An article on inventory management, inclulding variance analysis, valuation, financial implications, internal control and accuracy.

1. Inventory Management – A Financial Perspective by Lynn Sears, CMA
For many companies, inventory is the most complex and difficult item to
value. It may be the largest current asset if not the largest item on the
balance sheet. As such, its accuracy is of great concern to a company’s
stakeholders, internal or external auditors, and creditors such as banks and
vendors.
Many privately held firms, and all publicly trades ones, have their financial
records audited each year by a public accounting (CPA) firm. This type of
audit provides reasonable assurance that the company’s financial statements
are free of material misstatements. Auditors test three major aspects of
inventory to determine its fair representation on the balance sheet -
existence, rights of ownership and proper valuation.
Inventory was not always so extensively audited, in fact, it used to be limited
to the examination of inventory records. The McKesson & Roberts Fraud Case
of 1939 expanded the scope of auditors’ responsibilities. McKesson &
Roberts, a pharmaceutical company listed on the NYSE, was trying to boost
its stock price. Customary audit practices of the time didn’t include
verification of existence or observation of the physical inventory process
since auditors claimed they didn’t know enough about the products.
McKesson & Roberts’ inventory was overstated by $19 million – containing
fictitious items that amounted to one fourth of the total assets on their
balance sheet. Generally Accepted Auditing Standards were subsequently
revised to require that auditors observe the taking of physical inventory.
The annual audit is a long and involved process and very likely the busiest
time of year for your company’s accounting department. If you are involved
with inventory management, just when you’re knee deep in the annual
physical count you are visited by an auditor along with one or more of your
colleagues from Accounting. Armed with clipboards and calculators, they
question you regarding counting methods, recordkeeping transactions,
movement of stock within the facility and how duties are divided between
your staff. Depending on the relative dollar value of inventory and the
amount of cycle count adjustments done throughout the year, their efforts
spent on this could be extensive. The procedural questions help them
understand your company’s internal control system.
Internal control is a set of system attributes and procedures designed to
prevent inaccuracies and losses. Assessing internal control is an early step in
the audit process and helps the CPA firm plan the extent of their testing of
transactions and other components of their field work. Strong internal control
lends greater credibility to the financial records, results in substantially less
work for everyone involved, and reduces the overall cost of the audit.
How do you strengthen internal control over inventory? The easiest way, and
a given for large companies, is division of duties. In short, no one person
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2. should handle a transaction from beginning to end. Purchasing, receiving,
storing, processing and shipping duties should be performed independently of
each other. A good perpetual inventory system providing real time
information is essential for effective production planning, purchasing and
sales. It also promotes accountability and reduces the chance of theft. Serial
numbers, lot tracking, pre-numbered documents, timely processing, and safe
keeping of valuables further enhance accuracy and control. Computer
security, access control, and limited numbers of users performing certain
transactions, especially inventory adjustments, are also important. The cost
benefit criterion should be considered when choosing a system or evaluating
procedures.
The most compelling indicator of internal control over inventory is the
amount and nature of inventory variances. When the system quantity on
hand exceeds the physical quantity on the floor, this is a negative or
unfavorable variance. If the quantity on the floor is greater than the system
quantity, this is a positive or favorable variance. There are many reasons for
variances but errors can be minimal with modern inventory control
techniques such as RFID and bar code scanning. However, many companies
still experience variances and we’ll take a look at some of the major causes.
It’s essential to troubleshoot variances so they can be prevented in the
future. It is good for multiple departments to collaborate on this effort. The
value of interdepartmental variance analysis lies in its opportunity for
learning experiences, leading to greater understanding, more sound
processes, less errors and solid internal control.
Consistently recurring negative variances are the most disconcerting,
because they could represent waste, unbilled sales, duplicate vendor
invoices, higher than expected product costs, or chronic errors in the way
transactions are executed.
The first question is whether there exists a positive variance that could be
related. If so, then there is probably a training issue or system problem with
how transactions are recorded. For example, a negative work in process
inventory variance offsetting a related positive finished goods variance may
mean production is not being recorded in a consist manner. Similarly, a
positive work in process variance offset by a related negative raw materials
variance means the raw materials are not properly being issued or allocated
to production.
Manufacturing firms using a back-flush costing environment, where inventory
is relieved using theoretical consumption, persistent negative variances
signal inconsistencies between the production models and the actual
production process. This is assuming there is nothing wrong with how the
system is posting transactions. If variances have grown but no changes have
been made to the system, then a cross functional team of representatives
from production, and those departments responsible for designing and
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3. maintaining the models, and perhaps information technology staff, should
evaluate standard quantities for scrap, rework, production, and materials
usage to make sure they are accurate, and most importantly, to look for
opportunities for avoiding waste in the form of excessive scrap and rework.
In a job order environment, persistent negative variances are likely to signify
materials not allocated to the job perhaps due to parts pulled off the shelf
without being scanned or billed to the job. This will result in understated job
costs and possibly unbilled items. This is likely a procedural error that can be
easily corrected with proper training.
A recurring negative variance in purchased goods (raw materials or finished
goods for resale) warrants a review of the receiving and vendor invoice
process. Is every vendor invoice accompanied by a unique purchase order
receipt? Is the system receipt based on a unique source document, such as a
vendor packing list? Are there an especially high amount of open receipts for
which there are no vendor invoices? A good accounts payable and receiving
system usually prevents such errors, but if there is a variance, these are all
worth looking at.
