INTERNATIONAL STANDARD ON AUDITING (UK AND IRELAND) 501 AUDIT EVIDENCE ADDITIONAL CONSIDERATIONS FOR SPECIFIC ITEMS CONTENTS

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1 INTERNATIONAL STANDARD ON AUDITING (UK AND IRELAND) 501 AUDIT EVIDENCE ADDITIONAL CONSIDERATIONS FOR SPECIFIC ITEMS CONTENTS Paragraph Introduction Part A: Attendance at Physical Inventory Counting Part B: Superceded by ISA (UK and Ireland) 505 (paragraphs have been deleted) Part C: Procedures Regarding Litigation and Claims Part D: Valuation and Disclosure of Long-term Investments Part E: Segment Information Effective Date International Standard on Auditing (UK and Ireland) (ISA (UK and Ireland)) 501, Audit Evidence Additional Considerations for Specific Items should be read in the context of the Auditing Practices Board s Statement The Auditing Practices Board Scope and Authority of Pronouncements (Revised) which sets out the application and authority of ISAs (UK and Ireland). 1

2 Introduction 1. The purpose of this International Standard on Auditing (UK and Ireland) (ISA (UK and Ireland)) is to establish standards and provide guidance additional to that contained in ISA (UK and Ireland) 500, Audit Evidence with respect to certain specific financial statement account balances and other disclosures This ISA (UK and Ireland) uses the terms those charged with governance and management. The term governance describes the role of persons entrusted with the supervision, control and direction of an entity. Ordinarily, those charged with governance are accountable for ensuring that the entity achieves its objectives, and for the quality of its financial reporting and reporting to interested parties. Those charged with governance include management only when they perform such functions In the UK and Ireland, those charged with governance include the directors (executive and non-executive) of a company or other body, the members of an audit committee where one exists, the partners, proprietors, committee of management or trustees of other forms of entity, or equivalent persons responsible for directing the entity s affairs and preparing its financial statements Management comprises those persons who perform senior managerial functions In the UK and Ireland, depending on the nature and circumstances of the entity, management may include some or all of those charged with governance (e.g. executive directors). Management will not normally include non-executive directors. 2. Application of the standards and guidance provided in this ISA (UK and Ireland) will assist the auditor in obtaining audit evidence with respect to the specific financial statement account balances and other disclosures addressed. 3. This ISA (UK and Ireland) comprises the following parts: (a) (b) (c) Attendance at Physical Inventory Counting Superceded by ISA (UK and Ireland) 505 Part B has been deleted. Inquiry Regarding Litigation and Claims 2

3 (d) (e) Valuation and Disclosure of Long-term Investments Segment Information Part A: Attendance at Physical Inventory Counting 4. Management 1 ordinarily establishes procedures under which inventory is physically counted at least once a year to serve as a basis for the preparation of the financial statements or to ascertain the reliability of the perpetual inventory system In accordance with ISA (UK and Ireland) 315, Understanding the Entity and its Environment and Assessing the Risks of Material misstatement the auditor uses professional judgment to assess the risks of material misstatement. Risk factors relating to the existence assertion in the context of the audit of inventory include the: Reliability of accounting and inventory recording systems including, in relation to work in progress, the systems that track location, quantities and stages of completion. Timing of physical inventory counts relative to the year-end date, and the reliability of records used in any roll-forward of balances. Location of inventory, including inventory on consignment and inventory held at third-party warehouses. Physical controls over the inventory, and its susceptibility to theft or deterioration. Objectivity, experience and reliability of the inventory counters and of those monitoring their work. The degree of fluctuation in inventory levels. Nature of the inventory, for example whether specialist knowledge is needed to identify the quantity, quality and/or identity of inventory items. Difficulty in carrying out the assessment of quantity, for example whether a significant degree of estimation is involved. 1 In the UK and Ireland, those charged with governance are responsible for the preparation and presentation of the financial statements. 3

