Audit risks for the Manufacturing Industry – Stock Valuations

Companies in the manufacturing sector have faced a wide range of business challenges in recent times and a number of these will also have implications for the annual audit of the financial statements.

While managing the day-to-day impact of these challenges may be the most pressing matter for the Directors, it is important to consider the impact on Financial Reporting and Audit Risk at an early stage, to reduce the risk of encountering unwanted surprises during the annual audit process.

Michael Parry
Author Michael Parry

In the past two years manufacturing companies have been heavily impacted by both UK and Global economic conditions, with inflationary pressure on major areas of the supply chain such as raw materials prices, logistics and energy costs. Labour shortages and FX volatility have also driven up costs of production for businesses in the sector.

While most companies will have given thought to the impact of these pressures on their future cash flow and targeted sales pricing for customers, some may not have considered the impact on other areas of the accounts such as stock valuations. These have implications for the annual audit process.

As a means of simplifying the year end stock valuation process, businesses will frequently use a Standard Costing model for stock they hold, whether that be in the form of raw materials, work in progress (WIP) or finished goods. These standard costs may need to be revisited to account for the increase in costs in the supply chain.

For a Standard Costing model to be acceptable for stock valuations under accounting standards, FRS102 states that the result of the method should be a valuation that approximates cost, and the model must be regularly reviewed and if necessary revised in light of current conditions.

Some businesses may not have reviewed or revised their costings for several periods, something which in a low inflation environment may not have had a significant impact on the audit of the financial statements. However, the recent increase in inflation throughout the supply chain, or large FX movements during a period, could mean that the auditors are now unable to conclude that the Standard Costing model approximates the cost of stock. In turn this could lead to adjustment being required to the financial statements as a result of the audit testing performed.

Another area of stock valuation that could be impacted by inflationary pressures is the allocation of production overhead costs. Manufacturing businesses generally have high levels of energy consumption, so the increases in energy costs since 2022 will inevitably have a larger impact on them than other industries. These increases should feed through to the allocation of overhead costs to stock at the year end.

Consideration should also be given to whether increased energy costs are recoverable from customers, such that stock is not overvalued. If the auditor concludes that there is overvaluation of stock due to increased overhead cost allocations, adjustment will be needed to the accounts.

Stock valuations for manufacturers has always been a key consideration from an audit perspective, and the recent economic conditions have only increased audit risk in this area. To ensure a smooth audit process it will be important for Directors to give more consideration to the valuation of stock in advance of the year end than was required during times of low inflation and economic stability. This, along with early consultation with the audit team, should help to reduce the risk of unexpected changes being required to the financial statements during the audit process.

Photo by Rob Lambert on Unsplash

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