An Inventory Audit Guide for Wholesalers and Distributors
An audit strikes fear into most business owners and employees. Imagine hiring independent auditors to scrutinize and examine every record and process in the business. It’s enough to give most people second thoughts about undertaking an audit. However, we shall soon see why an inventory audit is critical for businesses dealing with physical stock.
You shouldn’t confuse an inventory audit with two popular means of tallying your stock: physical stock takes and cycle counting. Instead, it describes a far-reaching process used by auditors to assess the inventory method of your business. Also, to check if your accounting records match the physical count or percentage completion of your goods.
Here, we’ll cover what is mean by an inventory audit and why you need to do one every year. Then we’ll see some ways to perform an inventory audit. This brings up various metrics used during an inventory audit. Finally, we’ll touch on some issues that an inventory audit may not cover despite having your company’s interests at heart.
What is an Inventory Audit
An inventory audit is an annual exercise performed by external auditors appointed by a business. For proper checks and balances, your staff or employees should not conduct an inventory audit. It is an impartial and independent look at valuing inventory in your business. And whether the financial records and physical inventory count tally.
For businesses that deal with physical stock, inventory is the single largest and most important asset in its financial statements. Thus, as a physical asset, it needs regular checks and balances to prevent theft, fraud, and loss. Plus, you may be offering your inventory as collateral for working capital provided to your business.
Since inventory lives in a company’s balance sheet as a current asset, auditors perform inventory audits in order to find out four things:
1. Whether the inventory actually exists
2. To check if the business owns the inventory
3. That inventory has a fair value
4. The financial records fully and properly record the inventory.
How to Perform an Inventory Audit
Auditors typically use a few audit processes to satisfy themselves that the inventory’s value is fair and reasonable. The number of inventory audit methods used depends on the inventory size. For example, you may be storing your inventory elsewhere on consignment. After all, the goal is to obtain a fair and accurate for inventory in your books.
While an inventory audit is usually done annually, it is not disruptive to a business using cycle counting. The same inventory auditing methods can be applied to a cycle count. The auditors simply apply a method during one or more cycle counts.
It’s important that external and independent auditors are given adequate powers and means to do their job. Auditors will no doubt be working alongside your employees. They will need office space to comb through and verify your accounting records. Most importantly they will need co-operation from you and your employees for them to complete their inventory audit project.
Inventory Audit Methods
As you can tell by now, auditors can use a variety of different methods during an inventory audit for a business. They need not use all of them. A few methods can be applied according to the business and inventory type. After all, the auditors need to be satisfied at the end of the day that inventory is fairly valued and that the inventory records and physical count tally.
1. Inventory Audits According to Generally Accepted Accounting Principles
a. Apply lower of cost or market.
Generally, inventory is to be recorded at cost or market price, whichever is lower. This is a conservative view adopted by auditors for fair and accurate financial statements. Thus, during an inventory audit, the market prices of the goods will be compared with their recorded costs in your accounting records.
b. Provide for inventory allowances.
Sometimes it might be necessary to write-off and provide allowances for obsolete inventory or scrap. For example, perishable foodstuffs and expiry dates. Or scrap wood left over after cutting them out for furniture. Auditors check if your inventory allowances are adequate by observing your production processes, reviewing historical patterns, and checking production schedules.
c. Compare item costs.
One way to arrive at an accurate inventory valuation is to compare purchased costs in your accounting records with invoices from your suppliers. This assumes that your inventory is valued at their purchase cost. And since recent invoices are reviewed, your inventory will be valued at their most recent cost.
2. Inventory Audits by Location and Ownership
a. Inventory ownership.
At times the inventory in your warehouses may not belong to you. For example, customers may request that you store purchased items in your warehouses until they are ready to take delivery of them. Other times you may have inventory on consignment from your suppliers. Auditors review your purchase records to sort the actual ownership of the inventory.
b. Physical inventory count analysis.
The auditors want to be satisfied with your methods used for the physical inventory count. They will examine the counting procedure, observe your physical counts, test their physical counts with those of your inventory records, and verify that all inventory is accounted for. If you have multiple warehouse locations, this process will be done at each location.
c. Reconcile physical count with general ledger.
Auditors will match the value of the physical inventory count with those in your general ledger. This checks whether inventory is being properly brought forward in your accounting records. This is the final step in the inventory audit procedure. It informs the auditor whether inventory was properly counted and correctly valued.
