What is an Inventory Audit?
Inventory audit also referred to as stock audit, refers to an accounting process which takes into account a company’s total stock of physical goods. This is especially needed in manufacturing companies where raw materials need to be converted to finished goods and is a quintessential process of maintaining a healthy business and for it to succeed. Inventory audit is considered mandatory for keeping account of the quantity and quality of raw materials remaining in stock. This is because anything more than 70% of product cost involves material cost. Additionally, inventory audit is absolutely necessary for organisations with multiple branches as they tend to have a massive stock of physical goods. Audit of essential physical inventories is generally conducted at or near the end of the year.
Importance of Inventory Audit
Inventory tends to be the easiest assets to manipulate and hence it’s essential to keep a constant vigil over it. Here are some reasons why inventory audit is considered paramount:
- Inventory audit is also required to match the actual quantity of items in stock against the accounting records while also adjusting for differences and allowing for shrinkage so that the ledger reflects accurate values.
- Inventory audit will be able to reveal which physical goods or products are over- or under- stocked. This will allow you to properly and effectively stock your business thus helping maximize profit.
- Inventory audit is necessary to reduce unnecessary investment on stocks and to ensure that you have a proper line balancing in the process.
- Inventory audit is needed to compare actual physical counts and match it to business records: When this count is conducted accurately, an inventory audit will be able to disclose the true picture of what you actually hold as compared to the recorded stocks which, in turn, will give you an understanding of the financial health of the company. Misstatement of inventory balances often tends to have a direct effect on reported profit.
- Inventory audit is imperative to account for any sort of inventory losses resulting from, wastage, pilferage, damage, obsolescence, and dormant stock.
- An inventory audit will also help determine the effectiveness of your warehouse procedures and help reveal any issues within your organisation’s warehouse procedures, whether it is at the receiving dock or during the actual packaging. This could help in highlighting any potential inefficiencies in the process such as disorganisation of the warehouse and slow retrieving methods.
- Inventory audit will help reveal any failure owing to lack of security which results in loss, theft or misappropriation.
- High levels of stock generally result in unnecessary overstocking thus resulting in poor cash flows and financial loss. An inventory audit at timely intervals will help remedy that issue. Similarly, it helps in determining any obsolete inventory in stock or orders incorrectly supplied to customers which could not only lead to financial loss but also result in an irreparable damage to the organisation’s reputation.
Procedures of Inventory Audit
Comprehending the importance of inventory audit is half the battle won; to truly realise your inventory audit goals, you need to enlist the services of a professional to truly understand what’s working and what’s not working and ensure your in-store operations are efficient. Considering how enormous inventories tend to be, auditors may conduct several inventory audit procedures before they sign off that the valuation you have stated for the inventory asset is reasonable.
Essentially, there are two methods of carrying out inventory counts:
- Periodical Analysis which is usually conducted at or close to the year end.
- Perpetual Analysis which involves counting on a continuous basis over the whole year.
- In this procedure, every single item is physically inspected at least once a year, and more frequently in the case of items liable to loss.
- Accurate up to date records are maintained.
- Thereafter, the records are amended and signed as a result of the physical inspection. This is done to ascertain that there are appropriate reports and investigation procedures in place to account for any discrepancies.
Here are some of the inventory audit procedures that the auditor may follow:
- Cut-off analysis.
- Observing the physical inventory count.
- Reconciling the inventory count to the general ledger.
- Testing high-value items
- Testing error-prone items.
- Testing inventory in transit.
- Testing and matching item costs for accurate inventory valuation.
- Reviewing freight costs.
- Testing for lower of cost or market.
- Accurate analysis of finished goods costs.
- Direct labor cost analysis and matching with payroll records.
- Overhead analysis.
- Work-in-process testing.
- Inventory allowances for obsolete inventory or scrap.
- Inventory ownership of stock actually owned by the company.
Testing the Inventory layers to determine If you are using a FIFO or LIFO inventory valuation system.