Similarly, negative recurring variances in finished goods should call for
evaluation of the sales and customer invoicing process. Is there a consistent
procedure for scanning outbound shipments, and is there a method for
following up on all open sales orders to make sure they are invoiced? How
are samples, disposals and no charge replacements handled?
A cycle count is an opportunity to assess accuracy and should not be grounds
for making adjustments without finding the root cause. Timing of
transactions or not observing a clean month-end cutoff can lead to problems
that will reverse in the following month. To reduce errors, the entire SKU
should be counted as opposed to just one location. If variances are
substantial, pallet patterns and units of measurement should be checked.
Test counts are required in order for auditors to verify the existence of the
inventory. Typically they are given an inventory schedule, the sum total cost
of which ties to the dollar value of inventory in the financial records. Working
from a list of randomly selected samples, they trace each SKU back to the
inventory schedule and make sure the quantities agree.
The second generally accepted audit standard as it applies to inventory is to
confirm ownership of the asset. They trace a sample of SKU’s back to
suppliers’ invoices to make sure they were paid for, and to verify that the
goods are not on consignment or owned by another company. Auditors will
want to know if any of the goods are pledged as collateral for a loan; if so,
the arrangement must be disclosed in the notes to the financials and with a
corresponding liability account showing the debt.
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4. Lastly, the auditors must determine that the inventory is appropriately
valued. This entails evaluation of the appropriateness and consistent
application of costing methods, the choice of which can greatly impact cost of
goods sold, profitability and tax liability. The valuation method does not
necessarily mirror what is happening on the floor, i.e., you may be using
LIFO for valuation but you are still rotating stock and selling the oldest goods
first. Manufacturers using a standard costing system present their inventory
at standard cost. This is the expected current cost to produce the product or
to buy the raw materials. Standards are generally re-calculated every year,
and variances in purchase prices and other costs are expensed through cost
of goods sold as they are incurred.
Last in First Out, (LIFO), is probably the most widely used. The older
inventory assumed to remain on the shelf is always at a lower cost because
of inflation. Products sold in the current year wash through cost of goods sold
at higher rates since these were assumed to be bought most recently. The
result is lower gross profit and happily, less tax exposure. Inventories have a
lower value on the balance sheet, which satisfies an important accounting
convention known as conservatism.
First in, First out, (FIFO) can be used for product with a limited shelf life,
such as food. Since financial implications of FIFO are directly opposite to
those of LIFO, it is not very popular due the likelihood of higher tax bill.
Specific identification can be used when items are unique. But in the
absence of lot or serial numbers, this method allows for manipulation of costs
since a company can choose to assume the most expensive pieces were sold
if the company desires to show less profit.
Lower of Cost or Market is used for vehicles and other products whose
market value may decline over time. Its cost must never exceed net
realizable (wholesale) value (NRV). The difference between NRV and original
cost is expensed when the inventory value is recorded.
Market costing is used for commodities, such as gemstones, agricultural
products, precious metals, oil, etc. They are presented at ending market
value.
A weighted average or moving average method can be used. The costs are
re-calculated each time a purchase is made. This mitigates the volatility that
comes from fluctuating costs and therefore lessens the resulting impact on
gross profit.
Work in Process (WIP) is the most difficult aspect of inventory to value. The
allocation of raw materials is easy enough, but overhead and labor
allocations can be problematic and vary greatly depending on the costing
system being used. At any point in time the amount of WIP is usually
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5. substantial, and care should be taken to make sure all costs are captured
completely and on a timely basis lest variances arise in related areas.
Other considerations for proper inventory valuation are obsolescence,
spoilage, replacement cost and quality. Reserves for obsolete/aged and
damaged inventory are either based on historical experience or specific
identification & segregation of doubtful inventory. If the stock is vulnerable to
these conditions it should be adjusted accordingly by a reduction in value
and/or quantity and a corresponding expense.
Obsolescence, shrinkage and damages are key indicators of inventory
management effectiveness and should be tracked as a percentage of
purchases, production or sales. Taking corrective action when these amounts
exceed acceptable levels can reduce costs.
Inventory turnover is a useful benchmark, particularly when a company
monitors trends in its own ratio. A higher turnover ratio implies that
inventory is well managed, marketable and that the company is not holding
excessive stock. But in times of inflation, especially if using LIFO or standard
cost, this ratio can be misleading. Therefore, it should always be reviewed in
tandem with gross profit since higher product costs artificially increase this
ratio.
Many companies monitor the age of their inventory, most importantly in
dealing with perishable goods, but also any time inventory value may erode
with age. An aging report can also highlight the faster or slower SKU’s and
serve to facilitate corrective merchandising or marketing strategies.
Today more than ever we strike a fine balance between ordering costs and
carrying costs while avoiding stock-outs, raw materials shortages and heroic
recoveries that chip away at competitive advantage. We are fortunate in the
availability and cost efficiency of sophisticated systems and new technology
to effectively manage inventory, enhance productivity and control costs.
Nothing in business is ever static, and we constantly improve our processes
and acquire new understanding to adapt to ever changing environments. And
from an accountant’s perspective, this ultimately adds the most value to a
company, ensuring a healthy bottom line and a solid balance sheet for the
long term.
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