4 4-2. When planning the audit, the auditor also assesses the risk of material misstatements due to fraud. Based on this risk assessment, the auditor designs audit procedures so as to have a reasonable expectation of detecting material misstatements arising from fraud. Fraudulent activities which can occur in relation to inventory include: False sales involving the movement of inventory still owned by the entity to a location not normally used for storing inventory. Movement of inventory between entity sites with physical inventory counts at different dates. The appearance of inventory and work in progress being misrepresented so that they seem to be of a higher value/greater quantity. The application of inappropriate estimating techniques. Inventory count records prepared during physical inventory counts deliberately being incorrectly completed or altered after the event. Additional (false) inventory count records being added to those prepared during the count. 5. When inventory is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its existence and condition by attendance at physical inventory counting unless impracticable. The auditor s attendance serves as a test of controls or substantive procedure over inventory depending on the auditor s risk assessment and planned approach. Such attendance enables the auditor to inspect the inventory, to observe compliance with the operation of management s procedures for recording and controlling the results of the count and to provide audit evidence as to the reliability of management s procedures The principal sources of evidence relating to the existence of inventory are: (a) Evidence from audit procedures which confirm the reliability of the accounting records upon which the amount in the financial statements is based; (b) Evidence from tests of the operation of internal controls over inventory, including the reliability of inventory counting procedures applied by the entity; and 4

5 (c) Substantive evidence from the physical inspection tests undertaken by the auditor. 6. If unable to attend the physical inventory count on the date planned due to unforeseen circumstances, the auditor should take or observe some physical counts on an alternative date and, when necessary, perform audit procedures on intervening transactions. 7. Where attendance is impracticable, due to factors such as the nature and location of the inventory, the auditor should consider whether alternative procedures provide sufficient appropriate audit evidence of existence and condition to conclude that the auditor need not make reference to a scope limitation. For example, documentation of the subsequent sale of specific inventory items acquired or purchased prior to the physical inventory count may provide sufficient appropriate audit evidence. 8. In planning attendance at the physical inventory count or the alternative procedures, the auditor considers the following: The risks of material misstatement related to inventory. The nature of the internal control related to inventory. Whether adequate procedures are expected to be established and proper instructions issued for physical inventory counting. The timing of the count. The locations at which inventory is held. Whether an expert s assistance is needed The effectiveness of the auditor s attendance at a physical inventory count is increased by the use of audit staff who are familiar with the entity s business and where advance planning has been undertaken. Planning procedures include: Performing analytical procedures, and discussing with management any significant changes in inventory over the year and any problems with inventory that have recently occurred, for example unexpected stock-out reports and negative inventory balances. Discussing inventory counting arrangements and instructions with management. 5

6 Familiarisation with the nature and volume of the inventory, the identification of high value items, the method of accounting for inventory and the conditions giving rise to obsolescence. Assessing the implications of the locations at which inventory is held for inventory control and recording. Considering the quantity and nature of work in progress, the quantity of inventory held by third parties, and whether expert valuers or inventory counters will be engaged (further guidance on these issues is set out in paragraphs 8-2 and 8-3 below). Reviewing internal control relating to inventory, so as to identify potential areas of difficulty (for example cut-off). Considering any internal audit involvement, with a view to deciding the reliance which can be placed on it. Considering the results of previous physical inventory counts made by the entity. Reviewing the auditor s working papers for the previous year Prior to attending a physical inventory count, the auditor establishes whether expert help, such as that provided by a quantity surveyor, needs to be obtained by management to substantiate quantities, or to identify the nature and condition of the inventories, where they are very specialised. In cases where the entity engages a third party expert the auditor assesses, in accordance with ISA (UK and Ireland) 620 Using the Work of an Expert, the objectivity and professional qualifications, experience and resources of the expert engaged to carry out this work, and also the instructions given to the expert Management may from time to time appoint inventory counters from outside the entity, a practice common for inventory at, for example, farms, petrol stations and public houses. The use of independent inventory counters does not eliminate the need for the auditor to obtain audit evidence as to the existence of inventory. In addition, as well as obtaining satisfaction as to the competence and objectivity of the independent inventory counters, the auditor considers how to obtain evidence as to the procedures followed by them to ensure that the inventory count records have been properly prepared. In this connection, the auditor has regard to the relevant guidance set out in ISA (UK and Ireland) 402, Auditor s Considerations Relating to Entities Using Service Organizations. 6

