Overview
The Public Company Accounting Oversight Board (PCAOB) released its 2024 inspection findings in December 2024, revealing a troubling pattern: inventory audit deficiencies appeared in 100% of inspected Big 4 firms and a majority of mid-tier firms. This marks the third consecutive year where inventory observation failures have dominated inspection reports.
The findings underscore a persistent gap between PCAOB AS 2510 requirements and actual audit execution. With inventory fraud losses exceeding $2.1 billion annually in the U.S. alone, these deficiencies represent more than regulatory non-compliance—they signal systemic risk in financial reporting.
Key Findings
The 2024 PCAOB inspection cycle reviewed 252 audit engagements across 47 registered firms. Inventory-related deficiencies appeared in 68% of all inspected audits—the highest rate since the PCAOB began tracking this metric in 2003.
Most Common Deficiencies:
- Inadequate observation procedures (42% of deficiencies): Auditors failed to test a sufficient sample of inventory items or did not adequately observe client count procedures
- Insufficient testing of inventory valuation (31%): Failure to test net realizable value, obsolescence reserves, or lower-of-cost-or-market adjustments
- Inadequate roll-forward procedures (18%): When observation occurred before year-end, auditors failed to adequately test transactions between observation and balance sheet date
- Failure to address high-risk inventory (9%): Inadequate procedures for inventory held by third parties, consignment inventory, or inventory in transit
Firm-by-Firm Analysis
The PCAOB's 2024 reports reveal that inventory deficiencies are not isolated to a single firm or practice area. Below is a breakdown of specific findings by firm (firm names anonymized per PCAOB policy, identified by inspection report number):
| Firm Category | Specific Finding | Deficiency Type |
|---|---|---|
| Big 4 Firm A | Failed to test sufficient inventory locations; only observed 2 of 14 warehouses representing 18% of total inventory value | Critical |
| Big 4 Firm B | Inadequate testing of obsolescence reserves; accepted management's methodology without independent validation | Significant |
| Big 4 Firm C | Failed to perform adequate roll-forward procedures from observation date (10/31) to year-end (12/31) | Critical |
| Big 4 Firm D | Did not obtain sufficient evidence regarding inventory held by third-party logistics providers | Significant |
| Mid-Tier Firm E | Observation procedures did not include testing of high-value items; focused only on quantity, not condition or quality | Moderate |
| Mid-Tier Firm F | Failed to test cut-off procedures adequately; did not verify last shipping/receiving documents | Significant |
| Mid-Tier Firm G | Inadequate documentation of observation procedures; workpapers did not support conclusions reached | Moderate |
| Regional Firm H | Did not perform alternative procedures when unable to attend physical count due to timing constraints | Critical |
Note: The PCAOB does not publicly identify specific firms in Part I.A deficiencies. The table above represents composite findings from publicly available inspection reports. Firm categories are used to illustrate the breadth of deficiencies across firm sizes.
Don't Let Your Firm Appear in Next Year's Report
See how CPCON supports audit engagements with compliant, defensible inventory observation services.
Learn MoreDeficiency Patterns
Analysis of the 2024 findings reveals several recurring patterns that transcend firm size and industry specialization:
Multi-Location Sampling
Auditors consistently failed to visit enough locations to achieve sufficient coverage, particularly when inventory was dispersed across numerous sites.
Roll-Forward Gaps
When observation occurred before year-end, auditors often performed inadequate testing of intervening transactions, particularly for high-volume or high-value movements.
Valuation Testing
Insufficient skepticism when testing management's obsolescence reserves, net realizable value calculations, and lower-of-cost-or-market adjustments.
Third-Party Inventory
Inadequate procedures for inventory held by third-party logistics providers, consignees, or in-transit inventory, particularly in complex supply chains.
Root Causes
The PCAOB's inspection reports, combined with post-inspection remediation discussions, point to several underlying causes for the persistent inventory deficiencies:
1. Resource Constraints and Timing Pressures
Inventory observation often occurs during peak busy season when audit teams are stretched thin. Firms frequently assign less experienced staff to observation procedures, and senior reviewers may not adequately supervise or review the work performed.
Impact: Inadequate sample sizes, missed high-risk items, and insufficient documentation of procedures performed.
2. Overreliance on Client-Prepared Information
Auditors increasingly rely on client-generated reports, cycle count results, and perpetual inventory systems without performing sufficient independent verification. This is particularly problematic when internal controls are weak or untested.
Impact: Failure to detect material misstatements in inventory quantities, valuation, or existence.
3. Inadequate Training on AS 2510 Requirements
Despite AS 2510 being in effect since 2003, many audit staff lack comprehensive training on its requirements, particularly regarding alternative procedures, roll-forward testing, and third-party confirmations.
Impact: Non-compliance with fundamental observation requirements, leading to Part I.A deficiencies.
4. Complex Supply Chains and Inventory Systems
Modern supply chains involve multiple locations, third-party logistics providers, just-in-time inventory, and complex valuation methodologies. Audit procedures have not always kept pace with this complexity.
Impact: Incomplete coverage of inventory populations, particularly for high-risk or non-standard inventory items.
Download Our AS 2510 Observation Checklist
Ensure your inventory observation procedures meet PCAOB standards with our comprehensive, field-tested checklist.
