When inventory is considered significant, it plays a crucial role in the financial statement audit process. This is a requirement for both public and many private companies. Inventory counts—whether full physical counts or cycle counts—are essential to verify that a company’s financial records align with its actual inventory and what’s present on the shelves.
Gaining a clear understanding of what an inventory audit entails, preparing adequately, and following best practices can provide a competitive advantage to product companies. The last quarter of the year is particularly busy for retailers due to the holiday season’s impact on annual performance, but the workload doesn’t end on January 1st.
Soon after the new year begins, many companies conduct full physical inventory counts, often under the watchful eye of an auditor. For some, this process evokes memories of tedious days spent counting items in the warehouse. While physical inventory counts are often seen as a necessary burden, they are critical for accurate financial reporting.
The past two years have brought significant changes as businesses adapt to remote work environments. However, the approach to annual inventory counts has largely remained the same. While some companies have innovated with technology—using body-mounted cameras, smart glasses, and drones for remote audits—these methods are typically adopted by larger enterprises with substantial budgets. For most businesses, physical counts in 2022 will closely resemble those from early 2020.
There are several strategies to make inventory audits less burdensome. In this guide, we will discuss the situations that necessitate an audit, various counting methods, including the role of cycle counting, what to expect during an audit, and practical steps to streamline the inventory audit process. Our goal is to help make your 2022 inventory count faster, easier, and less disruptive.
Understanding Inventory Audits
Inventory audits are a crucial process to ensure the accuracy of a company’s financial and inventory records. During an inventory audit, companies verify that their financial records are consistent with their inventory records and that these records correspond with the actual physical inventory. This process involves employees meticulously counting every item in the warehouse, often aided by technology that helps tally and record the products in stock.
An inventory audit typically goes beyond just counting items. It often involves an independent third party who confirms not only the quantity but also the quality and condition of the inventory. This external validation helps identify discrepancies, such as theft, damage, or misplaced items, ensuring the integrity of the inventory data. By providing an objective assessment, audits play a critical role in maintaining accurate financial reporting and inventory management.
The Evolution of Inventory Audits
The origins of modern inventory audits date back nearly a century to a notorious scandal involving Phillip Musica, a twice-convicted felon, who in 1925 took control of the pharmaceuticals and medical products company McKesson. Musica, along with his brothers, orchestrated a scheme involving the creation of fake sales documentation and inflated inventory records to deceive the company’s auditors. They documented large quantities of non-existent crude drugs to falsely inflate the company’s inventory, which went unchecked due to lax auditing practices of the time.
The deception was eventually uncovered by McKesson’s treasurer, prompting an investigation by the Securities and Exchange Commission (SEC). Musica was arrested in 1938, revealing that approximately $20 million (equivalent to about $394 million in 2021) of McKesson’s reported $87 million in assets were fraudulent.
This scandal had a profound impact on the field of auditing and corporate governance. In response, the American Institute of CPAs (AICPA) introduced new standards for accounts receivable and inventory auditing, emphasizing the importance of verifying physical inventory. This case underscored the need for rigorous auditing practices to ensure the accuracy of financial statements and prevent fraud. As a result, inventory audits have become an essential and often mandatory practice for businesses, providing a crucial safeguard for financial integrity and transparency.
Are Inventory Audits Mandatory?
For public companies, inventory audits are mandatory if inventory is deemed material to the financial statements. According to the AICPA Auditing Standards (AU-C Section 501), if inventory is significant to a company’s financial records, the company must demonstrate to an auditor that the inventory exists and is in the stated condition. These audits are conducted annually by an independent, certified auditor as part of the overall financial statement audit to verify the book value of the company’s inventory.
Determining Materiality
Materiality in financial terms refers to items that could influence the economic decisions of users based on financial statements. Generally Accepted Accounting Principles (GAAP) do not provide a fixed standard for what constitutes “material” inventory, as it varies by industry. However, auditors often use benchmarks like:
- 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
Items falling within these ranges are typically included in financial statements at the auditor’s discretion. Items exceeding these thresholds are usually considered material and must be included in the audit.
The Public Company Accounting Oversight Board (PCAOB) further enforces this requirement, stating that observing inventories is a generally accepted auditing procedure, and auditors must justify their opinion on the inventory’s value.
