Is the amount of inventory on your company’s balance sheet accurate? Depending on the nature of a company’s operations, its balance sheet may include inventory consisting of raw materials, work in progress, and/or finished goods. Inventory items are recorded at the lower of cost or market value under U.S. Generally Accepted Accounting Principles (GAAP).
Estimating the market value of inventory may involve subjective judgment calls, especially if your company converts raw materials into finished goods available for sale. The value of work-in-progress inventory can be especially hard to objectively assess. That’s because it includes overhead allocations and, in some cases, may require percentage of completion assessments.
Why does accuracy matter?
It’s important to get the inventory count right for many reasons. First, you want a reliable estimate of ending inventory so that the profits you record this year are accurate. Your cost of sales — a major expense on the income statement — is a function of the value of beginning and ending inventories.
At the most basic level, the cost of sales equals beginning inventory plus purchases during the year minus ending inventory. If the inventory balance is incorrect at the beginning or end of the year, management won’t know how profitable the company truly is.
In addition, inventory is a major line item on your company’s balance sheet. Lenders rely on inventory as a form of loan collateral. Stockholders look to inventory-based ratios (such as the current ratio or days-in-inventory ratio) to evaluate financial strength. And if disaster strikes, your insurance coverage (which is based on asset values on your balance sheet) should be adequate to cover any inventory losses.
Most companies track the value of inventory through a computerized perpetual inventory system. In this system, the value increases when purchases are made (or as raw materials are processed into finished goods) and decreases when goods are sold. But a count taken from a perpetual inventory system may not always be accurate. That’s why periodic physical counts are part of a strong internal control system.
Why do discrepancies happen?
Possible reasons for differences between the perpetual inventory system and the physical count include:
- Data entry errors
- Inaccurate bin or part numbers
- Shipping errors
- Inventory in the authorized possession of employees
- Intentional financial misstatement
Companies that conduct a year-end physical inventory count send a message to would-be fraudsters: We’re watching our assets and taking steps to catch fraud.
Benefits of a physical count
A physical inventory count gives management a snapshot of how much inventory the company has on hand as of a specific date. For example, a manufacturing plant might need to count what’s on its warehouse shelves, on the shop floor and shipping dock, on consignment, at the repair shop, at remote or public warehouses, and in transit from suppliers and between company locations.
Well-executed physical inventory counts have benefits beyond accounting compliance and fraud prevention. They provide opportunities for management to evaluate how to stock items more efficiently, reduce carrying costs and identify actual fraud losses. In turn, more efficient inventory management can lead to improved customer satisfaction and higher sales.
For example, when conducting counts, management should evaluate how the warehouse is laid out. The most commonly used items should also be the most accessible. Employees should navigate the warehouse with familiarity and find items off the inventory listing with ease. Bin and aisle labels should be easy to read quickly. High-value items should be locked away during off hours and counted on a regular basis to reduce pilferage. And plant managers should know how to systematically compute the optimal reorder point and buffer stock levels for key inventory items (rather than just relying on gut instinct) to avoid manufacturing and shipping delays.
We can help
When it comes to physical inventory counts, we’ve seen the best and worst practices over the years, and we can advise you on how to manage your inventory more efficiently. Reach out to a KraftCPAs advisor for details.