Entrepreneur

The Comprehensive Guide to Inventory Audits

By Megan O’Brien, Brainyard Finance & Business Editor
January 14, 2021
inventory audit

In short:

  • When inventory is considered material, inventory audits are an integral component of the overall financial statement audit.
  • Required of public companies and many private companies, the process checks to ensure a business’s financial records match their inventory records and physical count.
  • Understanding what constitutes an inventory audit, whether it’s required and tips for preparation are all important for a company with inventory material to their financial statements.

You may have heard of the McKesson & Robbins scandal — or at least of McKesson, the pharmaceutical giant.

In 1925, a twice-convicted felon named Phillip Musica took control of the company. In addition to expanding its legitimate operations, he recruited three of his brothers to generate bogus sales documentation, then paid commissions to a shell distribution company under their control. The final piece of the plot involved documenting a huge amount of nonexistent crude drugs to bolster the shell company’s inventory. McKesson & Robbins’s auditors never questioned the documentation presented to them. They didn’t perform any sort of check of that physical inventory, either — it just wasn’t common practice at the time.

Eventually, the firm’s treasurer unearthed the scheme. The SEC opened an investigation and Musica was arrested. It was eventually determined that about $20 million (about $369 million in 2020 dollars) of the $87 million in assets on the company's balance sheet were phony.

That’s how a former bootlegger changed the face of auditing and governance forever. After the incident, the American Institute of CPAs (AICPA) adopted new standards around accounts receivable and inventory. Inventory audits have since become a commonplace, and oftentimes required, practice for companies.

What Are Inventory Audits?

Inventory audits check to ensure that financial records match a company’s inventory records and physical inventory count. Audits confirm not only the quantity of inventory but also its quality and condition — and identify any instances of theft, damage or misplacement.

Are Inventory Audits Required?

For public companies, inventory audits are required if the inventory is considered material.

According to the AICPA Auditing Standards (AU-C Section 501, Audit Evidence — Specific Considerations for Selected Items, Paragraphs .11–.14), “If inventory is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding the existence and condition of inventory.”

The audit must be conducted by an independent, external, certified auditor at least once a year as a part of the overall financial statement audit. It serves to verify the inventory part of the book value of the company.

Determining Materiality

According to GAAP, “Items are material if they could individually or collectively influence the economic decisions of users, taken from financial statements.”

Most auditors use one of the following percentages (which one, specifically, depends on the auditor’s judgment).

0.5 - 1% of Sales Revenue
1 - 2% of Total Assets
1- 2% of Gross profit
2 - 5% of Shareholders Equity
5 - 10% of Net Income Before Tax

The Public Company Accounting Oversight Board (PCAOB) reaffirms this requirement for public companies in AS2510: Auditing Inventories, stating that, “Observation of inventories is a generally accepted auditing procedure” and that the auditor “has the burden of justifying the opinion [of inventory value] expressed.”

For private companies, the requirements are situation-dependent. Many companies conduct inventory audits as a part of a financial statement audit — the latter of which is usually required by their investors or bank. An accounting firm won’t confirm a balance sheet without participating in a physical inventory observation.

An inventory audit may also be requested separate from the year-end process. For instance, some banks request an inventory appraisal as part of lending due diligence. The audit will ensure that the inventory still has the value as collateral that the bank needs for a loan.

Many private companies see inventory auditing as integral to running an effective business, even if they’re not required to do it.

“There’s no federal law or regulation requiring all organizations with some form of inventory to conduct a physical audit,” said Jim Pendergast, senior vice president of altLINE, a division of the Southern Bank Company. “But it's one of those best practices underpinning proper operational finances as well as business management that it can feel compulsory.”

An inventory audit, particularly the physical count part of the process, can help teams ensure appropriate inventory levels, identify inefficiencies and budget more accurately.

“A physical inventory count gives the business owner a precise count of available inventory, so they can ensure they maintain sufficient quantity in stock for customers,” said Bryce Bowman, founder of demand planning consultancy People First Planning. “Further, an inventory count helps the business establish the correct value of inventory on its balance sheet.”