7 9. When the quantities are to be determined by a physical inventory count and the auditor attends such a count, or when the entity operates a perpetual system and the auditor attends a count one or more times during the year, the auditor would ordinarily observe count procedures and perform test counts The nature of the auditor s procedures during their attendance at a physical inventory count will depend upon the results of the assessment of risks of material misstatements carried out in accordance with ISA (UK and Ireland) 315. In cases where the auditor decides to place reliance on accounting systems and internal controls, the auditor attends a physical inventory count primarily to obtain evidence regarding the design and operating effectiveness of management procedures for confirming inventory quantities Where entities maintain detailed inventory records and check these by regular test counts the auditor performs audit procedures designed to confirm whether management: (a) (b) (c) Maintains adequate inventory records that are kept up-to-date; Has satisfactory procedures for inventory counting and test-counting; and Investigates and corrects all material differences between the book inventory records and the physical counts. The auditor attends a physical inventory count to gain assurance that the inventory checking as a whole is effective in confirming that accurate inventory records are maintained. If the entity s inventory records are not reliable the auditor may need to request management to perform alternative procedures which may include a full count at the year end In entities that do not maintain detailed inventory records the quantification of inventory for financial statement purposes is likely to be based on a full physical count of all inventory held at a date close to the company s year end. In such circumstances the auditor will consider the date of the physical inventory count recognising that the evidence of the existence of inventory provided by the inventory count is greater when the inventory count is carried out at the end of the financial year. Physical inventory counts carried out before or after the year end may also be acceptable for audit purposes provided the auditor is satisfied that the records of inventory movements in the intervening period are reliable. 7

8 10. If the entity uses procedures to estimate the physical quantity, such as estimating a coal pile, the auditor would need to be satisfied regarding the reasonableness of those procedures. 11. When inventory is situated in several locations, the auditor would consider at which locations attendance is appropriate, taking into account the materiality of the inventory and the risk of material misstatement at different locations. 12. The auditor would review management s instructions regarding: (a) The application of control activities, for example, collection of used stocksheets, accounting for unused stocksheets and count and recount procedures; (b) Accurate identification of the stage of completion of work in progress, of slow moving, obsolete or damaged items and of inventory owned by a third party, for example, on consignment; and (c) Whether appropriate arrangements are made regarding the movement of inventory between areas and the shipping and receipt of inventory before and after the cutoff date The auditor examines the way the physical inventory count is organised and evaluates the adequacy of the client s instructions for the physical inventory count. Such instructions, preferably in writing, should cover all phases of the inventory counting procedures, be issued in good time and be discussed with the person responsible for the physical inventory count to check that the procedures are understood and that potential difficulties are anticipated. If the instructions are found to be inadequate, the auditor seeks improvements to them. 13. To obtain audit evidence that management s control activities are adequately implemented, the auditor would observe employees procedures and perform test counts. When performing test counts, the auditor performs procedures over both the completeness and the accuracy of the count records by tracing items selected from those records to the physical inventory and items selected from the physical inventory to the count records. The auditor considers the extent to which copies of such count records need to be retained for subsequent audit procedures and comparison If the manner of carrying out the inventory count or the results of the testcounts are not satisfactory, the auditor immediately draws the matter to the 8

