COVID -19 has caused significant disruptions to business operations. Several U.S. states have already begun mandating that non-essential businesses, basically anything beyond supermarkets, pharmacies, and other life sustaining businesses, close their doors to customers. CPA Firms are requiring staff to work from home and banning staff travel. Clients are telling auditors not to come on site for visits.
These disruptions can cause significant accounting and auditing challenges, especially when it comes to conducting an annual physical inventory count. Companies with June 30 year-end may find themselves in a situation where they legally cannot conduct inventory counts or have their auditors on site to observe inventory counts by the deadline. Healthcare experts have stated that COVID-19 could recycle itself. Most recently Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious diseases, said there were early indications COVID-19 could return with the changing of the seasons as influenza does. If this were to occur, companies with a December 31 year-end may also find themselves in this situation.
There are auditing standards directly related to physical observation of inventory that auditors need to comply with. Those standards are outlined in AU-C Section 501 Audit Evidence—Specific Considerations for Selected Items, paragraphs 11 through 15. Paragraph 11 states in part:
- If inventory is material to the financial statements, the auditor should obtain enough appropriate audit evidence regarding the existence and condition of inventory by;
- Attending physical inventory counting, unless impracticable, to
- Evaluate management’s instructions and procedures for recording and controlling the results of the entity’s physical inventory counting,
- Observe the performance of management’s count procedures,
- Inspect the inventory, and
- Perform test counts, and
- Perform audit procedures over the entity’s final inventory records to determine whether they accurately reflect actual inventory count results.
- Attending physical inventory counting, unless impracticable, to
There a few alternatives available to both management and auditors. All the alternatives are under the assumption that inventory is material to the financial statements. These alternatives include:
- Physical inventory not conducted by the company
- Roll forward / roll back
- Video observation
- Cycle Counting
Physical Inventory Not Conducted by the Company
Not conducting a physical inventory is the worse alternative and one that should be avoided at all cost. The impact of not conducting a physical count will result in the auditor issuing a qualified opinion on the company’s audited financial statements. A qualified auditor’s report could have an impact on the company’s debt covenants, its ability to obtain a loan, or its ability to raise capital.
Roll Forward / Roll Back
Management may conclude to postpone the inventory counting and observation to a different date either before or after the company’s year-end. Postponement may be due to the stay-at-home orders mandated by federal, state, or local government. The auditor could count inventory and observe the counting of inventory on the selected date and then perform additional testing on the sales and purchases either prior to or subsequent to year-end. Management could effectively roll back or roll forward the inventory to the year-end and provide its roll back /roll forward analysis to the auditor. Depending on the length of time, either before or after the company’s year-end, the inventory counted will determine the extent of the roll back / roll forward. Generally, two weeks or less would be best for roll back /roll forward. Due to the uncertainty of when COVID-19 pandemic will end, picking a date for the inventory count will be difficult. Consequently, it is possible the inventory count date could be greater than two weeks after the company’s year-end date.
Some state CPA societies as well as the AICPA believe that video observation would be acceptable for the auditor to use to observe the physical inventory count. This is supported by Paragraph.A34 of AU-C §501 that indicates that one circumstance that may make a physical observation impracticable, as in the inventory is held in a location that may pose threats to the auditor’s safety.
Video observation will require someone from the company, that is familiar with the inventory, to walk around the operating facility either wearing a video camera or carrying a video camera that has a live feed like Microsoft Teams or Zoom. The auditor would need to be able to talk to the counter with an interactive dialogue. The auditor will need to be familiar with the company’s operating facility in order to recognize it on the video feed. Video observation may need to be combined with roll back / roll forward inventory procedures.
The overriding consideration when using remote video is that the auditor needs to have a comfortable feel for the authenticity of the video feed. If it’s a live situation where perhaps someone from the company 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, Microsoft Teams or Zoom and somebody is walking around to the inventory and counting it in response to verbal commands of the auditor with an interactive dialogue, you can be comfortable that’s an authentic video feed. You can recognize the client location.
The use of a recorded observation versus a live video feed will present challenges to the auditor, with the largest challenge being determining the authenticity of the recording, the date it was taken and determining if the recording was recorded on that date.
A cycle count is an inventory auditing procedure, which falls under inventory management, where a small subset of inventory, in a specific location, is counted on a specified day. Cycle counts contrast with traditional physical inventory in that a full physical inventory may stop operations at a facility while all items are counted at one time. Cycle counts are less disruptive to daily operations and provide an ongoing measure of inventory accuracy and procedure execution. They can be tailored to focus on items with higher value, higher movement volume, or that are critical to business processes. Although some say that cycle counting should only be performed in facilities with a high degree of inventory accuracy (greater than 95%), cycle counting is one means of achieving and sustaining high degrees of accuracy. There are specific procedures to use when cycle counting to quickly identify root causes of problems in the processes that control inventories and then monitor the effectiveness of the actions to eliminate the root causes. Periodically through-out the year “Super Cycle Counting” will be taken, in which a larger number of cycle counts are performed. As cycle counting occurs throughout the year management can track the accuracy of inventory. Depending on the results and accuracy achieved with the cycle counts a full physical count may not be needed. The auditor could observe the cycle counts through-out the year to gain comfort with counting procedures used by the company as well as the inventory quantities reflected on the company’s books and records. Should a postponement of the physical count occur prior to the company’s year-end, due to the COVID-19 pandemic, picking a date to conduct “Super Cycle Counting” may not be critical when compared to the traditional annual physical count.
Due to the uncertainty surrounding COVID-19, cycle counting is worth the consideration for monitoring and counting inventory to avoid not being able to conduct the physical inventory count or having to count the inventory at much later date after the company’s year-end.