It can also help identify more nefarious activities, like theft.

“Products may be damaged or stolen, and this isn't always captured by the inventory management system,” Bowman added.

For companies with those inventory control or sales systems, the inventory audit process can also provide valuable insight into whether the system is effective. Small variances are standard. While the percentage variance that is “acceptable” is dependent on the industry and company, many aim for an inventory variance between 1-2% of sales. Anything over 10% should be setting off alarms — your inventory management system may need some investigating.

Quick Review: Inventory Counting Methods and Frequency

Cycle counts
Generally, businesses perform a cycle count on a monthly or quarterly cadence depending on the nature of an industry.

“[The frequency of inventory counts] can vary based on the type of business and whether the inventory is perishable,” said Bowman. “A restaurant will likely check its inventory of fresh ingredients on a near-daily basis, as they simply aren't able to systematically measure how much product is consumed in each entree. Conversely, an HVAC distributor maintains its inventory in a secured warehouse and likely will perform cycle counts on a quarterly basis.”

A cycle count is a partial count that samples a small portion of inventory. Four common approaches to cycle count are:

  1. ABC analysis: An inventory management technique where inventory is divided into three categories: “A items,” “B items” and “C items.” The ABC analysis harks back to the Pareto Principle, which states that 20% of stock accounts for 80% of value to the business. In this system, you’ll count “A items” more frequently than “B” or “C items.”
  2. Control group: This entails counting a small group of items a number of times in a very short time period. Over time, this repetitive counting uncovers any errors in the count technique. After you correct the errors, you can apply the process across other product categories.
  3. Diminished population: With this method, you’ll count a certain number of items, then avoid counting them again until all other items in the warehouse are counted.
  4. Opportunity-based: This type of count is conducted during critical points of the inventory management process, such as when an item is reordered, put away or falls below its predetermined threshold. It’s also used after short-picks, or when a company ships an order with fewer than the quantity the customer ordered.

Full counts
As opposed to cycle counts, full counts are wall-to-wall inventory checks that account for all items. They’re typically performed once a year at the company’s financial statement period-end. These are the inventory counts that will be subject to external audit if required or desired by the company.

Cycle Count Full Count
Counts a small sample of inventory based on significance or priority. Full, wall-to-wall count of inventory.

The Inventory Audit Process

At some companies, a full count may require an auditor to be present as part of preparing a year-end statement. Other companies may want auditors involved to verify their own procedures.

“A fresh pair of eyes is always advantageous — someone outside of the company who will be ruthless in asking questions,” said Rick Hoskins, founder of Filter King, an air filter manufacturer and subscription service.

External auditors are less likely to be affected by biases in instances of theft, mismanagement, inefficiencies, damage and obsolescence.

“External auditors bring a sense of objectivity and thoroughness that's hard to cultivate with internal-only audits,” said altLINE’s Pendergast.

“Paired with a centralized inventory management system that’s accessible to all relevant employees, [external auditors are] an organization's best way to get accurate, unbiased insights and spot discrepancies you sometimes can't when your nose is pressed too close to the glass,” he added.

Inventory auditors look for several things, according to AICPA director Robert Durak. First, they verify that the inventory exists and determine its condition by attending the physical inventory count. Then, the focus turns to management.

During the physical inventory count, auditors “will evaluate management’s instructions and procedures for recording and controlling the results of the count, observe the performance of management’s count procedures, inspect the inventory and perform test counts,” said Durak.

*Remember, auditors are not doing the full physical inventory count for the company, but rather observing employees during the count and conducting spot test counts to validate the company’s findings.

For some businesses, having employees run the full physical inventory count is ideal. But for others — for example, a department store like Saks Fifth Avenue — having salespeople go through their massive inventory might not be efficient. In that case, there are non-audit companies (e.g., RGIS) that will perform physical inventory counts for you.

