Inventory is a significant asset on many companies’ balance sheets, so its accuracy is critical to reliable financial reporting. However, the current guidance for inventory — Auditing Standard (AS) 2510, Auditing Inventories — is one of the oldest in the Public Company Accounting Oversight Board (PCAOB) framework. Originally adopted from the American Institute of Certified Public Accountants (AICPA) guidelines in 2003, AS 2510 has remained largely unchanged despite significant advancements in inventory management and audit technology.
Recognizing the need for modernization, the PCAOB is actively considering proposals to update the guidance. A formal proposal is expected later this year. Public companies and their stakeholders should be aware of potential changes on the horizon.
Overview of existing inventory audit standards
AS 2510 outlines an auditor’s responsibilities when auditing inventory for public companies. It establishes procedures for observing, evaluating and testing inventory to ensure accurate financial reporting.
Under AS 2510, auditors are generally required to observe a company’s physical inventory count. They must assess management’s inventory counting procedures for reliability and perform test counts to reconcile with inventory records. If attending a physical count isn’t feasible, alternative audit procedures must be applied to obtain sufficient and appropriate evidence.
Beyond physical observations, auditors must evaluate the effectiveness of a company’s internal controls over inventory. If controls are weak, additional substantive testing may be required. Auditors must also verify that inventory records accurately reflect the physical inventory count by performing reconciliations, analytical procedures and detailed testing.
Another key aspect of AS 2510 is ensuring that inventory is valued appropriately under the applicable accounting methods, such as first-in, first-out (FIFO); last-in, first-out (LIFO); or weighted average. Auditors must also assess whether the inventory contains obsolete, damaged or slow-moving items.
Proper cutoff procedures are critical to ensure transactions near the end of a reporting period are recorded in the correct period. Auditors examine shipping and receiving documents to verify that inventory movement aligns with accounting records. Additionally, financial statement disclosures must properly classify inventory and provide transparency about valuation methods and associated risks.
PCAOB improvement efforts
The PCAOB is considering revising AS 2510 to reflect new technologies, evolving business practices and enhanced risk-based audit approaches. The PCAOB staff had identified the following three possible areas of improvement:
- Technology integration. The PCAOB is evaluating how audit standards can be updated to leverage advanced technology. Drones, radio frequency identification (RFID) scanners and real-time inventory tracking systems are becoming increasingly common, yet current audit standards don’t address their use in obtaining audit evidence. Using technology could reduce logistical challenges and costs. The staff is exploring whether such technology should be used as a supplemental audit tool or as a substitute for in-person inventory observations.
- Third-party involvement. Today, many companies store inventory in public warehouses, use third-party logistics providers or hire external firms for inventory counts. Auditors must determine how to obtain sufficient audit evidence when inventory is managed outside the client’s direct control. The PCAOB is considering whether additional guidance is needed regarding auditors’ responsibilities when relying on third-party custodians or external inventory count services. For example, auditors might be required to obtain service organization control reports or to perform alternative procedures when third-party verification is insufficient.
- Scalability. The nature and risk profile of inventory varies across industries, so a one-size-fits-all approach may not be appropriate. Potential updates could require auditors to tailor procedures based on specific risk factors, such as:
- The complexity of the supply chain,
- The susceptibility of inventory to obsolescence or fraud, and
- The use of automated inventory systems versus manual tracking.
The PCAOB is also evaluating whether auditors should place greater reliance on automated inventory management systems or require additional testing and verification.
By modernizing inventory audit procedures, the PCAOB aims to improve audit efficiency and enhance the accuracy of inventory verification. Plus, more robust procedures could lead to greater investor and lender confidence in reported inventory figures.
Stay tuned
AS 2510 plays a vital role in ensuring that inventory balances presented in financial statements are accurate and free from material misstatement. Given the importance of inventory to many businesses, these audit procedures help maintain financial reporting integrity and investor confidence.
Contact your CPA for more information on how potential changes to inventory audit standards could impact your company. Understanding these changes early can help businesses adapt to new expectations and improve their financial reporting processes.
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