9 attention of the management supervising the inventory count and may have to request a recount of part, or all of the inventory When carrying out test counts, the auditor gives particular consideration to those inventory items which the auditor believes to have a high value either individually or as a category of inventory. The auditor includes in the audit working papers items for any subsequent testing considered necessary, such as copies of (or extracts from) inventory count records and details of the sequence of those records, and any differences noted between the records and the physical inventory counted The auditor determines whether the procedures for identifying damaged, obsolete and slow moving stock operate properly. The auditor obtains (from observation and by discussion e.g. with storekeepers and inventory counters) information about the inventory condition, age, usage and, in the case of work in progress, its stage of completion. Further, the auditor ascertains that stock held on behalf of third parties is separately identified and accounted for. 14. The auditor also considers cutoff procedures including details of the movement of inventory just prior to, during and after the count so that the accounting for such movements can be checked at a later date The auditor considers whether management has instituted adequate cut-off procedures, i.e. procedures intended to ensure that movements into, within and out of inventory are properly identified and reflected in the accounting records in the correct period. The auditor s procedures during the inventory count will depend on the manner in which the year end inventory value is to be determined. For example, where inventory is determined by a full count and evaluation at the year end, the auditor tests the arrangements made to identify inventory that corresponds to sales made before the cut-off point and the auditor identifies goods movement documents for reconciliation with financial records of purchases and sales. Alternatively, where the full count and evaluation is at an interim date and year end inventory is determined by updating such valuation by the cost of purchases and sales, the auditor performs appropriate procedures during attendance at the physical inventory count and in addition tests the financial cut-off (involving the matching of costs with revenues) at the year end. 15. For practical reasons, the physical inventory count may be conducted at a date other than period end. This will ordinarily be adequate for audit purposes only when the entity has designed and implemented controls over changes in inventory. The auditor would determine whether, through the 9

10 performance of appropriate audit procedures, changes in inventory between the count date and period end are correctly recorded. 16. When the entity operates a perpetual inventory system which is used to determine the period end balance, the auditor would evaluate whether, through the performance of additional procedures, the reasons for any significant differences between the physical count and the perpetual inventory records are understood and the records are properly adjusted. 17. The auditor performs audit procedures over the final inventory listing to determine whether it accurately reflects actual inventory counts. 18. When inventory is under the custody and control of a third party, the auditor would ordinarily obtain direct confirmation from the third party as to the quantities and condition of inventory held on behalf of the entity. Depending on materiality of this inventory the auditor would also consider the following: The integrity and independence of the third party. Observing, or arranging for another auditor to observe, the physical inventory count. Obtaining another auditor s report on the adequacy of the third party s internal control for ensuring that inventory is correctly counted and adequately safeguarded. Inspecting documentation regarding inventory held by third parties, for example, warehouse receipts, or obtaining confirmation from other parties when such inventory has been pledged as collateral. Testing the owner s procedures for investigating the custodian and evaluating the custodian s performance. The guidance set out in ISA (UK and Ireland) The auditor s working papers include details of the auditor s observations and tests (for example, of physical quantity, cut-off date and controls over inventory count records), the manner in which points that are relevant and material to the inventory being counted or measured have been dealt with by the entity, instances where the entity s procedures have not been satisfactorily carried out and the auditor s conclusions Although the principal reason for attendance at a physical inventory count is usually to obtain evidence to substantiate the existence of the inventory, 10

11 attendance can also enhance the auditor s understanding of the business by providing an opportunity to observe the production process and/or business locations at first hand and providing evidence regarding the completeness and valuation of inventory and the entity s internal control. Matters that the auditor may wish to observe whilst attending a physical inventory count include: Understanding the business The production process. Evidence of significant pollution and environmental damage. Unused buildings and machinery. Completeness and valuation of inventory Physical controls. Obsolete inventory (for example goods beyond their sale date). Scrap, and goods marked for re-work. Returned goods. Internal control Exceptions identified by the production process (for example missing work tickets). The operation of shop-floor disciplines regarding the inputting of data such as inventory movements into the computer systems Some entities use computer-assisted techniques to perform inventory counts; for example hand held scanners can be used to record inventory items which update computerised records. In some situations there are no stock-sheets, no physical count records, and no paper records available at the time of the count. In these circumstances the auditor considers the IT environment surrounding the inventory count and considers the need for specialist assistance when evaluating the techniques used and the controls surrounding them. Relevant issues involve systems interfaces, and the controls over ensuring that the computerised inventory records are properly updated for the inventory count information. The auditor considers the following aspects of the physical inventory count: (a) How the test counts (and double counts where two people are checking) are recorded; 11