At the end of the inventory audit, said Durak, auditors will determine the accuracy of the count results by testing the following assertions:

  • Existence: Inventory balances reported on financial statements actually exist at the reporting date.
  • Completeness: Inventory reported on the balance sheet includes all inventory transactions that have occurred during the accounting period.
  • Rights and obligations: All inventory reported on financial statements as of the reporting date really belongs to the company.
  • Valuation: Inventory balances truly reflect its economic value.
  • Presentation and disclosure: Inventory is properly classified and sufficiently disclosed in the notes to financial statements.

The procedures that auditors use to test these assertions will differ based on a company’s industry, sector and individual needs. However, there are several common analyses used:

  • Physical inventory count observation: As mentioned above, auditors will observe either the in-house team or third party that is counting the inventory, to ensure they are comfortable with the procedures in place. The auditors will then do random test counts to validate the numbers.
  • Cutoff analysis: Auditors might examine the procedures in place for cutoff, which entails pausing warehouse operations to halt any further receiving or shipments during the physical count process. The analysis here involves making sure all transactions have been reported in the proper financial period. Auditors will test receiving and shipping documents to prove accuracy of recorded movement into and out of inventory.
  • Finished goods cost analysis: For manufacturing companies, auditors will review the bill of materials for a selection of finished goods for accuracy and completeness.
  • Freight cost analysis: This analysis looks at shipping costs, the time it takes and instances of products being lost or damaged in transit.
  • Overhead analysis: This analyzes the indirect costs of the business (e.g., rent, utilities, insurance) to see how they affect the overall inventory cost, if the business includes them.
  • Inventory in transit analysis: If some inventory is being transferred between locations, auditors will examine transfer documentation and include that inventory in the count.
  • High-value inventory item tests: If some inventory is unusually high-value relative to other items, auditors will likely spend extra time counting it, ensuring it’s valued correctly, and tracing it into the valuation report, which carries forward into the inventory balance in the general ledger.
  • Error-prone inventory items tests: If there has been an error trend in prior years for specific inventory items, auditors will be more likely to test these items again.
  • Direct labor analysis: If direct labor is included in the cost of inventory, auditors will trace the labor charged during production on timecards or labor routings to the cost of the inventory.
  • Inventory ownership verification: Auditors may review purchase records to ensure the company actually owns the inventory in its warehouse.
  • Lower of cost or market testing: Under GAAP, inventory is recorded at either its cost or market value, whichever is lower. Auditors may check a selection of inventory to ensure its valuation follows this rule.
  • Receivable report testing: Auditors may test several invoices from accounts receivable to verify they were billed in the correct amounts, to the correct customers, on the correct dates.
  • Item cost testing: An auditor might compare supplier invoices to the costs listed in your inventory valuation.
  • Inventory count reconciliation: At the end of the process, the auditors will check to ensure the physical count matches the company’s books.

Planning for an Inventory Audit

Planning is key prior to an inventory audit, according to Durak. Without proper preparation, companies will face a disorganized, expensive and time-consuming audit.

Think about timing.

In order to prevent confusion during the inventory audit, operations are frozen, eliminating transportation in and out of the facility and halting product movement. Inventory can’t be transferred between retail shops or manufacturing facilities — it needs to stay put. Companies will need to work with auditors to ensure the physical inventory count won’t obstruct a company’s ability to fulfill orders.

Many companies’ year-end is in December, which can pose issues for a count due to holiday demand. These companies might use roll forwards and roll backs to conduct the physical count well before or after year-end.

Roll Forwards Roll Backs
Take the inventory per the last full physical count, add purchases and other direct costs, then subtract the cost of goods sold to arrive at the ending inventory. Set a cutoff date for the period in question (e.g., the end of the financial reporting period). Next time the physical inventory count occurs, disregard any transactions that occurred after the cutoff date to get the full year’s inventory count.

Organize your inventory.

“Organization is key,” said Hoskins. “Prior to the audit, minimize the number of mixed pallets in the warehouse. It will take much longer and cost more to count random cases of product spread throughout your facility. Rather, keep similar products together, ideally stored in a consistent manner — for example, 36 cases per pallet — to allow quick and accurate counting.”

