Editor’s note: The coronavirus pandemic has made inventory testing a huge challenge for auditors, particularly for client entities with a March 31 fiscal year end.
Audit firms are requiring staff to work from home and banning staff travel. Clients are telling auditors not to come on site visits. And in many places, most businesses are legally prohibited from opening their doors.
But AICPA Chief Auditor Bob Dohrer, CPA, CGMA, said it is possible for auditors to observe inventory without being on-site, under generally accepted auditing standards issued by the AICPA Auditing Standards Board. Here are his comments, which come with the caveat that they do not necessarily apply to audits of public companies under PCAOB standards.
There are situations coming very quickly here, where by law we may not be able to go out to a client location and physically observe inventory like we’ve done in the past for March 31 year ends and probably extending out to June 30 year ends. We do have standards directly related to physical observation of inventory that we need to comply with. Those are in AU-C Section 501, Audit Evidence — Specific Considerations for Selected Items, Paragraphs .11–.14, and then a series of application paragraphs that go along with it.
When you step back at a principles level, what are those requirements really driving at? For any organization, any business where inventory is material, the existence of that inventory is going to be a relevant assertion. And I think in the vast majority of cases, historically, it has just been generally accepted that the way that an auditor can test the existence of that inventory is to physically observe its counting.
Of course, the generally accepted procedure that has been there for years has been stood on its head when you can’t actually get to the client’s site to observe the inventory. But there are probably a handful of alternatives available. They all have their pros and their cons, of course. But I think it’s important for auditors to recognize that there are alternatives.
Roll forward and roll back
The most obvious alternative may work if the client doesn’t have a looming deadline to have its audit report submitted by a certain date. Auditors can work with the client and think whether it would be possible and realistic to postpone the inventory counting and observation to a later date, when perhaps the stay-at-home orders might be lifted and people might feel safe visiting the client site. The auditor could count inventory and observe it at that point and then perform additional testing on the sales subsequent to year end as well as subsequent purchases, which probably aren’t extensive in this environment. You could effectively roll back the inventory to the year end, even if it was counted subsequent to year end. Actually, this is not an extraordinarily rare thing for auditors to do, especially in situations where, for example, you’re engaged to perform an audit after year end, so you weren’t even engaged when the inventory was counted. That’s one option, although I don’t think anybody knows how soon we might be able to do that.
The other more traditional alternative procedure can be performed if the client is using a cycle count procedure and a perpetual inventory system. A cycle count procedure is where the client essentially has controls in place where on a periodic basis — a lot of times, quarterly — they will conduct their own test counts of just a portion of their inventory. And then they go back to their perpetual system and prepare the counts, make corrections, and things like that.
With cycle counting, the client doesn’t perform one huge year-end, wall-to-wall count in most cases. If the auditor had been testing those controls and relying on those controls to establish the existence of inventory, the auditor may be able to go back to the last prior cycle count that was taken and then be able to roll forward to year end, again using sales transactions and purchase transactions and testing those during that interim period.
So roll forward and roll back are two available alternatives.
The method that we’re getting the most questions about is video observation, which is certainly worth considering. A common question is, “Is it even permissible under the auditing standards to not physically count inventory in person?” One aspect is that Paragraphs .11 and .14 of AU-C Section 501 reference the requirement to attend the physical inventory counting unless it is impracticable to do so. There are actually some application paragraphs (Paragraph .A34 of AU-C §501) that indicate that one circumstance that may make a physical observation impracticable is if the inventory is held in a location that may pose threats to the auditor’s safety.
I think it’s a very reasonable interpretation of that paragraph in the standard to say that COVID-19 is putting auditors’ safety in jeopardy. I don’t think there would be any problem with an interpretation of our standards that says the health crisis is making attendance at the physical inventory counting impracticable. And therefore alternative procedures would be appropriate. So I think that’s very supportable under our standards.
The overriding question is, can we use video to observe the inventory? And I think the answer is “yes.” I think some of the special considerations are around how well trained the personnel using the video equipment and technology are and what type of video you are going to use. There is great variety in video capabilities. A GoPro camera can be strapped to a person’s baseball cap or hard hat, and they can walk around and perform counting. A lot of warehouses also have security cameras that record and can be remotely controlled to focus in on different areas of the warehouse. That’s a different option for video. The other alternative that we’re hearing some firms are considering is a situation where client personnel go out and make a video recording of the counting of inventory.