12 (b) (c) How differences are investigated before the computerised inventory records are updated for the counts; and How the computerised inventory records are updated, and how inventory differences are recorded. After the Physical Inventory Count After the physical inventory count, the matters recorded in the auditor s working papers at the time of the count or measurement, including apparent instances of obsolete or deteriorating inventory, are followed up. For example, details of the last serial numbers of goods inwards and outwards records and of movements during the inventory count may be used in order to check cut-off. Further, copies of (or extracts from) the inventory count records and details of test counts, and of the sequence of inventory count records may be used to check that the results of the count have been properly reflected in the accounting records of the entity Where appropriate, the auditor considers whether management has instituted procedures to ensure that all inventory movements between the observed inventory count and the period end have been adjusted in the accounting records, and the auditor tests these procedures to the extent considered necessary to address the assessed risk of material misstatement. In addition, the auditor follows up all queries and notifies senior management of serious problems encountered during the physical inventory count In conclusion, the auditor considers whether attendance at the physical inventory count has provided sufficient reliable audit evidence in relation to relevant assertions (principally existence) and, if not, the other procedures that should be performed. Work in Progress Management may place substantial reliance on internal controls designed to ensure the completeness and accuracy of records of work in progress. In such circumstances there may not be a physical inventory count which can be attended by the auditor. Nevertheless, inspection of the work in progress may assist the auditor in understanding the entity s control systems and processes. It will also assist the auditor in planning further audit procedures, and it may also help on such matters as the determination of the stage of completion of construction or engineering work in progress. For this purpose, the auditor identifies the accounting records that will be used by 12

13 management to produce the work in progress figure in the year-end accounts and, where unfinished items are uniquely identifiable (for example by reference to work tickets or labels), the auditor physically examine items to obtain evidence that supports the recorded stage of completion. In some cases, for example in connection with building projects, photographic evidence can also be useful evidence as to the state of work in progress at the date of the physical inventory count, particularly if provided by independent third parties or the auditor. Part B: Superceded by ISA (UK and Ireland) 505 (paragraphs have been deleted). Part C: Procedures Regarding Litigation and Claims 31. Litigation and claims involving an entity may have a material effect on the financial statements and thus may be required to be disclosed and/or provided for in the financial statements. 32. The auditor should carry out audit procedures in order to become aware of any litigation and claims involving the entity which may result in a material misstatement of the financial statements. Such procedures would include the following: Make appropriate inquiries of management 2 including obtaining representations. Review minutes of those charged with governance and correspondence with the entity s legal counsel. Examine legal expense accounts. Use any information obtained regarding the entity s business including information obtained from discussions with any in-house legal department. 33. When the auditor assesses a risk of material misstatement regarding litigation or claims that have been identified or when the auditor believes they may exist, the auditor should seek direct communication with the entity s legal counsel. Such communication will assist in obtaining sufficient appropriate audit evidence as to whether potentially material litigation and claims are known and management s 1 estimates of 2 In the UK and Ireland the auditor makes appropriate enquiries of those charged with governance. 13