3. Inventory Audits by Value and Classification
a. Examine high-value items.
If your business deals with goods or raw materials of extremely high value, such as gems and precious metals, then the auditors will pay extra attention to them. Their relatively smaller quantities mean that the auditors will physically count them themselves. Auditors want to know whether you are valuing them correctly. And whether you are recording their valuation properly.
b. Review error-prone items.
During the reconciliation of physical counts with inventory records, auditors may detect errors in past years for specific items. For example, you may forget to count and include consignment inventory held by retailers. Or staff may confuse different units of measurements, counting per bottle instead of per case. Auditors, in this case, will focus on these error-prone items and test them again.
4. Inventory Audits of Stock Flow
a. Cutoff analysis.
Here, the auditors stop the receipt of goods into your warehouses and any shipments from it. This excludes inventory items outside the time of the physical inventory count. They then test all receiving and shipping transactions before the physical inventory count date. Auditors also check subsequent transactions after the inventory audit date.
b. Count inventory in transit.
If your business has various warehouse locations — for example, at the west and east coast of the United States, or within the European Union — then it is likely that you will have inventory in transit. This means inventory is held in vehicles or shipping containers. They may be moving from one warehouse to another at the time of the physical count. Auditors will examine your transfer documentation and include them in the count.
c. Trace freight costs.
There are two ways to treat the shipping costs of your purchases or freight costs. You can include them in the inventory cost. Or expense them in the financial period that they occurred. Whichever method you choose, you must apply them consistently. Thus, auditors will examine freight invoices and check their treatment in your accounting records.
4. Inventory Audit for Manufacturers
a. Finished goods cost analysis.
For manufacturers, finished goods will make up the bulk of their inventory. Hence, one inventory audit methods involve comparing the bill of materials with that of the finished goods. Auditors then examine the BOM to see if they accurately list the raw materials used in the finished goods as well as their costs.
b. Direct labor analysis.
Some items require human labor in order to assemble them into finished goods. For example, office chairs and furniture. Thus, you need to include the cost of labor in the cost of inventory. Auditors will compare the labor charged with time or punch cards. In addition, labor costs can be verified by checking them with payroll records.
c. Overhead analysis.
Overhead costs are indirect costs such as the depreciation of machinery, rent, and electricity. They are paid during the production of semi-finished and finished goods. They must be allocated to inventory because these expenses are incurred to produce the goods. Also, auditors will check if there were any one-off or abnormal costs, as well as whether they were applied consistently.
d. Work-in-process testing.
This is of interest to manufacturers who have a large proportion of semi-finished or work-in-progress goods in their inventory. For example, the production cycle of a product may be significantly long such as airplanes and ships. Here, auditors will compare the percentage of completion in your accounting records with the actual completion percentage of the work-in-progress products.
Inventory Audit Issues
While the tools and methods available to auditors to do an inventory audit are comprehensive and far-reaching, they are not foolproof. There are three situations where an inventory audit may not be conclusive or accurate. Thus, you need to look at the inventory audit and the resulting report as a whole.
1. Timing of Inventory Audits
Firstly, the timing of the inventory audit may affect the outcome. Inventory audits typically take place at the end of October or the end of December. This usually coincides with a physical stock take that happens at the same time as it is disruptive to business. But, fraud or theft may be more common during the winter holidays. Thus, it may be better to do an inventory audit during December to take into account these seasonal effects.
2. Evaluating and Valuing High-Valued Items
The second situation involves very high-valued or rare items. An auditor is not qualified to assess if certain gems, artworks or vintage cars are genuine. And putting a fair market value on them is beyond the reach of a business auditor. Thus, auditors may need to hire experts and specialists. They must provide a fair opinion about the authenticity or market value of expensive and rare goods.
3. Getting Employees On Board
Finally, it is understandable that staff and employees may view external auditors with suspicion. Getting an accurate value on your inventory means getting impartial and independent auditors who should have no ties or conflict with your business. Thus, employees may resent their presence or be reluctant to work with auditors who are checking their work. In addition, you may have to ask certain key employees to take a leave of absence while auditors undertake an audit.
In conclusion, an inventory audit is a necessary but critical accounting procedure for businesses that deal with physical stock. Getting an accurate value of inventory in your books involves trusting and giving wide-ranging powers to auditors to probe, test and verify your business processes and records. Whichever methods they use, a final value on your inventory is only as good as your co-operation and openness with external auditors.