Inventory and non-current assets - PPE existence and depreci...

Learning Outcomes

After reading this article, you will be able to identify auditor objectives and assertions relating to inventory and property, plant and equipment (PPE). You will understand key audit procedures for existence and depreciation, judge evidence quality, and apply ISA 16 requirements for PPE recognition and measurement. By the end, you should be able to explain substantive tests for inventory and PPE, respond to common audit risks, and address issues of valuation, ownership, and completeness in line with ACCA AA expectations.

ACCA Audit and Assurance (AA) Syllabus

For ACCA Audit and Assurance (AA), you are required to understand both the practical audit procedures and the fundamental financial reporting standards related to inventory and non-current assets (PPE). In particular, revision should focus on:

• The auditor’s objectives and key assertions for inventory and PPE (existence, rights and obligations, completeness, valuation).
• Tests of control and substantive procedures for inventory counting, attendance at counts, and inventory held by third parties.
• Substantive procedures for PPE including existence, additions, disposals, depreciation, and impairment.
• The requirements of IAS 16: recognition, subsequent expenditure, componentization, revaluation, and depreciation.
• How to obtain and evaluate sufficient appropriate audit evidence over inventory and PPE, including external confirmations and inspection.
• Addressing audit risks: misstatement of cost, impairment, or misclassification.
• Communication and reporting of material misstatements or limitations on audit evidence.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. List two main assertions tested in the audit of physical inventory and two for PPE.
2. What substantive procedure provides the most reliable evidence of PPE existence at year end?
3. Under IAS 16, when should subsequent expenditure on PPE be capitalized?
4. If an auditor is unable to attend the client’s inventory count, what alternative actions must be taken?
5. What are the risks if repairs are incorrectly capitalized as PPE additions?

Introduction

Inventory and tangible non-current assets (property, plant and equipment, or PPE) often make up large portions of the statement of financial position. Accurate reporting in these areas is essential for presenting a true and fair view under IAS 2 and IAS 16. Auditors must assess not only numerical valuation, but also existence, ownership, and correct depreciation. Deficiencies in these areas frequently lead to material misstatements or modified opinions.

Key Term: Inventory
Tangible assets held for sale, in production for sale, or as materials to be consumed in the production process, measured at the lower of cost and net realisable value.

Key Term: Property, Plant and Equipment (PPE)
Physical, long-term assets held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, expected to be used over more than one period.

Key Term: Depreciation
The systematic allocation of the depreciable amount of a tangible asset over its useful life.

Key Term: Existence (audit assertion)
Assets and balances recorded in the financial statements physically exist at the reporting date.

Key Term: Rights and Obligations (audit assertion)
The entity holds or controls the rights to assets (or has obligations for liabilities) presented in the accounts.

Key Term: Substantive procedure
An audit activity (test of detail or analytical procedure) designed to detect material misstatement at the assertion level.

Inventory: Existence and Audit Procedures

Inventory is inherently prone to error due to its quantum, diversity, and movement. The two most critical assertions for inventory are existence (does it actually exist?) and completeness (is any missing?).

Auditor’s Responsibilities

Auditors must obtain sufficient appropriate evidence about inventory quantities, often through attending client inventory counts as prescribed by ISA 501. If the auditor does not observe the count, alternative evidence must be obtained, or a scope limitation may result.

Common Audit Procedures

• Attend inventory count and observe procedures for accuracy and completeness.
• Conduct test counts from inventory records to physical goods and vice versa.
• Confirm inventory held by third parties with direct external confirmation.
• Review cut-off procedures for goods received and dispatched near year-end.
• Inspect condition of goods for obsolescence or damage.

Worked Example 1.1

Scenario:
You attend Medlake Ltd’s year-end inventory count. The client provides printed count sheets, and you are assigned to observe in a warehouse where high-value electronics are stored.

Question:
What substantive procedures do you perform during and after the count to test the existence of inventory, and how would you deal with inventory held at a third-party logistics provider?

Answer:
During the count: Observe client adherence to instructions; perform physical counts; trace selected items from count sheets to physical goods and vice versa; note any damaged or obsolete items.
For third-party inventory: Obtain written confirmation from the warehouse provider of descriptions, quantities, and conditions. If material, consider visiting the location.