Additionally, warehouses will often have damaged, obsolete or returned inventory put to the side to be processed. Before your audit, deal with those items — whether it be writing them off, writing them down, repairing or reshelving them.

inventory write-offs

Inventory Write-Offs: Definition, Steps, & FAQs: Events like spoilage, damage or obsolescence can reduce or even eliminate inventory’s value. When you experience these losses, write them off correctly.

Also consider ordering two-part count tags for all inventory that will be counted. These tags should be sequentially numbered, so they can be individually tracked as part of the counting process.

A clean warehouse, with inventories organized in an orderly fashion, will both facilitate the observation and instill auditor confidence that everything has been accurately counted.

Prepare documentation.

Ensure the proper documentation is ready for auditors to review. This includes inventory records, invoices, shipping/receiving reports and proof of inventory ownership (e.g., a certificate of ownership or bill of sale).

Companies should also have their inventory manual (which lays out their policies and procedures for managing inventory), written documentation of the protocols used in the physical inventory count (e.g., the counting instructions given to the staff) and the cutoff procedures on-hand for auditors to review.

Prepare your personnel.

Consider assigning two-person teams — ideally employees who don’t typically work together — to count inventory, to minimize errors and fraud.

If possible, arrange to have knowledgeable warehouse personnel available to assist the auditors during the observation. These experienced personnel can expedite the auditor’s evaluation of the overall condition of inventories and help them locate and identify items selected for test counts.

Companies new to inventory audits or with drastically fluctuating inventory levels may find it helpful to conduct a dry run a few days before the count to determine how many workers to schedule.

Employ available technology.

Ensure your company is taking advantage of technology to help expedite the audit. This could look like using a barcode scanner to help physically count each item or the data provided by inventory and account software to generate insights for auditors.

The question of technology use is even more integral now, when audits may be conducted virtually by video. (More on that below.)

Minimize work-in-process inventory.

Inventory is classified as one of the following: raw materials, work-in-process (WIP) or finished goods. WIP is infamously difficult to account for since it requires the company to determine inventory’s percentage of completion and assign a value to it. To avoid complexity, many companies try to minimize the amount of WIP inventory prior to an audit.

Consider additional locations.

Auditors will need insight into any inventory the company keeps in additional locations or held by a third party, like a public warehouse. Management should instruct third-party inventory custodians to count inventories as of the same date as the principal inventory count and forward records to management.

Physical Inventory Count Observation in 2021

While auditors were given some relief in terms of audit timing and regulatory inspections at the beginning of the pandemic, they are still held to standards that require physical observation of inventory.

For both auditors and clients, this presents quite the conundrum: How can they check inventory if it’s considered unsafe or against restrictions to be on-site?

For many, it has meant getting creative. Using video to conduct physical inventory audits has become popular among those who can’t host an on-site visit. Through a tablet, phone footage, security cameras, body cam, GoPro, or even drones, staff livestream inventory for auditors.

However, there are drawbacks. Your technology must have the capabilities to clearly record the inventory, and auditors have to verify the video feed’s authenticity, date and scope. The personnel recording this video need to have familiarity with the inventory, the counting process and the technology itself.

“When counts are observed by the auditor virtually, substantially more planning is needed,” said Durak. “A virtual approach to gaining this necessary evidence poses additional audit risks. As auditors begin to think about these additional risks, they need to consider the preconditions that [will allow them to feel] confident that remote auditing of test counts and cutoff amounts will be effective.”

These preconditions will only be effective if management’s processes are well-designed and reliably testable, he added. In this potential near-future of inventory audits, management would provide auditors with written proof that it has provided the auditor with all relevant information and access, as agreed upon in the terms of the audit engagement.

While this future reality may indeed manifest, some companies, like Anthropologie and its auditors from Deloitte & Touche LLP, have resumed semi-normal on-site inventory checks in recent months. Before your company does the same, auditors will need to confirm they are comfortable with your company’s safety protocols. Common measures include gloves, temperature checks, social distancing and sanitization.

Mark Bianco

For more helpful information from the Brainyard and our friends at Grow Wire and the NetSuite Blog, visit the Business Now Resource Guide.

  

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