Auditing Inventory

Process of ensuring that an entity’s financial records are correct and fairly represented

Author: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Reviewed By: Josh Pupkin
Josh Pupkin
Josh Pupkin
Private Equity | Investment Banking

Josh has extensive experience private equity, business development, and investment banking. Josh started his career working as an investment banking analyst for Barclays before transitioning to a private equity role Neuberger Berman. Currently, Josh is an Associate in the Strategic Finance Group of Accordion Partners, a management consulting firm which advises on, executes, and implements value creation initiatives and 100 day plans for Private Equity-backed companies and their financial sponsors.

Josh graduated Magna Cum Laude from the University of Maryland, College Park with a Bachelor of Science in Finance and is currently an MBA candidate at Duke University Fuqua School of Business with a concentration in Corporate Strategy.

Last Updated:December 12, 2023

What is Auditing Inventory?

Auditing is the process of ensuring that an entity’s financial records are correct and fairly represented. Financial transactions must accurately reflect the entity’s financial situation and real operating activity.

Auditing Inventory is the process of cross-referencing financial data with tangible inventory and documentation. Both auditors and other parties are able to finish it.

Because financial documentation and records are created internally, there is a considerable risk of insiders tampering with them. For example, when generating financial records, insiders can make mistakes or purposefully manipulate information, which is considered fraudulent behavior.

Here, in Auditing Inventory, counting the physical inventory involves counting every kind of inventory that the business has on hand. This physical inventory count is then compared and reconciled with the inventory count recorded in the business's books of accounts.

Auditing guarantees that these errors do not occur.

Audits also guarantee that companies follow accounting rules such as the International Financial Reporting Standards (IFRS), Generally Accepted Accounting Principles (GAAP), and other relevant accounting standards.

Evidence In Auditing

Evidence is needed to determine if financial statements or records have been prepared following standards and if they are free from material errors. Promoting audit reports' accuracy, transparency, and independence is also required.

Evidence is required by auditors to verify the validity of financial records. It can either confirm or provide support for the financial information that is presented. On the other hand, the evidence can contradict the financial information, indicating errors or fraudulent behavior.

How do you perform an audit?

The steps to follow are: 

1. Prepare your checklist

You will need to compile a list of inventories using your management software, inventory spreadsheet, or manual inventory system to audit the stockpile you have on hand. 

You will want to make a checklist as you audit if you don't already have one.

Your checklist should include a list of all of your company's inventories and assets, as well as every detail about them. If you are creating this report with automated software, you will also be able to include images in the PDF or spreadsheet.

2. Note all key details

The next step is to double-check and count each item in your inventory. If your company is already well-organized, all you need to do now is double-check your goods' quantity, location, and condition.

If you are building your stock list as you audit, you may want to note:

  • Name of the item 
  • Item number, SKU, and other identifiers, if possible. 
  • Item Location 
  • Item manufacturer, model, date of manufacturing, and other relevant details 
  • Quantity on hand  
  • The purchase price, retail price, and wholesale price of the item 
  • Item characteristics such as color, condition, etc. 

You may also use this time to add images to your app and sync any barcodes or QR codes if you are generating your stock checklist while auditing.

For unlabeled material, you may want to add an asset tag or develop a barcode or QR code as part of your audit. This will assist you in keeping track of inventories between audits and make your next item count much easier.

Inventory audits are also a great opportunity to spot goods that are about to expire or become obsolete.

3. Take on what you can

If your organization has a lot of goods spread out over various sites or you can not close for an audit, you might choose to do it piecemeal.

To make audits more manageable, your company should employ an inventory cycle count technique. While it is ideal to do an audit all at once, counting everything throughout time is more vital than never validating records of inventories.

4. Record the data

You will want to update your management system with the most up-to-date information after receiving your audit results. 

If you find any differences, you will need to discuss them with the personnel in charge.

Remember that while maintaining an effective asset of inventories takes time, it will save your company time, money, and worry in the long term.

common auditing procedures

Organizations can use different auditing procedures for inventory. Physical Inventory Count, Cut-off Analysis, Freight Cost Analysis, Overhead Analysis, Finished Goods Inventory Analysis, Analytical Procedures, and Reconciliations.