The overriding consideration when using remote video like that is that the auditor needs to have a pretty good feel for the authenticity of the video feed. If it’s a live situation where perhaps someone from the client is on-site and can send a live video feed back to the auditor for them to watch, that makes it easier to determine authenticity. If you’re using, for example, Skype or Zoom and somebody is actually walking around to the inventory and counting it in response to verbal commands of the auditor with an interactive dialogue, you can be pretty comfortable that’s an authentic video feed. You can recognize the client location.
I think the more challenging situation, and one that I’d probably personally be more skeptical about, is if the auditor wants to use a recorded video. I chuckle because when I’ve had some of these discussions, some of the suggestions about how you could authenticate that type of video remind me of a bad mystery or action-drama movie where there is a kidnapping and they hold up a copy of today’s newspaper to prove that it is today and that person is still alive. But some people have suggested something like that might be appropriate if you’re recording, just to authenticate the time or date that it was taking place.
There are some possible limitations in that type of scenario, too, because it’s likely going to be a lengthy recording, so file size might be a problem. And if you’re going to try chopping it up into smaller pieces, then the integrity of the recording itself is called into question because it starts and stops. So the recorded video option is a possibility, but I think there would have to be some really tight controls over that, and the evidence on authenticity would have to be pretty substantial.
Another reason auditors observe inventory is to evaluate physical condition, and that’s more difficult with remote video. You can check it for whether there is a lot of dust on the boxes that would indicate there’s obsolescence and that sort of thing. But I think you can still evaluate that in a live feed by getting the person who is operating the camera to do essentially what you would do, and you’d be able to look at that through the video feed. A lot of options are available to us.
Another issue with a live feed is who should hold the camera. First, the safety of anyone involved in the process should be paramount. Precautions must first be taken to maintain social distancing, and local and jurisdictional rules related to personnel health and safety should be followed.
A third party that doesn’t work for the client might be a good choice to hold the camera, but if you’re not able to go to the client’s site because of health concerns, I’m not sure you’re going to find many third parties who are willing to go there.
If you’re dealing with a larger client that has an internal audit department, someone from the internal audit department would be a good choice to hold the camera. The next best person would be a client employee who is not involved in the inventory accounting function and is not involved in the warehouse shipping and receiving function. So, if you can’t be there and a third party can’t be there, then you’d be looking for someone within the client organization who would be objective or as far removed as possible from the accounting or the physical handling of the inventory as you could.
Nonetheless, if inventory is material and an auditor is not able to either roll forward or roll back the inventory or get comfortable with a video feed process, then the audit is likely to have a scope limitation, and if inventory is material, the audit opinion is likely to be qualified. We’re trying to work to help auditors think creatively about unnecessary qualified opinions for scope limitations, but we also bear in mind that there may be some of those situations in this environment.
Additional supporting evidence
There are other audit procedures that are normally performed that might lend some audit evidence about the existence of inventory. For example, inventory price-testing is performed on almost every audit, and the primary objective of inventory price-testing is, of course, to address the valuation assertion. However, you’re always looking at the quantity in the inventory, the price at which it was purchased, and what the cost was.
So when you’re price-testing inventory, while it’s not the primary purpose, you are getting some evidence around the quantity of inventory in stock. Obviously, when you look at testing sales prices, subsequent sales for obsolescence, and writedowns in value, you’re looking at subsequent sales transactions, or sales transactions subsequent to year end. Obviously, if the client is selling product after year end, they likely would have had to have that in inventory at year end, depending of course on inventory turns, especially the closer you are to year end.
So with cutoff testing and price-testing, even in our traditional audits taking place before the pandemic, there have been other audit procedures that auditors perform that contribute to evidence about existence. The caveat there would be that you certainly couldn’t get sufficient, appropriate audit evidence about the existence assertion by only doing price-test and subsequent sales transactions. You’d have to do some roll forward, roll back, and that type of thing. But it’s not as if the inventory observation is the only evidence that’s obtained with respect to existence.
The bottom line is that while these are challenging times with respect to observing inventory on-site, there are ways for auditors to get sufficient, appropriate evidence about inventory that will allow them to perform a successful, high-quality audit.
For more news and reporting on the coronavirus and how CPAs can handle challenges related to the pandemic, visit the JofA’s coronavirus resources page.
An in-depth discussion of remote auditing is available on the rebroadcast of a free webcast with Bob Dohrer, CPA, CGMA, and Andrew Prather, CPA, CGMA, a shareholder with Clark Nuber in Bellevue, Wash. The webcast will be available on April 1 and April 10.
— Ken Tysiac (Kenneth.Tysiac@aicpa-cima.com) is the JofA’s editorial director.