Entrepreneur

The Comprehensive Guide to Inventory Audits

By Megan O’Brien, Brainyard Finance & Business Editor; and Ian McCue, Content Marketing Manager
January 3, 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, inventory counts — whether full physical counts or cycle counts — check to ensure a business’s financial records match its inventory records and what’s actually on its shelves.
  • Understanding what constitutes an inventory audit, how to prepare for it and best practices to make it as fast and easy as possible can give products companies an edge.

The last three months of the year are a hectic and pressure-filled time for retailers because the run-up to the holidays often has a disproportionate impact on their annual performance. But the end-of-year rush doesn’t necessarily end on Jan. 1.

Not long after the new year kicks off, many companies conduct a full physical inventory count, oftentimes with an auditor looking on. For some, those words rekindle memories of long days counting items in the warehouse that seem to crawl by. The physical inventory count is one of those necessary evils for many businesses.

The past two years have brought radical change for businesses as they reimagine processes, collaboration and offices for a remote world, but there has not been such a sea change with annual counts. Some companies got creative with body-mounted cameras, smart glasses and drones to provide live video feeds that allowed remote auditors to observe counts from afar. But those remote inventory audits seem to be more the exception than the rule and likely saw greater adoption among larger enterprises with bigger budgets. In many cases, physical counts in 2022 will look much the same as they did at the beginning of 2020.

However, there are a number of ways businesses can ease the pain of inventory audits, and we’re here to help as you gear up for your 2022 count. We’ll explain when counts need to be audited, strategies for counting — including the role of cycle counting — what to expect during an audit, and steps to make inventory audits faster, easier and less disruptive.

What Are Inventory Audits?

Inventory audits check to ensure that financial records match a company’s inventory records and that those records align with a physical inventory count. As part of that physical count, employees go through every item in the warehouse, typically with the assistance of technology that adds up and records products on hand. Audits add another piece to this, bringing in a third party to confirm not only the quantity of inventory but also its quality and condition — and identify any instances of theft, damage or misplacement.

History of Inventory Audits

The history of inventory audits can be traced back nearly 100 years to 1925, when a twice-convicted felon named Phillip Musica took control of the pharmaceuticals and medical products company McKesson. In addition to expanding its legitimate operations, Musica recruited three of his brothers to generate bogus sales documentation, then paid commissions to a shell 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’s auditors never questioned the documentation presented to them and 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 in 1938. It was eventually determined that about $20 million (about $394 million in 2021 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.

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 a company’s financial statements, it must prove to an auditor that the inventory both exists and is in the described condition.

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.”

There are no standards on what constitutes “material” inventory as it varies significantly based on industry. However, auditors tend to select inclusion criteria from the following benchmarks based in the industry at hand:

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 the industry’s selected ranges are included in financial statements at the auditor’s discretion. If above the range, the item should be considered material and included.

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. Any businesses that want to comply with GAAP also need to perform inventory counts.

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.

It can also help identify more nefarious activities, like theft, as well as damaged or forgotten goods.

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 between actual inventory levels and records 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 needs some investigating.

Inventory Counting Methods and Frequency

There are two primary approaches to counting inventory: physical counts and cycle counts. Physical counts require far more work than cycle counts and are more disruptive to business, which is why they’re less frequent. However, many companies that practice cycle counting still need to count every item in a warehouse or store annually. Main differences between these approaches and how they work:

Cycle Counts

A cycle count is a partial count that samples a small portion of inventory. A company counts a select group of items on a regular basis and compares that to what the inventory management system shows, noting any differences. This approach usually makes sense for companies with larger amounts of inventory because it helps them limit physical counts to once per year.

There are a number of ways businesses can determine which products to count, but six 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.” A items contribute the most to overall sales or profitability, while B items are in the middle and C products are those least important to the business. The ABC analysis harks back to the Pareto Principle, which states that 20% of stock accounts for 80% of value to the business. Using this technique, 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 you’ve counted all other items in the warehouse. The pool of potential SKUs to count shrinks over time until there’s nothing left.
  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. This strategy incorporates counting into existing day-to-day processes.
  5. Random sample: As you may have guessed, this strategy involves randomly choosing an item or group of items to count on a frequent basis. The random nature of this approach can decrease the chance that a certain product category or inventory in a less-visited part of the warehouse will be overlooked.
  6. Objective counting by surface area: Businesses that count this way break their facilities into sections – and may assign each to a specific employee. Workers then gradually move through the areas until they’ve covered the entire space.

