OCW041: Controlling Inventory

Internal Controls

Inventory internal controls ensure that a company has sufficient resources to meet its customers’ needs without having too much goods.

Learning Objectives

Explain how a company would use storage, inventory management systems and inventory counts to control inventory

Key Takeaways

Key Points

  • Companies should store inventory in secure spacious warehouses so that inventory is not stolen or damaged. Goods and resources of the same or similar type should be kept in the same general area of the warehouse to minimize confusion and to ensure accurate counts.
  • An inventory management system is a series of procedures, often aided by computer software, that tracks assets progression through inventory. A properly used and maintained inventory management system allows management to be able to know how much inventory it has at any given time.
  • Detailed physical inventory counts are a way of ensuring that a company’s inventory management system is accurate and as a check to make sure goods are not being lost or stolen. A physical count of a company’s entire inventory is generally taken prior to the issuance of a company’s balance sheet.
  • To conduct a cycle count, an auditor will select a small subset of inventory, in a specific location, and count it on a specified day. The auditor will then compare the count to the related information in the inventory management system to ensure the information in the system is correct.

Key Terms

  • cycle counts: Process by which an auditor selects a small subset of inventory and counts it to ensure that it matches the information in the company’s inventory management system. Meant to test the accuracy of inventory system.
  • physical inventory count: Physical inventory is a process where a business physically counts its entire inventory. A physical inventory may be mandated by financial accounting rules or the tax regulations to place an accurate value on the inventory, or the business may need to count inventory so component parts or raw materials can be restocked. Businesses may use several different tactics to minimize the disruption caused by physical inventory.
  • internal auditor: one who conducts an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations

Internal controls over a company’s inventory are meant to ensure that management has an accurate count of what materials and goods it has available for sale and to protect those goods from being spoiled, stolen or otherwise made unavailable for sale. In short, inventory internal controls are meant to ensure that a company always has sufficient resources to produce and sell goods to meet its customers’ needs without having oversupply.

This process is affected by the company’s structure, its employees, and its informational systems. Since a company’s inventory is directly tied to the business’s ability to generate profit, the internal controls must be comprehensive and require significant thought when being designed.

Storage

Companies should store inventory in secure, spacious warehouses so that inventory is not stolen or damaged. Goods and resources of the same or similar type should be kept in the same general area of the warehouse to minimize confusion and to ensure accurate counts.

Inventory Management Systems

An inventory management system is a series of procedures, often aided by computer software, that tracks assets progression through inventory. For example, assume a set amount of raw material is acquired by the company. When the company receives that material, the amount should be noted in the inventory management system. As the material is processed into the goods for resale, the amount of raw material used should be deducted from the “raw material inventory” and the amount of goods that result from the process should be added to the “finished goods inventory. ” As each finished item is sold, the “finished goods inventory” should be decreased by that amount.

The benefit of a properly used and maintained inventory management system is that it allows management to be able to know how much inventory it has at any given time.

Physical Inventory Count

Physical inventory counts are a way of ensuring that a company’s inventory management system is accurate and as a check to make sure goods are not being lost or stolen. A detailed physical count of a company’s entire inventory is generally taken prior to the issuance of a company’s balance sheet, to ensure that the company accurately report its inventory levels.

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Keeping track of Inventory: Clerk conducting physical inventory count using a handheld computer in a Tesco Lotus supermarket in Sakon Nakhon, Thailand

Cycle Counts

Companies usually conduct cycle counts periodically throughout an accounting period as a means to ensure that the information in its inventory management system is correct. To conduct a cycle count, an auditor will select a small subset of inventory, in a specific location, and count it on a specified day. The auditor will then compare the count to the related information in the inventory management system. If the counts match, no further action is taken. If the numbers differ, the auditor will take additional steps to determine why the counts do not match.

Cycle counts contrast with traditional physical inventory in that a full physical inventory may stop operation at a facility while all items are counted at one time. Cycle counts are less disruptive to daily operations, provide an ongoing measure of inventory accuracy and procedure execution, and can be tailored to focus on items with higher value, higher movement volume, or that are critical to business processes. Cycle counting should only be performed in facilities with a high degree of inventory accuracy.

Perpetual vs. Periodic Counting

Perpetual inventory updates the quantities continuously and periodic inventory updates the amount only at specific times, such as year end.

Learning Objectives

Explain the differences between perpetual inventory and periodic inventory

Key Takeaways

Key Points

  • Perpetual inventory, also called continuous inventory, is when information about amount and availability of the product is updated continuously, usually via computer.
  • Periodic inventory is a system of inventory in which updates are made on a periodic basis.
  • Theft, breakage, or untracked movement can cause the perpetual inventory to be inaccurate.

Key Terms

  • breakage: Something that has been broken.
  • perpetual: Continuing uninterrupted
  • periodic inventory system: accounting for goods and materials held for eventual sale that is not continually updated

Perpetual Inventory

Perpetual inventory, also called continuous inventory, is when information about amount and availability of a product is updated continuously. Generally, this is accomplished by connecting the inventory system either with the order entry system or for a retail establishment the point of sale system.

A company using the perpetual inventory system would have a book inventory that is exactly (within a small margin of error) the same as the physical (real) inventory.

Periodic Inventory

Periodic inventory is when information about amount and availability of a product is updated only periodically. Physical inventories are conducted at set time intervals; both cost of goods sold and the inventory are adjusted at the time of the physical inventory. Most companies who use periodic inventory perform this at year-end.

Periodic vs. Perpetual

In earlier periods, non-continuous or periodic inventory systems were more prevalent. Many small businesses still only have a periodic system of inventory.