The primary objective of conducting an auditing procedure in the inventory is to understand the point of shrinkage, maintaining the accuracy and availability of the stock for sale.

Each of these procedures will have its benefits and limitations.

One of the methods we will discuss here is the physical inventory count method

Auditing Inventory: Physical Inventory Count

A physical inventory count is an organized way that employees of an organization use to count the goods. At the end of each reporting period, companies conduct a physical inventory count, more often than not, using a predetermined approach. 

Before completing their yearly financial reports, most businesses conduct an annual physical count. Performing the count simply once a year may not necessarily result in the most reliable statistics. 

The optimum inventory counting method is determined by the sort of business and its objectives.

Retailers, manufacturers, wholesale distributors, and e-commerce-based enterprises are among the companies that do annual physical inventories. They can either undertake a thorough inventory or cycle count. 

Staff count parts of stock in a revolving or methodical manner in cycle counting.

Advantages Of Physical Inventory Count

The advantages of physical inventory count are as follows:

  • Physical inventory counts are an important aspect of maintaining accurate and up-to-date data. Up-to-date stock data allows for more accurate sales and purchase forecasting and ensures that you always have the proper amount of stock on hand.

  • Physical inventories are beneficial to your customers, and accurate physical inventory counts are required. In today's world of rapid gratification, no end-user, whether consumer, reseller, or wholesaler, wants to cope with unknown stock levels. 

  • Customer happiness is extremely important. Updated levels of inventories ensure that you can swiftly fulfill your clients' orders or notify them when they can be filled.

  • Another advantage of manually counting your stockpile is that you will be able to plan for loss.

Disadvantages Of Auditing Inventory

However, there are issues with performing physical inventories too, and these include: 

  • The most common complaint regarding physical inventories is that they consume significant time and resources. Some businesses shut down sections or all of their operations to perform physical inventories. 

     They risk providing bad customer service if this occurs.

  • Some businesses lack the personnel necessary to conduct a full physical inventory.

  • Internal or temporary personnel do not appropriately record some stockpiles or classify or register new things inaccurately, leading to disparities in a physical count. 

Regardless of accuracy levels, some items should not be counted during the physical inventory.

Auditing Inventory: ABC Analysis

Another notable inventory auditing technique is the ABC analysis which includes the categorization of distinct value and volume inventory. The stock could be categorized as Low, Medium, and High-Value Inventory.

ABC analysis is a strategy that assesses the worth of stock items based on their importance to the company. These items are ranked by ABC based on demand, cost, and risk data and are then classified based on the said criteria. 

This makes it easier for business executives to identify the products or services that are most crucial to the financial success of their organization.

In terms of sales volume or profits, “Class A” items seem to be the most significant SKUs, followed by “Class B” items and “Class C” items, which are the least significant.

Some businesses may opt for a classification system that divides commodities into more than just three categories (A-F, for example).

The formula for ABC analysis is: 

(Annual Number of Items sold) * (Cost per item) = (Annual usage value per product)

According to the Pareto Principle, only 20% of efforts or causes result in 80% of the outcomes in any system. ABC analysis determines the 20% of commodities that provide around 80% of the value in accordance with Pareto’s 80/20 rule.

Advantages of ABC analysis

The study determines which products are in high demand. A corporation can use its valuable warehouse space to effectively stock such items while keeping Class B and C stock levels low.

  1. Monitoring and collecting data on products with a significant client demand helps improve sales forecasting accuracy. Managers might use this data to adjust stockpile levels and prices to boost the company’s overall income.

  2. A spike in sales for a single item indicates that demand is rising, and a price rise may be justified, boosting profitability. 

  3. ABC analysis is a method of continually evaluating resource allocation to guarantee that Class A items align with consumer demand. Reclassify the item when demand falls to better use staff, time, and space for the new Class A products.

  4. Many factors influence service levels, including the amount sold, item cost, and profit margins. Once you've identified them, offer better service levels for the most profitable things.

  5. Forecasting demand and stocking levels of inventories effectively require knowledge of where a product is in its life cycle (launch, growth, maturity, or decline).

  6. The success of a corporation is inextricably linked to its Class A inventories. Monitoring demand and maintaining healthy stock levels ensure you always have enough of the most important products on hand.