Requirements for Private Companies
For private companies, inventory audit requirements depend on specific circumstances. Many private companies perform inventory audits as part of a financial statement audit, often required by investors or banks. Accounting firms typically require physical inventory observations to verify the balance sheet. Additionally, private companies aiming to comply with GAAP must also conduct inventory counts.
An inventory audit might be requested separately, such as by banks during lending due diligence, to ensure that inventory still holds the collateral value needed for loans. Many private companies consider inventory auditing integral to effective business management, even when not legally required.
Benefits of Inventory Audits
Regular inventory audits help companies maintain appropriate inventory levels, identify inefficiencies, and budget more accurately. They also help detect theft, damage, or misplaced goods. Audits can provide valuable insights into the effectiveness of inventory control systems. Small discrepancies between actual inventory levels and records are common, but significant variances (e.g., over 10%) may indicate issues with the inventory management system that need investigation.
Inventory Counting Methods and Frequency
Inventory counting is primarily done through physical counts and cycle counts.
- Physical Counts: These are comprehensive checks that account for all inventory items and are typically conducted annually. Physical counts are time-consuming and disruptive, often requiring a temporary halt in operations.
- Cycle Counts: This method involves counting a select portion of inventory regularly and comparing it to the inventory management system’s records. Cycle counting is less disruptive and can be done daily, weekly, monthly, or quarterly, depending on the business’s needs.
Different approaches to cycle counting include:
- ABC Analysis: Divides inventory into three categories (A, B, and C) based on importance, with “A items” being the most critical.
- Control Group: Repeatedly counts a small group of items to identify counting errors and refine the process.
- Diminished Population: Counts a set number of items before moving on to the next, reducing the pool of items over time.
- Opportunity-Based: Conducts counts during specific inventory management events, such as reordering or restocking.
- Random Sample: Randomly selects items to count, ensuring that less visible inventory is not overlooked.
- Objective Counting by Surface Area: Divides facilities into sections for systematic counting.
Can Cycle Counts Replace Physical Counts?
Cycle counts can sometimes replace physical counts, provided they meet the requirements of the requesting entity, such as a regulatory body or financial institution. GAAP permits cycle counts if all inventory is eventually counted. However, cycle counts are not yet universally accepted as a replacement for physical counts. Over time, with proven accuracy and consistency, cycle counting might become a standard practice, reducing the need for disruptive physical counts.
The Inventory Audit Process Explained
In many companies, a full inventory count may require the presence of an auditor, especially when preparing year-end financial statements. Some companies also choose to involve auditors to verify their internal procedures. According to Rick Hoskins, founder of Filter King, having an external auditor provides a fresh perspective, as they are likely to ask probing questions and remain unbiased in assessing issues such as theft, mismanagement, inefficiencies, damage, and obsolescence.
External auditors play a critical role in the inventory audit process. As outlined by Robert Durak, director at the AICPA, the audit process begins with verifying the existence and condition of the inventory through attendance at the physical count. This initial phase is followed by an evaluation of management’s procedures.
During the physical inventory count, auditors do not conduct the count themselves. Instead, they observe the company’s employees and perform spot checks to ensure the accuracy of the count. This approach helps validate the company’s inventory records.
For some businesses, using internal staff for inventory counts is practical. However, for large retailers like department stores, employing specialized firms such as RGIS to perform these counts can be more efficient.
At the conclusion of the audit, auditors assess the accuracy of the inventory count by testing several key assertions:
- Existence: Ensuring that inventory reported in financial statements actually exists at the reporting date.
- Completeness: Verifying that all inventory transactions during the period are included in the financial statements.
- Rights and Obligations: Confirming that the company has ownership of the reported inventory.
- Valuation: Checking that inventory balances accurately reflect economic value.
- Presentation and Disclosure: Ensuring that inventory is properly classified and disclosed in financial statements.
Auditors use various procedures to test these assertions, tailored to the company’s industry and specific needs. Common analyses include:
- Physical Inventory Count Observation: Auditors observe the counting process and conduct random test counts to validate accuracy.
- Cutoff Analysis: Examining procedures to ensure that all inventory transactions are recorded in the correct financial period.
- Finished Goods Cost Analysis: Reviewing bills of materials for accuracy in manufacturing companies.