Companies may perform a cycle count on a daily, weekly, monthly or quarterly cadence. It varies depending on the industry and nature of the business.

“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 entrée,” said Bryce Bowman, founder of demand planning consultancy People First Planning. “Conversely, an HVAC distributor maintains its inventory in a secured warehouse and likely will perform cycle counts on a quarterly basis.”

Physical Counts

Physical 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.

Physical counts are not only time-consuming but also very disruptive. In most cases, operations must temporarily halt — meaning no inventory can enter or exit the warehouse — while the count is being conducted, and it could last several days to a week or more. Cycle counting is much less of an ordeal.

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

Can Cycle Counts Eliminate Physical Counts?

Cycle counts are sometimes positioned as a superior alternative to physical counts, rather than a process to run in addition to the end-of-year physical count.

To know whether you can skip the full count, first determine whether the organization you’re conducting the count for — like a bank, investors or a regulatory organization — will accept auditing of a cycle count in place of the full count. GAAP rules, for example, allow cycle counts in place of a physical count, so long as you eventually get through all of your inventory. However, the group requesting your audit may have a different standard.

If the group approves of using cycle counts instead, then your business will probably need to prove the accuracy and effectiveness of cycle counting over time by showing a consistently high inventory record accuracy (IRA).

While replacing physical inventory with cycle counts is not yet common practice, businesses can aspire to it. Over time, using cycle counts in place of physical ones may become more widely accepted. This would majorly benefit product companies, as they wouldn’t have to shut down operations for several days each year or pay employees exclusively to count goods.

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 since they’re removed from the business and not part of everyday operations.

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.

More Resources From NetSuite

Cycle Counting Best Practices & Benefits

Perfect your cycle-counting practice with this guide to the various methods, associated KPIs and risk mitigation.

Easing the Pain of Physical Inventory Counts

Find more ways to lessen the burden of a physical count, including the key to boosting inventory accuracy year-round.

Inventory Management in NetSuite

Users can easily run periodic cycle counts for select SKUs instead of performing a full cycle count in our inventory management system.

Planning for an Inventory Audit

Planning is key prior to an inventory audit. Without proper preparation, companies will face a disorganized audit that’s also more expensive and time-consuming.

Think about timing.

Since operations are often frozen during the physical count, eliminating transportation in and out of the facility and halting product movement, inventory can’t be transferred between retail shops or manufacturing facilities. If this is the case, companies will need to plan their physical count — and thus their audit — for a time when halting operations will disrupt fulfillment as minimally as possible.

Many companies’ year-end is in December, which can pose issues for a count due to increasing demand in the lead-up to the holidays. 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.

“Prior to the audit, minimize the number of mixed pallets in the warehouse,” Hoskins said. “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 waiting to be processed sitting around, sometimes in random locations. 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.

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 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. Workers assigned to the full count should also be dedicated to that task for the entirety of their shifts over the course of the count. If possible, also use your most detail-oriented and attentive warehouse employees.

Additionally, 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 get everyone familiar with the process and determine how many workers to schedule.

Minimize work-in-process inventory.

All inventory is classified as 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 3PL partner. 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.

Employ available technology.

Technology can make audits faster and easier so they have less of an impact on your business. This starts with an inventory management system, which most companies have. But the type of inventory management system makes a big difference. Must-have inventory management system features include a display of inventory numbers in real time — not from close-of-business yesterday or two hours ago. The software should also prompt employees to perform cycle counts based on customizable criteria around frequency and counting strategies (ABC analysis, opportunity-based, etc.). A system that allows for regular cycle counts based on triggering events will minimize discrepancies when you do a complete physical count.

Adding a warehouse management system (WMS) can make counts even more efficient. Your WMS should run on mobile devices and support attached scanners that will make counts faster and easier for all. With a mobile scanner, employees can scan bins as they start counting a new item to make sure they’re in the right place. They can then scan the barcode of each item in that bin, and the WMS will automatically add everything up and record it. No one has to complete the error-prone process of manually entering a number. The WMS can then compare it to inventory records, highlighting any issues for further review.

Modern financial and inventory solutions also facilitate smoother audits because they make it simple to find all the data and documentation an auditor will want to see. It’s even better if these two systems are tightly connected, as some of the analyses and tests the auditor will perform tie into accounting.

The bottom line

Inventory counts and audits are a lot of work for any organization, but knowing what to expect going in and preparing accordingly can lessen the burden — as can cycle counting and the right pieces of technology.

  

Sales Chat

How is your business adapting to change?

Start chat