Drawbacks Of ABC Analysis

1. Managers frequently assign up to 50% of items to a new category every quarter or year as a consequence of ABC analysis. 

2. Companies frequently do not notice changes until there is a demand issue, and the need to reevaluate can be time-consuming and detrimental to consumer satisfaction.

  • Factors like new product releases and seasonality are not taken into consideration by the typical ABC technique. A new product, for example, may have low sales volume due to a lack of purchasing history. 

3. When demand changes or is unclear, ABC analysis will be inefficient since it has a static perspective of demand.

  • Information from ABC classes may not have all of the statistical data or detail required to make well-informed strategic management decisions.

  • Although ABC analysis assigns product importance based on revenue or frequency of use, some goods may defy this logic. 

4. In the aerospace industry, for example, a specific item for a plane may be infrequently used and have a really low market value, but it may provide a critical safety role.

Benefits of auditing inventory

The procedure aids in preserving inventory accuracy, identifying any spot reasons for shrinkage in the inventory, and ensuring that the proper quantity of product is available to the business at the appropriate time.

  1. An independent auditor offers an opinion on whether the financial records of inventories accurately mirror the physical inventories being carried, which is a commonly accepted auditing technique.

  2. Auditing inventories is crucial to acquiring evidence, particularly for manufacturing and retail organizations. It might represent a large asset or capital balance, thereby bringing in some prestige for the organization in question. 

  3. When auditing, it is important to check not just the quantity but also the quality and condition of the stock to see if the value of the stock is accurately represented in financial records and statements.

  4. It ensures that your stock levels align with their financial records. Auditing inventories regularly improves your understanding of your stock flow, assists you in accurately calculating earnings and losses, and keeps your firm running smoothly.

  5. It is also possible to detect which things are missing by comparing physical counts to the theoretical data with these inventory audits, thereby reducing and eliminating any gaps within your inventory management system. 

  6. While auditing, if you notice an unusual pattern of inventory shrinkage with your supplies or items, further investigations to see if they were lost, stolen, damaged, or discarded can be held, and then appropriate steps to prevent shrinking can be taken.

  7. Checks on inventories will also help you to identify whether or not certain items are routinely understocked. You can then: 

    a) figure out which supplies are not being used and are wasting up room in your storage, and then b) modify your needs for inventories accordingly. 

  8. Auditing can help you avoid squandering money on products that are always in excess. They might also assist you in figuring out if you need to stop spending on products that are already in surplus and redirect funding to items that run out more frequently.

Challenges Of Inventory Auditing

Inventory audits are a crucial part of obtaining proof, particularly for companies in the manufacturing or retail industries. It could stand for a sizable capital or asset balance.

The main issue is that the corporation will have to pay more for such a thorough audit because inventory audits happen often.

1. Businesses find it difficult to scale

When it comes to inventory management, the bigger you get, the more strategic you will need to be. In between comprehensive physical audits of inventories, spot-checking might be a more reasonable way to keep stock audits under control. 

This entails selecting a product, counting the number of units on hand, and comparing it to the number stated in the system.

2. It can halt operations

You halt operations when you suspend everything to conduct an inventory audit, which includes logistics services and having commodities dispatched to customers. 

In the age of Amazon, achieving consumer expectations for rapid delivery can significantly impact their whole experience with your product and brand.

3. It increases costs for the business

Inventory audits are common and can dramatically increase the costs of the company. 

To save money, the company’s auditor would have to limit his auditing scope and rely on techniques such as test checking, etc., defeating the entire objective of the audit in the first place.

4. Manipulation

Because workers are involved, there is a possibility of manipulation of data. Auditors are often required to falsify data to present a different picture. In such instances, an inventory audit will yield no useful results.

5. Consignment Stock Issues

Consignment is a trade arrangement where Party A sells or agrees to sell goods or services on behalf of Party B. This arrangement can also allow party A to return the said goods if it is unable to sell them. 

While auditing, more often than not, auditors find out that the stock owned by the business or corporation may be out on consignment, or the stock currently held by the business may be bought on consignment.

This makes it all the more difficult for auditors to detect the correct value or worth of the said business’ stock and can, therefore, lead to errors and misjudgments. 

Researched and Authored by Sara MalwiyaLinkedIn

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