14 the financial implications, including costs, are reliable. When the auditor determines that the risk of material misstatement is a significant risk, the auditor evaluates the design of the entity s related controls and determines whether they have been implemented. Paragraphs of ISA (UK and Ireland) 315, Understanding the Entity and Assessing the Risks of Material Misstatement provides further guidance on the determination of significant risks. 34. The letter, which should be prepared by management 3 and sent by the auditor, should request the entity s legal counsel to communicate directly with the auditor. When it is considered unlikely that the entity s legal counsel will respond to a general inquiry 4, the letter would ordinarily specify the following: A list of litigation and claims. Management s 1 assessment of the outcome of the litigation or claim and its estimate of the financial implications, including costs involved. A request that the entity s legal counsel confirm the reasonableness of management s assessments and provide the auditor with further information if the list is considered by the entity s legal counsel to be incomplete or incorrect. 35. The auditor considers the status of legal matters up to the date of the audit report. In some instances, the auditor may need to obtain updated information from entity s legal counsel. 36. In certain circumstances, for example, where the auditor determines that the matter is a significant risk, the matter is complex or there is disagreement between management and the entity s legal counsel, it may be necessary for the auditor to meet with the entity s legal counsel to discuss the likely outcome of litigation and claims. Such meetings would take place with management s 5 permission and, preferably, with a representative of management in attendance In the UK and Ireland the letter should be prepared by those charged with governance. In the UK, the Council of the Law Society has advised solicitors that it is unable to recommend them to comply with non-specific requests for information. In the UK and Ireland the auditor seeks the permission of those charged with governance. 14

15 37. If management 4 refuses to give the auditor permission to communicate with the entity s legal counsel, this would be a scope limitation and should ordinarily lead to a qualified opinion or a disclaimer of opinion. Where the entity s legal counsel refuses to respond in an appropriate manner and the auditor is unable to obtain sufficient appropriate audit evidence by applying alternative audit procedures, the auditor would consider whether there is a scope limitation which may lead to a qualified opinion or a disclaimer of opinion. Part D: Valuation and Disclosure of Long-term Investments 38. When long-term investments are material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding their valuation and disclosure. 39. Audit procedures regarding long-term investments ordinarily include obtaining audit evidence as to whether the entity has the ability to continue to hold the investments on a long term basis and discussing with management whether the entity will continue to hold the investments as long-term investments and obtaining written representations to that effect. 40. Other audit procedures would ordinarily include considering related financial statements and other information, such as market quotations, which provide an indication of value and comparing such values to the carrying amount of the investments up to the date of the auditor s report. 41. If such values do not exceed the carrying amounts, the auditor would consider whether a write-down is required. If there is an uncertainty as to whether the carrying amount will be recovered, the auditor would consider whether appropriate adjustments and/or disclosures have been made. Part E: Segment Information 42. When segment information is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its presentation and disclosure in accordance with the applicable financial reporting framework. 43. The auditor considers segment information in relation to the financial statements taken as a whole, and is not ordinarily required to apply audit procedures that would be necessary to express an opinion on the segment information standing alone. However, the concept of materiality 15

16 encompasses both quantitative and qualitative factors and the auditor s procedures recognize this. 44. Audit procedures regarding segment information ordinarily consist of analytical procedures and other audit procedures as appropriate in the circumstances. 45. The auditor would discuss with management 1 the methods used in determining segment information, and consider whether such methods are likely to result in disclosure in accordance with the applicable financial reporting framework and perform audit procedures over the application of such methods. The auditor would consider sales, transfers and charges between segments, elimination of inter-segment amounts, comparisons with budgets and other expected results, for example, operating profits as a percentage of sales, and the allocation of assets and costs among segments including consistency with prior periods and the adequacy of the disclosures with respect to inconsistencies. Effective Date This ISA (UK and Ireland) is effective for audits of financial statements for periods commencing on or after 15 December

17 NOTICE TO READERS The Auditing Practices Board Limited This document has been obtained from the website of the Financial Reporting Council (FRC) and its operating Boards, which includes the Auditing Practices Board (APB). Use of the website is subject to the WEBSITE TERMS OF USE, which may be viewed in a separate section of the website. Readers should be aware that although the FRC and its Boards seek to ensure the accuracy of information on the website, no guarantee or warranty is given or implied that such information is free from error or suitable for any given purpose: the published hard copy alone constitutes the definitive text. The ISAs (UK and Ireland) are based on International Standards on Auditing of the same titles, which have been issued by the International Auditing and Assurance Standards Board and published by the International Federation of Accountants. 17