Perpetual inventory systems can still be vulnerable to errors due to overstatements (phantom inventory) or understatements (missing inventory) that occurs as a result of theft, breakage, scanning errors, or untracked inventory movements. These errors lead to systematic errors in replenishment.

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Periodic inventory is performed once a year.: Physically counting inventory ensures that book value and physical value are the same.

While the perpetual inventory method provides a close picture of the true inventory information, it is a good idea for companies using a perpetual inventory system to do a physical inventory periodically.

Conducting a Physical Inventory

There are three phases of a physical inventory: planning and preparation, execution, and analysis of results.

Learning Objectives

Identify the three phases of a physical inventory

Key Takeaways

Key Points

  • Physical inventory is a process where a business physically counts its entire inventory.
  • In the planning and preparation period, a list of stocks which is supposed to be counted are set up. Different teams are then assigned to count the stock.
  • Each team counts a specific inventory. The results are recorded on the inventory listing sheet.
  • The physicial count is compared to the computer count. The company must note any discrepancies between the actual number and the computer system, recount these inventory items to determine the correct quantity, and adjust the computer inventory quantity if needed.
  • Any discrepancies between the actual number and the computer system must be fixed.

Key Terms

  • cycle counting: A cycle count is an inventory auditing procedure, which falls under inventory management, where a small subset of inventory, in a specific location, is counted on a specified day. Cycle counts contrast with traditional physical inventory in that a full physical inventory may stop operation at a facility while all items are counted at one time. Cycle counts are less disruptive to daily operations, provide an ongoing measure of inventory accuracy and procedure execution, and can be tailored to focus on items with higher value, higher movement volume, or that are critical to business processes.
  • perpetual inventory system: Perpetual inventory or continuous inventory updates information on inventory quantity and availability on a continuous basis as a function of doing business. Generally this is accomplished by connecting the inventory system with order entry and in retail the point of sale system.

Conducting a Physical Inventory

Physical inventory is a process where a business physically counts its entire inventory. Companies perform a physical inventory for several reasons including to satisfy financial accounting rules or tax regulations, or to compile a list of items for restocking.

Most companies choose to do a physical inventory at year-end.

Businesses may use several different tactics to minimize the disruption caused by physical inventory. For instance, inventory services provide labor and automation to quickly count inventory and minimize shutdown time.

In addition, inventory control system software can speed the physical inventory process. A perpetual inventory system tracks the receipt and use of inventory, and calculates the quantity on hand. Cycle counting, an alternative to physical inventory, may be less disruptive.

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A company’s inventory is a valuable asset.: An inventory control system ensures that the company’s books reflect the actual inventory on hand.

The Phases Of Physical Inventory

There are three phases of a physical inventory:

  • Planning and preparation
  • Execution
  • Analysis of results

Planning and Preparation

In the planning and preparation period, a list of stocks that need to be counted is set up. Teams are then assigned and sent to count the stock.

Execution

The teams count the inventory items and record the results on an inventory-listing sheet.

Analysis Of Results

When analyzing the results, a company must compare the inventory counts submitted by each team with the inventory count from the computer system. If any discrepancies occur between the actual number and the computer system, it may be necessary to recount the disputed inventory items to determine the correct quantity. After the final amounts are determined, the company must make an adjusting entry to the computer inventory.

Impact of Measurement Error

Measurement error leads to systematic errors in replenishment and inaccurate financial statements.

Learning Objectives

Explain how a measurement error affects a company’s inventory value

Key Takeaways

Key Points

  • In inventory controlling, measurement error is the difference between the actual number of stocks and the value obtained by measurement.
  • Inventory systems can be vulnerable to errors due to overstatements (phantom inventory) or understatements (missing inventory). Overstatements and understatements can occur as a result of theft, breakage, scanning errors or untracked inventory movements.
  • Based on inaccurate measurement data, the company will make either excessive orders or late orders which then may cause production disruption. In sum, systematic measurement error can lead to errors in replenishment.
  • An incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income.

Key Terms

  • phantom inventory: Phantom inventory is a common expression for goods that an inventory accounting system considers to be on-hand at a storage location, but are not actually available. This could be due to the items being moved without recording the change in the inventory accounting system, breakage, theft data entry errors or deliberate fraud. The resulting discrepancy between the online inventory balance and physical availability can delay automated reordering and lead to out-of-stock incidents. If not addressed, phantom inventory can also result in broader accounting issues and restatements.

Measurement Error Impacts

Measurement error is the difference between the true value of a quantity and the value obtained by measurement. The two main types of error are random errors and systematic errors. In inventory controlling, measurement error is the difference between the actual number of stocks and the value obtained by measurement.

Inventory systems can be vulnerable to errors due to overstatements (phantom inventory) when the actual inventory is lower than the measurement or understatements (missing inventory) when the actual stocks are higher than the measurement. Overstatements and understatements can occur as a result of theft, breakage, scanning errors or untracked inventory movements. It is quite easy to overlook goods on hand, count goods twice, or simply make mathematical mistakes.

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Physical inventory: Female clerk doing inventory work using a handheld computer in a Tesco Lotus supermarket in Sakon Nakhon, Thailand

Based on inaccurate measurement data, the company will make either excessive orders or late orders which then may cause production disruption. In sum, systematic measurement error can lead to errors in replenishment.

Inventory controlling helps revenue and expenses be recognized. As a result, an incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income. A general rule is that overstatements of ending inventory cause overstatements of income, while understatements of ending inventory cause understatements of income. Since financial statement users depend upon accurate statements, care must be taken to ensure that the inventory balance at the end of each accounting period is correct. It is also vital that accountants and business owners fully understand the effects of inventory errors and grasp the need to be careful to get these numbers as correct as possible.


Source: Accounting