- Freight Cost Analysis: Analyzing shipping costs and instances of lost or damaged goods in transit.
- Overhead Analysis: Assessing the impact of indirect costs like rent and utilities on inventory cost.
- Inventory in Transit Analysis: Verifying inventory being transferred between locations.
- High-Value Inventory Item Tests: Focusing on high-value items to ensure correct valuation and inclusion in financial records.
- Error-Prone Inventory Items Tests: Reassessing items with a history of discrepancies.
- Direct Labor Analysis: Checking that labor costs are correctly allocated to inventory.
- Inventory Ownership Verification: Reviewing purchase records to confirm inventory ownership.
- Lower of Cost or Market Testing: Ensuring inventory is recorded at the lower of cost or market value, as required by GAAP.
- Receivable Report Testing: Verifying that invoices are correctly billed to customers.
- Item Cost Testing: Comparing supplier invoices with inventory costs.
- Inventory Count Reconciliation: Ensuring that the physical inventory count matches the company’s financial records.
These procedures help companies maintain accurate inventory records, which are crucial for financial reporting and overall business management. By identifying and addressing discrepancies, businesses can improve their inventory management systems, reduce errors, and enhance operational efficiency.
Effective Planning for an Inventory Audit
Proper planning is crucial for a smooth and efficient inventory audit. Without adequate preparation, companies may face a disorganized audit process that is both costly and time-consuming. Here are key steps to consider when planning for an inventory audit:
Timing Considerations
The timing of an inventory audit is critical, as operations often need to pause during a physical count, stopping the movement of goods in and out of the facility. To minimize disruptions, companies should schedule the audit during a period when halting operations will least impact fulfillment. For many companies, year-end is a common time for audits, but this can be challenging due to increased holiday demand. To address this, some companies conduct their physical count either before or after the fiscal year-end, using roll forwards and roll backs to adjust the timing.
Organizing Inventory
A well-organized inventory is essential for an efficient audit. As Rick Hoskins of Filter King suggests, reducing the number of mixed pallets and grouping similar products together can streamline the counting process. This organization facilitates quick and accurate counting and reduces costs. Additionally, companies should handle damaged, obsolete, or returned inventory before the audit, whether through write-offs, repairs, or reshelving, to present a clean and orderly warehouse.
Documentation Preparation
Ensure that all necessary documentation is ready for auditor review, including inventory records, invoices, shipping and receiving reports, and proof of inventory ownership. Additionally, companies should have an inventory manual outlining inventory management policies and procedures, as well as documentation of the protocols used during the physical count and cutoff procedures.
Preparing Personnel
Assigning two-person teams to count inventory, preferably employees who do not usually work together, can help minimize errors and reduce the risk of fraud. Workers involved in the count should be dedicated to this task for the entire duration of their shifts. It is also beneficial to have experienced warehouse personnel available to assist auditors, providing insights into the inventory’s condition and helping locate items for test counts.
For companies new to inventory audits or with fluctuating inventory levels, conducting a dry run before the actual count can be helpful. This practice familiarizes staff with the process and helps determine the appropriate number of workers to schedule.
Minimizing Work-in-Process Inventory
Work-in-process (WIP) inventory can be challenging to account for, as it requires assessing the percentage of completion and assigning a value. To simplify the audit, companies should minimize the amount of WIP inventory before the audit date.
Considering Additional Locations
Companies should ensure that auditors have access to all inventory, including items stored in additional locations or held by third-party logistics partners. Third-party custodians should be instructed to count inventory on the same date as the principal count and forward records to management for inclusion in the audit.
Leveraging Technology
Technology can significantly enhance the efficiency of inventory audits. An inventory management system (IMS) that provides real-time data and supports cycle counting based on specific criteria can help minimize discrepancies. A warehouse management system (WMS) with mobile devices and scanners can further streamline the counting process, allowing for quick and accurate recording of inventory.
Modern financial and inventory systems that are tightly integrated can also facilitate smoother audits by making it easy to access the data and documentation auditors need. These systems can help ensure consistency between inventory and financial records, supporting the auditor’s analyses and tests.
Conclusion
While inventory counts and audits are labor-intensive, proper preparation can ease the burden. Companies can mitigate the challenges of inventory audits by organizing inventory, preparing documentation, training personnel, leveraging technology, and strategically timing the audit.
