Inventory Audits: How to Create Counting Procedures

Even reading the word “audit” is enough to send shivers down most business owners’ spines. But, whether the audit is for internal purposes or at the request of an external auditor, understanding the nuances of an inventory audit ahead of time will prepare you for what’s to come and set you up for success.

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What is an inventory audit?

An inventory audit is when either you or an auditor uses analytical procedure to check a company’s inventory methods and confirm that the financial records and actual count of goods match.

It’s important to conduct inventory audits to maintain inventory accuracy, spot causes of shrinkage, and ensure that you always have the right amount of stock at the right time. A better understanding of stock flow will also help ensure the business runs smoothly, because you’ll know what products you have on hand.

Audit procedures for inventory

If your inventory undergoes an audit, an internal employee or external auditor will conduct a series of procedures to validate your records. Procedures can include inspection, observation, confirmation, recalculation, performance, or analytical analysis of inventory during any stage of operations.

Here’s a list of the various inventory auditing procedures that could occur.

  • Physical inventory counting: This is the process of counting each piece of inventory so you can account for all items. You’ll want to schedule a physical inventory count ahead of time because it will likely be an inconvenience to normal business flow. You might also want to consider using technology, like a bar code scanner, to help physically count each item. (If you’re working with an auditor, they will likely want to observe this process and will want to reconcile the count with your general ledger.)
  • Inventory layers: If you do inventory using the FIFO (first-in, first-out) or LIFO (last-in, first-out), you’ll want to look at the layers of inventory you’ve recorded to make sure they’re valid.
  • High-value item inventory analysis: This can also be known as an ABC Analysis. High-value items are given the grouping of A products, mid-tier are B, and low value are C. ABC analysis can also help you manage a stockroom better and save time. If you put the high-volume items in Group C near the entrance, this will speed up trips from the sales floor, while low-volume, high-value items in Group A should be secured safely away to reduce costly theft. (If you’re working with an auditor, they will likely spend more time counting high-value inventory items.)
  • Inventory in transit analysis: When materials are moving between two or more locations, you’ll want to track the time between the date of shipment or shift, and the date of receipt. These inventory audits will help ensure nothing is lost or damaged in transit. Auditors test for this by reviewing any kind of transfer documentation.
  • Freight cost analysis: This analysis will determine shipping costs, or how much it costs to get products from one place to another.
  • Finished-goods cost analysis: This is best used if you create your own products. When all the work on the inventory is completed, it becomes a “finished good” and is ready to be sold. You can then analyze the value of the inventory for the current accounting period.
  • Direct labor analysis: Direct labor is production or services labor that is assigned to a specific product, cost center, or work order. The cost of direct labor is generally considered to be the cost of regular hours, shift differentials, and overtime hours worked by employees. You’ll also want to add in payroll taxes or any benefits costs associated with employees to properly analyze this cost. (This analysis is only done if direct labor is included in the cost of inventory.)
  • Overhead analysis: Overhead is the cost of doing business that doesn’t include the direct materials and labor required. This should include the cost of rent, electricity, etc. When doing an analysis of overhead costs, you’re trying to predict the indirect cost of doing business, which will help you budget for the year. (Again, auditors will only want to look at this if overhead is included in your inventory costs.)
  • Reconciling items investigation: If there are discrepancies between the inventory counts in the company’s records and the actual amounts on the warehouse shelves, you’ll need to figure out why there are differences between the two amounts and make adjustments to the records to reflect this analysis. Inventory reconciliation is an extremely important part of cycle counting.
  • Test invoices listed in receivable report: Auditors will select invoices from the accounts receivable aging report at random and compare them to supporting documentation to see if they were billed in the correct amounts, to correct customers, on the correct dates. This is a test of the entire system to see how things line up.
  • Match invoices to shipping log: Here an auditor will verify that invoices for products match the amount of items and cost of what was shipped from your warehouse.
  • Cash receipts review: An auditor will count and balance all receipts of items paid for by cash.

An inventory audit checklist

Conducting your own audit periodically increases visibility of how your materials are moving through the supply chain. It can help you evaluate costs and prepare for any external audit procedures.

The best inventory audits have three phases: planning, execution, and analysis. Here’s a checklist to help you conduct an inventory audit.

  1. Assess which items to audit: Higher-risk inventory items should be assessed more frequently. You can sort inventory out by SKU or bar code, then prioritize.
  2. Create an audit schedule: Next, you’ll need to map out an auditing schedule. Unfortunately, conducting an inventory audit can disrupt the normal business flow. You’ll want to choose times that are least impactful for the business, but also happen at a good frequency to ensure those high-value items will be accounted for. The policies and procedures of buying and shipping items may also affect the schedule of your audit.
  3. Collect the necessary documentation: Get out any important documents ahead of time and make sure they are easily accessible, but secure.
  4. Conduct the inventory audit: As discussed above, there are a number of different audits that can be essential, depending on the nature of your business. Make sure you have an internal auditor that is unbiased but knows how to conduct the audit.
  5. Record the findings: Keeping track of audit results year to year or cycle to cycle is key. The main goal of an audit is to find gaps in compliance and look at opportunities to fix the deficit and improve operational processes.
  6. Report the findings: When it’s all over, you’ll want to create an easy-to-read audit report to serve as evidence if an external audit is ever conducted.

Why inventory management is important

Maintaining an efficient inventory management process can reduce the length and complexity of audits. For example, if you have a system that tracks and scan items when they come in to or leave your store, there will be time stamps associated with each action that can be easily tracked.

Square POS has a built-in inventory management system that can help you successfully track inventory anywhere and at any time. You can import your product spreadsheet in the inventory management system and have the option to customize names, manage quantities, and edit prices of products.

You can also set up stock alerts that will notify you when your product inventory reaches a certain count. This can help you quickly react to sudden demand changes and keep your processes running smoothly.

If you’ve opened a retail store, you might need additional capabilities like managing inventory across multiple locations or creating purchase orders based on stock counts. Square’s retail POS has a powerful inventory management tool included that can satisfy these needs.

Having inventory management systems like these will keep your business operating efficiently and can track your inventory with precision. That way, when inventory audit requests arise you can quickly respond with accurate data and take the necessary steps to complete an audit without fear.

Running a business is no easy feat, but Square is here to help. We have all the tools you need to start, run, and grow your business, whether you’re selling in person, online, or both. And we’ve made all our tools to work together as one system, saving you time and money — and making decisions easier. So you can get back to doing the work you love and focusing on whatever’s next. See how Square works.