AU 331 and Modern Inventory Audit Procedures

The historical auditing standard AU 331 established the requirement for auditors to physically observe a client’s inventory count. This guidance was issued by the Auditing Standards Board (ASB) and for decades formed a procedure in audits where inventory was a material amount. While the designation AU 331 has been superseded, its principles are now codified within AU-C Section 501 and the Public Company Accounting Oversight Board’s (PCAOB) AS 2510.

The principles of the original standard remain part of modern auditing. Inventory often represents a significant portion of a company’s assets, directly impacting its financial statements. Because of this, auditors must obtain sufficient evidence regarding its existence and valuation, and physical observation is a direct way to gather this evidence.

The Core Requirement of Observation

The primary purpose of an auditor’s physical presence during an inventory count is to obtain direct evidence about two financial statement assertions: existence and condition. The existence assertion verifies that the inventory recorded in the company’s accounting records actually exists. Reviewing purchase invoices provides some evidence, but it is less persuasive than physically seeing the assets.

Observing the inventory also allows the auditor to gather evidence about its condition, which is a component of the valuation assertion. By visually inspecting the goods, an auditor can identify items that are obsolete, damaged, or slow-moving. This direct observation is a persuasive form of audit evidence because it is obtained by the auditor, rather than through inquiry of the client.

Auditor Responsibilities During the Count

When present at a physical inventory count, an auditor has several responsibilities. The first is to observe the client’s count procedures and evaluate their effectiveness. This involves understanding the instructions provided to count teams and how counts are controlled to prevent double-counting or omission.

A second responsibility is to perform independent test counts on a sample basis. The auditor selects items from the client’s inventory listing and traces them to the physical items on the warehouse floor, which tests the existence of recorded inventory. The auditor also selects physical items from the floor and traces them back to the inventory records, which tests the completeness of the records.

Throughout the count, the auditor must also remain alert for signs of obsolete or damaged goods. This involves inquiring with client personnel about product age and inspecting for physical damage or outdated packaging. Any such items are noted to ensure the client records appropriate write-downs for valuation.

When Observation is Not Possible

There are circumstances where an auditor cannot be present for the client’s physical inventory count. This may occur if the auditor is engaged after the year-end count has already taken place or if attending is impracticable due to the inventory’s location. In these situations, auditing standards require the auditor to perform alternative procedures to obtain sufficient evidence about the inventory’s existence and condition.

The primary alternative procedure involves the auditor observing a physical count on a date after the client’s original count and testing the intervening transactions. This process, often called a “roll-forward” or “roll-back,” audits the purchases and sales that occurred between the client’s count and the auditor’s observation. For example, if a count was on December 31 and the auditor observes on January 31, the auditor would test January’s transactions to reconcile the count back to the year-end inventory balance.

Auditing Inventory Held by Third Parties

Companies often store inventory in public warehouses or with other outside custodians. In these cases, the auditor’s approach is adapted to gather evidence from the third party. The primary procedure is to obtain direct written confirmation from the custodian, which requests that the third party respond directly to the auditor with the quantities and condition of the inventory they hold.

For this confirmation to be reliable, the auditor must control the process by sending the request and receiving the response directly. If the inventory held by the third party is a material amount, confirmation alone may not be sufficient. The auditor may need to perform additional procedures to gain assurance over the inventory.

These other procedures could include reviewing the third-party custodian’s audit reports on their internal controls, known as a SOC 1 report. In some cases, the auditor may decide it is necessary to arrange for a physical count at the third-party location. This can be done by the auditor attending themselves or by engaging another auditor to perform the observation.