Exam Warning

ISA 501 makes auditor attendance at physical counts mandatory if inventory is material and physical count possible. Failure to attend without valid reason may prevent issuance of an unqualified opinion if alternative evidence cannot be obtained.

PPE: Existence, Additions, and Depreciation

Auditor Objectives

The primary assertions for PPE are existence, rights and obligations, valuation (including correct depreciation), completeness (all assets recorded), and proper classification.

Audit of Existence and Ownership

Standard procedures:

• Physically inspect a sample of assets from the register at client premises.
• For assets visible at the location, ensure they appear on the register (completeness).
• Inspect title deeds or ownership documentation (for buildings, land, vehicles).
• Verify that purchased assets are owned by the entity, not leased or belonging to others.

Audit of Additions and Repairs

IAS 16 requires that only amounts that bring future economic benefits and can be measured reliably should be capitalized as PPE. Ordinary repairs or maintenance are expensed.

Procedures include

• Test a sample of additions: inspect invoices and contracts; check that expenditure relates to asset acquisition or enhancement, not repairs.
• For repairs and maintenance, examine supporting documents to confirm these are not incorrectly capitalized.

Worked Example 1.2

Scenario:
Stone Co's financial statements show $400,000 of PPE additions and $95,000 of repairs and maintenance. Some costs relate to an assembly line refurbishment.

Question:
Which audit tests would you perform to assess correct classification, and what risks might arise from misclassification?

Answer:
Trace additions to original invoices, contracts, and board minutes. Check whether costs improve the asset or merely restore it to original condition. Misclassifying repairs as additions inflates assets and delays recognition of expenses, leading to overstated profit and PPE.

PPE: Depreciation and Valuation

IAS 16 requires depreciation to be calculated on a systematic basis reflecting the asset’s pattern of use. Depreciation rates and useful lives must be reviewed at least annually.

Substantive Procedures

• Recalculate the depreciation charge for a sample of assets.
• Agree depreciation rate, method, and useful life with supporting documentation.
• Review significant profit or loss on disposal of assets as an indicator of inappropriate depreciation policies.
• Compare accumulated depreciation with prior years and investigate unexpected fluctuations.
• Inspect board minutes for changes in accounting estimates for useful lives or residual values.

Worked Example 1.3

Scenario:
Grace Ltd depreciates fixtures and fittings on a 10-year straight-line basis. The book value decreased from $800,000 to $720,000 this year after $40,000 in new purchases.

Question:
How would you audit the depreciation expense in this scenario, and what evidence would you seek?

Answer:
Recalculate depreciation for existing and new items, confirm opening and closing balances, agree new purchases to invoices, examine disposal records, and review policy compliance with IAS 16.

Revision Tip

Prepare a table summarizing assertions, common audit risks, and typical procedures for inventory and PPE. Practice writing concise audit procedures as seen in the Sample Exemplar.

Summary

Accurate accounting for inventory and PPE depends on confirming existence, correct valuation, and appropriate classification of costs. Auditors are required to obtain direct evidence, often by attending inventory counts and inspecting physical fixed assets. Repairs must be distinguished from capital additions, and depreciation calculations must reflect economic reality as required by IAS 16. Insufficient or inappropriate evidence risks material misstatement and a modified audit opinion.

Key Point Checklist

This article has covered the following key knowledge points:

• State and apply the key assertions relevant to inventory and PPE audits.
• Describe the auditor’s responsibilities for observing inventory counts and confirming third-party holdings.
• Identify and explain substantive procedures for testing existence, valuation, and rights of PPE.
• Differentiate capital expenditure from repairs in line with IAS 16, and audit depreciation expense.
• Discuss audit risks and consequences of insufficient evidence or incorrect asset classification.
• Outline typical evidence required and auditor responses to common misstatements.

Key Terms and Concepts

• Inventory
• Property, Plant and Equipment (PPE)
• Depreciation
• Existence (audit assertion)
• Rights and Obligations (audit assertion)
• Substantive procedure