Inventory Audit: How Auditors Can Optimize Audits in 2021

Inventory Audit: How Auditors Can Optimize Audits in 2021

For many companies, inventory is the single largest asset on the balance sheet. At Walmart, as an example, inventory represents 72% of the company’s current assets. Based on past performance, this year the company is likely to lose more than $4 billion to “inventory shrinkage,” which is an industry term for shoplifting and theft. 

What Is an Inventory Audit? 

Any company that makes or sells products has some level of inventory to report as an asset, and the financial reports must be accurate. The primary procedure for validating a company’s inventory is the inventory audit.     

While there are no general inventory audit standards for non-accountants, an inventory audit is a physical count of goods and merchandise to validate a company’s inventory levels and to confirm the financial records and actual count of inventory match. Inventory audits confirm the current asset valuation, validate the amount of shrinkage to adjust, and also help company reset their on-hand merchandise counts so managers can order products they need to sell or to produce goods. 

In other types of inventory reconciliation, the process may look different, but you can still determine what to look for when auditing inventory. In nearly every organization there is a reconciliation performed for technology hardware such as the laptop you have been assigned. The inventory reconciliation may be an automated process, or employees may be required to confirm or acknowledge the tracking number for their device.

How Does an Inventory Audit Occur? 

An inventory audit occurs when an auditor checks the existing processes a company uses to perform inventory counts and validates its system of record accurately reflects the inventory on hand. When auditing merchandise inventory at year-end, a snapshot is taken of the inventory record. The physical inventory is then counted and compared to the inventory record. The difference between the inventory record and the physical count is recorded as an inventory adjustment. The difference is investigated and usually attributed to either shortage or shrinkage. The two designations point to when in the inventory cycle the goods were lost. Shortage happens when the inventory received is less than what was expected. Shrinkage occurs after the goods have been received and recorded. 

Since any changes in inventory create confusion, the physical count usually occurs when there are no changes expected. Retail locations often count their merchandise in January, after the holiday rush has brought inventory level to a low point. The counting is usually done when the location is normally closed or can be closed for a short period of time.

Technology also plays an important role in the counting process. First, the warehouse or retail location is divided up into sections and marked with control numbers. To reduce the element of human error, the counting is done by scanning the barcodes for the various items with a handheld device into a database that compiles the information. The scanned items are tied to the location control number for that area to aid in secondary verification and research prior to making adjustments. 

What Are the Most Common Types of Inventory Audits?

The most common type of inventory audit occurs in warehouses, distribution centers, and retail and grocery chains, but inventory audits are also performed in any business scenario where there is a physical inventory of products or assets, such as IT inventory or sales inventory. Understanding the common types of audits will help you determine what to look for when auditing inventory.

Traditional Inventory Auditing Process

For the traditional inventory audit (when auditing merchandise inventory at year-end), the stages involved are a store or floor inventory count, a third-party count, and an internal audit validation of both processes using audit procedures for inventory.

Inventory Counts 

The initial inventory count is when a store or floor employee performs a physical count of inventory, the goods or items received into the location, and checks inventory daily for shrinkage, goods that have been damaged, lost, or stolen. Minor adjustments are made continually by employees who refill empty shelves and order items to keep an optimum inventory level. 

Third-Party Counts 

Public companies will also hire a third party to perform complete inventory audits on a rotational basis for each location. Internal audit is responsible for providing assurance on both processes. This is typically achieved through inventory cycle counts, inventory test counts,  and surprise audits. The inventory may be checked for accuracy by external auditors as well who follow inventory audit standards (AS 2510).

Inventory Cycle Counts and Surprise Audits 

Inventory cycle counts involve counting portions of the entire inventory in a location over a period of time. Internal audit will use basic inventory auditing procedures on the inventory system of record to generate a listing of the inventory on hand in a spreadsheet; this is the inventory count sheet that testers assigned to the audit will use to test the inventory. There are two types of tests for how to check inventory: sheet to floor and floor to sheet. 

