Control of Inventory

Inventory Control Objectives

Inventory control in a business is important for safeguarding the inventory from theft and damage, and to ensure that inventory is accurately reported on financial statements.

In merchandising and manufacturing companies, the primary course of business is selling and buying inventory to generate a profit. Therefore, building proper controls to safeguard inventory and ensure accurate reporting is vital to the success of a business.

Safeguarding the inventory starts before the inventory is even ordered. Companies use various tools to establish compliance with procurement and purchase procedures. Traditionally, the ordering of inventory begins with a purchase order. A purchase order (PO) is a record used to document approval and authorization for the purchase of inventory. The use of a purchase order system allows management to sign off and approve the purchase of inventory before it is ordered. Once the purchase is approved, ordered, and received, a receiving report is generated to provide a record that shows what items were received from a vendor. The goal of a receiving report is to confirm that the inventory received matches what was ordered. Therefore, the receiving report is often compared with the purchase order. Both the purchase order and receiving report are frequently prenumbered, which makes the inventory easier to track and match.

In addition to requesting payment, the vendor's invoice details the price, quantity, and description of all items purchased. To ensure uniformity across the systems, the vendor's invoice is also compared to the purchase order and receiving report to make certain there are no discrepancies. If there are no discrepancies and the purchase order, receiving report, and vendor's invoice all match, then the inventory is recorded in the accounting system. However, if there are any differences, then those differences should be investigated and reconciled prior to recording them in the accounting system. This is an additional internal control.

The subsidiary inventory ledger includes individual ledger accounts used to keep track of current inventory on hand and values for various items. This is helpful in maintaining proper inventory levels at all times. Designating minimum and maximum levels allows for timely reordering of inventory while also preventing the inventory levels from becoming excessively high.

Security measures that help prevent and deter damage and theft of inventory are also a key component to the safeguarding of inventory. Some examples of these measures include keeping inventory in restricted areas only available to certain employees, locking up high-priced inventory items, and using security cameras, tags, and guards to ensure continuous monitoring of the goods.

A physical inventory is a documented count of inventory that usually takes place at year-end to verify that the inventory amounts reported on the financial statements are accurate. These physical counts are used to determine the amount of inventory on hand, but not the cost of the inventory. The cost will be assigned based on the inventory cost flow method used by the company.

The important thing to note here is that though most companies use a perpetual inventory system that provides real-time updates to the inventory counts, it is imperative that the organization still performs periodic physical counts of inventory. Many employees who work in retail have been privy to this process. This physical count of inventory is used as a periodic check to see if there are any glitches in the perpetual inventory system. These glitches can be because of employee or customer theft, a high amount of damaged or expired goods (including or excluding consigned goods), or issues with the inventory control system (purchase order, receiving report, and vendor's invoice). All accounting systems must ensure there are checks and balances to prevent misstatements and errors. An inventory system is no different.

Inventory Accounting Principles

Four common accounting principles associated with inventory are consistency, disclosure, materiality, and conservatism.

Some basic concepts in accounting principles represented in the generally accepted accounting principles (GAAP) that are relevant to inventory accounting include consistency, disclosure, materiality, and conservatism. Application of these principles is required for inventory accounting.

The principle of consistency states that once an organization determines a method of valuing its inventory, the organization must remain consistent in that method. Therefore, an organization is not allowed to use the first in, first out (FIFO) method this year and change to the last in, last out (LIFO) method next year. Based on the method used, the ending inventory for that company will be valued at the current costs or the oldest costs. Because inventory is a permanent account that continuously rolls over from year to year, jumping back and forth between different methods would have a devastating effect on the accuracy of the organization's financial statements, particularly the assets section of the balance sheet. While a switch is allowed, called a change in accounting principle, there are special rules that must be followed to ensure that consistency is always present and attainable.

GAAP also requires that financial statements fully disclose all information that a stakeholder may need to assess the current state of finances for a business. Though it is not required that the particular method of inventory valuation is stated in a company's financial statements, any changes to the method used must be disclosed. A change in the method of inventory valuation would qualify as a significant change in accounting policy and would require the organization to notify its stakeholders. The financial statement disclosure would need to provide details as to the effects of the shift.

Inventory is made up of different items and related costs, so keeping track of the value of inventory can be complex and tedious. Financial statements are provided to stakeholders to present an overall picture of the company's financial condition. So, while accuracy is imperative, the accountant must weigh the effort and expense of valuing the inventory precisely with the impact that the precise results will have on the financial statements as a whole. The accountant determines at what point the effort and cost outweigh the significance that the inventory value will have for the overall financial statements. Materiality has both quantitative (dollar value) and qualitative (nature of item) aspects. Therefore, the dollar size of an item or error should be weighed in relation to the financial size of the company. The nature of the item also plays a part, in that fraudulent activity is always material, regardless of the dollar value. A way to view materiality and judge financial statement impact is to ask the question, "Would the information presented in the financial statement help a stakeholder have a different perspective about the company's performance?"

Another inventory-related principle represented in the generally accepted principles of accounting is conservatism. Accountants must use the method or value that will result in lower income or lower value. Once losses are calculated, they must be recognized, and gains must be reported when items are sold. Practicing this principle helps businesses become aware of losses immediately and also prevents overvalued revenue or profit. Conservative values for inventories are used for financial reports. For example, a company's product in inventory can currently be purchased for $400, but the company bought it for $500. In this case, the value of that product must be written down to $400, the lower of cost or market. However, if that product now costs $600 to purchase, the value must still remain at $500 on the company's records, the lower amount.