.

Auditing Inventories at Alternative Dates

AS 2510 allows the physical inventory count to be performed on a date other than the company’s fiscal year-end. If a company counts its inventory at an interim date, the auditor must perform additional procedures. These steps ensure the inventory balance is accurate as of the final financial statement date.

This additional work involves auditing the transactions between the count date and the balance sheet date, a process known as a “roll-forward.” The auditor tests transactions that changed inventory levels during this period. To do this, they examine supporting documents like purchase orders and vendor invoices for additions, and sales invoices and shipping documents for reductions. The goal is to verify that the final inventory figure on the balance sheet is reasonably stated.

Verifying Inventory Held by Third Parties

When a company’s inventory is held by an outside custodian, like a public warehouse, AS 2510 outlines specific audit procedures. The preferred method is to obtain direct written confirmation from the third party. The auditor controls this process by sending a request to the custodian, who responds directly to the auditor with the quantities and condition of the inventory.

If the inventory held by the third party is a significant portion of the company’s assets, direct confirmation alone may not be sufficient. In these cases, the standard requires the auditor to perform additional procedures. These steps provide stronger evidence to address the heightened risk of assets not in the company’s possession.

Alternative procedures include testing the company’s methods for monitoring the warehouseman’s performance. The auditor could also obtain a report from the warehouse’s own auditor on its internal controls for custody of goods. If necessary, the auditor may arrange for a physical count to be observed at the remote location, either by another auditor or by visiting themselves.