  • Sheet to floor: the auditor will validate everything on the count sheet is on the floor. The sheet to floor validation is how to check inventory for the existence of items on the inventory record.
  • Floor to sheet: the auditor counts everything on the floor and marks it off on the sheet. The floor to sheet test is how to check inventory record accuracy. 

Surprise audits are when internal audit performs an inventory test count on the inventory count sheets of third-party counters on days they perform audits. Since the counting process is time-sensitive, the auditors generally count immediately after the third party count has ended, often late at night and into the early morning hours.

Internal Audit Procedures for Inventory

Following the actual counts, internal audit will perform follow-up audit procedures for inventory to determine why there were missing or extra products and note any controls that are not operating effectively. Auditors will then assign remediation action plans and follow up with issue owners throughout the remediation process. The results of these audits are documented in an audit report document. In this way, internal audit helps the business uncover issues and fix them before external audit performs the year-end audit. 

Unlocking Operational Risk Management: Empower the Front Line to Effectively Manage Risk

4 Ways to Optimize the Internal Audit of Inventory Management Process

Inventory audits encompass high-risk, high-value areas that are important for organizations to have coverage over. Below are the best practices you can leverage for your 2021 audit program to maximize the efficiency and effectiveness of your inventory audits.

1. Understand where the value is in the warehouse

Prior to stepping into the warehouse, study its accounting. Spend time learning what makes up the inventory, what outliers exist, and identify where the highest value and risk is located. Look at items that are different from the rest of the population. Reviewing reconciliations and roll-forwards for reconciling items can show what management is having difficulty with and indicate where you want to spend most of your time. This information can help you optimize your inventory audit to spend more time on high-value items with the greatest risk to your financial statements. 

2. Take a Socratic approach

The most effective way to learn the inventory system is to ask as many questions as possible and not make any assumptions. Sit down or schedule a video conference with management and warehouse teams to learn how they receive inventory and process it in the system of record (SAP, Oracle, etc), as well as how they process and run reports. Be specific and ask if there are any issues they are experiencing in the system and steps that have been taken to address them. These conversations will better position you to spend your time where management is spending its time and experiencing issues, setting you up for a more effective audit. 

3. Look at the results of cycle counts

Variances in cycle counts provide insights into issues. These should not be used to identify root causes but should be seen as symptoms to take into account with your other research, helping to paint the full picture of the inventory system. 

4. Build and improve on relationships

Understand the limited perception audit clients often have of auditors. Turning your audit clients into allies by explaining internal audit‘s goal is to understand how they do their jobs in order to help make improvements that make their lives easier. Once audit clients understand the internal audit‘s goal is to help the company, rather than to find errors, they are more likely to be helpful collaborators.

Why Is Auditing Inventory Important?

Several key reasons for auditing inventory were mentioned earlier, and there are many reasons why this particular audit is so critical. Basic inventory auditing procedures are to match the actual quantity of items in stock against the accounting records. Finding the difference allows accounting adjustments for shrinkage so that the financials reflect accurate values.

Inventory auditing reveals which inventory items are either understocked or overstocked. Neither situation is ideal since understocking leads to lost sales and overstocking leads to lost profits. When an overstock situation is found, retailers may choose to reduce prices or sell the items to another retailer so as not to hold stale inventory.

From a fraud perspective, inventory is one of the easiest assets to manipulate. A common fraud scenario is processing fake returns. In this scheme, an employee processes a return for an item that was never purchased and either takes cash or applies the refund to a credit card. Since this creates an inventory overage, the audit is likely to find the discrepancy.

Inventory auditing reveals losses resulting from theft, damage, and obsolescence. While no one wants to find that inventory has been stolen, the losses very often point to a root cause (or person) responsible for the losses. It may be a weak spot in the control environment, like having high-value items too close to an unmonitored exit, or it could point to fraudulent activity by an employee. 

Inventory auditing will also help determine the effectiveness of your logistics and warehouse procedures. We mentioned the difference between shortage and shrinkage at the beginning. Shortage happens in the logistics process. Research into inventory discrepancies sometimes leads to these back of house processes. Items can be removed from a shipping container and never scanned into inventory.

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