Updated: Jun 19
It goes without saying that accurate and timely physical inventories are one of the most important responsibilities in assuring making business more profitable. An inaccurate inventory can make the difference between the profit and loss. For example, if a corporation overstates its inventory, it will exaggerate gross profits and net income as well as current assets, total assets, retained earnings, stockholders' equity, and all of the related financial ratios for the current year. The gross profit and net income are overstated as a result of overstating inventory because the unavailable cost of goods are being charged to the cost of goods sold. The higher amount of net income means that the reported amount of retained earnings and stockholders' equity is also too high. Since the current year-end overstated amount of inventory becomes the beginning inventory of the following period, the following period's cost of goods sold will be too high significantly reducing in the period's gross profit and net income. Therefore, business decisions will have been made based on incorrect information leading to an adverse effect on profits.
When do firms need a physical inspection?
1. Seasonally/ Periodically
Performing a seasonal inventory count can give people useful information about stock. They may find this information coming in handy throughout the year - particularly with seasonal items having limited shelf life.
Periodic system allows a company to know the beginning inventory and ending inventory within an accounting period, but it does not track inventory on a daily basis. In businesses where annual shrinkage runs at a rate of several percent of total inventory, a periodic physical inspection is useful to avoid overstating the value of goods on hand, or misleading customers into thinking they are available when in fact they are not.
A perpetual inventory tracking system keeps track of balances of inventory after every transaction through point-of-sale inventory systems. Inventory management software can make real-time updates to stock levels; however, it is necessary to execute physical examining when management believes that automatic systems are undercounting. To illustrate, automatic tracking systems do not over count unless the same item is scanned more than once, and then only if items do not have individual identification such as serial numbers. Undercounts occur due to some items bypass scanning, or inventories lost through theft, such as pilferage, shrinkage, leakage, or shoplifting.
For tax purposes, a physical inventory count needs to be done at least once per year requiring the least effort - any losses recorded in inventory can reduce tax burden.
Here is an example of an inventory count procedure.
1. Decide on a count date
Schedule inventory count after business hours, if possible, so you don’t disrupt business. If that doesn’t work, you’ll need to close stores for a day or at least a block of several hours.
2. Order count tags
Order a sufficient number of two-part count tags for the amount of inventory expected to be counted. To be individually tracked as part of the counting process, these tags should be sequentially numbered.
3. Preview inventory
Review inventory notations for legibility, reasonableness, consistency, and completeness before the scheduled count. If there are any missing parts, or if items appear to be in a difficult condition to count, such as not being bagged or boxed, notify the warehouse staff to make the necessary corrections.
4. Pre-count inventory
Number the inventory and any items placed in sealed containers a few days in advance of the scheduled examination. Seal them in the containers and mark the quantity on the sealing tape. If a seal is broken, a counting team will know that they need to re-count the contents of a container. Moreover, make sure necessary supplies available, including cards or counting sheets, clipboards, pencils, etc.
5. Complete data entry
If there are any remaining data entry transactions to be completed, do so before the physical inventory count begins. This encompasses transactions for issuances from the warehouse, returns to the warehouse, and transfers between bin locations within the warehouse.
6. Notify outside storage locations
For any outside storage facilities or third-party locations holding company’s inventory on consignment, notify them that they should count their inventory on hand as of the official count date and forward this information to the warehouse manager.
7. Freeze warehouse activities
Stop all deliveries from the warehouse, and also segregate all newly-received goods where they will not be counted.
8. Instruct count teams
Assemble two-person teams and instruct them in their counting duties. These duties involve having one person count inventory while the other one marks down the information on a count tag. One copy of the tag is affixed to the inventory, while the team retains the other copy.
9. Issue tags
A secretary issues blocks of count tags to the count teams. Each team is responsible for returning a specific numeric range of count tags, whether or not the tags are used. Maintaining control over all count tags ensures that lost tags will be investigated promptly.
10. Assign count areas
Assign a particular range of bins to each count team. Note these locations with a highlighter on a map of the warehouse. The inventory clerk should maintain a master list of which areas of the warehouse have been counted, and which teams have been assigned to each area.
11. Count inventory
One person on each team counts a specific item within a bin location, and then the other one marks the bin location, item description, part number, quantity, and unit of measure on a count tag. The team affixes the original copy of the tag to the inventory item and retains the copy.
12. Verify tags
After accomplishing a count area, each team returns to the clerk. If there are more warehouse areas to be counted, assign a new area to the count teams and issue them new blocks of count tags as necessary.
13. Enter tag information
Enter the information on the count tags into an online data entry form. Once data entry is completed, print a report showing all tag numbers entered, sorted by tag number, and look for any gaps in the numbers. Investigate any numbering gaps found. This will ensure that all count tags issued were included in the file.
14. Investigate unusual result
Arrange the inventory report some ways to look for unusual information, and discover the tag entry associated with each one.
15. Consider future cycle count
This would help check inventory continuously and find leaks before they become a flood.
In conclusion, taking at least one physical inventory count during the year is an important part of internal control procedures. Keeping a close eye on the inventories based on paper versus what’s actually in-store helps you to maintain inventory accuracy, identify causes of shrinkage or problems in bookkeeping, and make sure you have the right amount of stock on hand to meet customer demands.