Get the ChecklistImplications for 2026 Audits
The 2024 inspection findings have immediate implications for audits currently in progress and those planned for 2026:
Heightened PCAOB Scrutiny
Given the high deficiency rate, the PCAOB has indicated that inventory observation will remain a focus area in 2025 and 2026 inspection cycles. Firms should expect:
- Increased selection of audits with significant inventory balances
- More detailed review of observation workpapers and documentation
- Greater scrutiny of roll-forward procedures and alternative procedures
- Enhanced focus on multi-location inventory and third-party holdings
Audit Committee Expectations
Audit committees are increasingly aware of PCAOB findings and are asking more pointed questions about inventory observation procedures. Auditors should be prepared to discuss:
- How observation procedures address identified risks
- Rationale for location selection and sample sizes
- Use of specialists or third-party observation services
- Quality control procedures over observation work
Reputational and Regulatory Risk
Repeated Part I.A deficiencies can lead to enhanced monitoring by the PCAOB, potential enforcement actions, and reputational damage. Firms with multiple inventory deficiencies across inspection cycles face increased regulatory scrutiny and potential client concerns about audit quality.
Recommendations for Audit Firms
Based on the 2024 findings and discussions with audit quality leaders, CPCON recommends the following actions for audit firms:
Enhance Training and Supervision
Implement mandatory AS 2510 training for all staff involved in inventory observation, with annual refreshers. Ensure senior reviewers are actively involved in planning and reviewing observation procedures.
Action: Develop firm-specific observation checklists and require partner-level review of all observation workpapers before audit completion.
Improve Location Selection Methodology
Develop a risk-based approach to location selection that considers inventory value, risk of material misstatement, control environment, and historical accuracy. Document the rationale for locations selected and not selected.
Action: Create a standardized location selection template that requires quantitative analysis and partner approval.
Strengthen Roll-Forward Procedures
When observation occurs before year-end, perform comprehensive testing of intervening transactions, including detailed review of high-value movements, cycle count results, and reconciliations.
Action: Require detailed roll-forward workpapers with specific testing of material transactions and reconciliation to year-end balances.
Consider Third-Party Specialists
For complex, multi-location, or high-risk inventory populations, consider engaging independent inventory observation specialists who can provide additional coverage and expertise.
Action: Evaluate the cost-benefit of third-party observation services versus internal resource allocation and potential inspection risk.
Enhance Documentation Standards
Ensure workpapers clearly document the procedures performed, items tested, results obtained, and conclusions reached. Include photographs, detailed item descriptions, and evidence of testing performed.
Action: Implement standardized observation workpaper templates with required fields and evidence attachments.
Frequently Asked Questions
Why are inventory deficiencies so common in PCAOB inspections?
Inventory observation is inherently complex, requiring significant resources, coordination, and professional judgment. The combination of timing pressures, resource constraints, complex supply chains, and inadequate training creates conditions where deficiencies are more likely to occur. Additionally, the PCAOB has made inventory a focus area, leading to increased scrutiny and detection of deficiencies.
What is the difference between a Part I.A and Part I.B deficiency?
Part I.A deficiencies are the most serious—they indicate that the auditor failed to obtain sufficient appropriate audit evidence to support the opinion issued. Part I.B deficiencies are less severe and relate to deficiencies in the firm's quality control system. Inventory deficiencies are typically classified as Part I.A because they directly affect the sufficiency of audit evidence.
How many locations should an auditor visit for inventory observation?
There is no fixed rule, but AS 2510 requires auditors to be present at locations where significant inventory is held. A risk-based approach should consider the number of locations, value of inventory at each location, risk of material misstatement, and the effectiveness of internal controls. Generally, auditors should aim to observe inventory representing at least 70-80% of total inventory value, with higher coverage for high-risk situations.
Can auditors rely on client cycle counts instead of performing observation?
AS 2510 allows auditors to observe cycle counts instead of a full physical inventory count, but only if the cycle count program is well-designed, properly controlled, and provides sufficient coverage. The auditor must still observe some cycle counts during the year, test the effectiveness of the program, and perform roll-forward procedures to year-end. Simply relying on client-reported cycle count results without observation is insufficient.
What should auditors do if they cannot attend the physical inventory count?
AS 2510 requires auditors to perform alternative procedures if they cannot attend the count due to unforeseen circumstances or if attendance is impracticable. Alternative procedures might include observing a subsequent count, testing intervening transactions, and obtaining confirmations from third parties. However, these alternatives must provide sufficient appropriate evidence, and the auditor must document why attendance was impracticable.
How can audit firms prevent inventory deficiencies in future inspections?
Prevention requires a multi-faceted approach: enhanced training on AS 2510 requirements, improved supervision and review of observation work, risk-based location selection methodologies, adequate resource allocation, use of specialists when appropriate, and robust documentation standards. Firms should also conduct internal inspections focused on inventory observation procedures to identify and remediate issues before PCAOB inspection.
Need Independent Inventory Observation?
CPCON is trusted by Big 4 and regional firms nationwide to provide compliant, defensible inventory observation services that withstand PCAOB scrutiny.
Learn How We Support Auditors