Product-focused brands must occasionally justify their inventory figures for various reasons. A company may need its inventory to be audited as part of a loan application. For larger enterprises, it could even be part of an internal “best practices.” Whatever the reason, auditing for inventory will become a fact of life at some point for most product-driven companies. If you’re not familiar with what it is and why it’s important, this is your place to start.
What Is Auditing for Inventory?
An inventory audit is the process of checking financial records against a physical stock count. While auditing for inventory can provide useful insights into a company’s financial situation, the process is time-consuming and requires a bit of manual labor.
Auditing processes vary according to their purpose. This can range from a staff member running spot checks to an official inventory audit for a third party, such as a tax authority or financial regulator. An inventory audit is considered a generally accepted auditing procedure for assessing financial statement assertions and the inventory methods that companies use.
Inventory balance is tracked on the balance sheet in a current asset account, and an audit looks at four specific assertions related to that account:
- Existence: Is the inventory present?
- Rights: Does the audited company actually own it?
- Valuation: Does its price reflect a real-world benchmark?
- Completeness: Does it include all goods that should be counted as inventory?
What Are the Typical Steps in an Inventory Audit?
Here are the most common inventory analyses and procedures used in an inventory audit.
- Cutoff analysis. The audit starts before the physical inventory count. This procedure determines whether transactions were recorded in the correct time period. For example, if a sale was made on the last day of one month but the product was dispatched at the start of the following month, the cost of goods sold should be recorded in the same month as the sale.
- Physical inventory count. Similar to regular stocktakes, staff members check each physical item against recorded inventory. Ideally, an auditor should be on hand to observe the process.
- Analytical procedures. The auditor compares the current year’s gross margins, inventory turnover ratio and/or unit costs of inventory against previous years.
- ABC analysis. Product companies often sort inventory reports into groups according to sales volume and inventory value. This helps the auditor focus on high-value inventory items, for example, as opposed to slow-moving or low-margin products.
- Reconciling items. As an inventory audit uncovers discrepancies, many companies will begin an investigation to determine the root cause. There may be certain error-prone SKUs to keep an eye on in the future.
- Shipping log verification. An auditor may select invoices at random to check against shipping logs. This is to verify that the right quantity was shipped and the right amount was charged to a customer.
Why Is Inventory Auditing Important?
While an audit may be required under certain circumstances, the process is beneficial to companies beyond regulatory or other business obligations. The specific act of checking inventory against inventory records gives companies a useful reality check. Comparing physical stock with inventory records can help companies identify and record shrinkage, improve their warehouse operations and identify overstocking/understocking issues.
Much of that can also be accomplished with an inventory management solution that tracks inventory in real time and at every stock location. With accurate data, companies can take action to optimize inventory and react to issues like overstocked items and inventory shrinkage well before it’s time to do an audit or a regular stocktake.