Maintaining Proper Inventory Internal Controls

Inventory is often the most valuable asset on a company’s balance sheet. Nevertheless, many companies do not have the internal controls in place to properly safeguard this important asset. Improper controls can lead to incorrect inventory values and quantities and to unnecessary loss or damage to inventory. If you are an inventory-based company you don’t need to be reminded how detrimental these errors can be to your business. To avoid these accounting errors and loss of inventory, the following control objectives should be in place:

• Properly record inventory items for both purchasing and manufacturing. This includes correctly allocating applicable costs.
• Correctly record inventory movement, usage, and cost of sales in relation to account, amount and period.
• Properly value inventory, identifying and accounting for all excess, slow-moving, obsolete, and defective inventories in a timely manner.
• Make all efforts to avoid physical loss of inventory. If a loss does occur, account for it on a timely basis.

Do these objectives sound like what your company is trying to achieve but you aren’t quite accomplishing these goals? The procedures outlined below can help you determine whether your company has the proper inventory internal controls in place. If the benefit outweighs the cost the procedure should be in place. If an answer is no to any of the questions, management should investigate and understand why.

Reduce Theft Losses: Separate Duties and Restrict Access

1. Are there formal policies for scrap sales? Do these policies include having the sales reviewed by the appropriate person and periodically evaluating alternative scrap purchasers to ensure that scrap sales are reasonable?
2. Is physical access to inventory limited? If inventory theft is a problem, consider limiting access to highly vulnerable items by storing them in a locked facility.
3. Is there no risk of theft in the warehouse? Consider video surveillance in these areas if theft has been a problem.
4. Is there adequate insurance on inventories?
5. Are employees who have access to valuable inventory items bonded?
6. Is the person responsible for maintaining inventory independent of shipping, billing and recordkeeping?
7. Are vacations required for those employees with inventory, shipping and receiving responsibilities? Can other employees perform those functions when an employee is absent?
8. Is access to computerized inventory records limited to only those with a need for such access?

Maintain Accurate Records: Recording Processes

Do you use prenumbered documents and account for the sequence in the areas of purchasing, receiving, production, shipping and counting?

Reconciliations and reviews:

a) Do you regularly reconcile perpetual records to general ledger control accounts? Does an appropriate individual review this reconciliation?

b) Are there periodic reviews of how materials, labor, and overhead are applied to work-in-process and finished goods inventories?

c) Does the appropriate person review and approve adjustments to inventory control accounts and/or perpetual records?

d) Does the appropriate person review budgeted and actual production costs and investigate significant differences on a periodic basis?

Other checking or processing routines:

a) Physical count or cycle count

i) Are physical inventory counts or cycle count procedures performed on a regular, periodic basis?

ii) Are physical inventory counts or cycle counts monitored by the appropriate person?

iii) Are written inventory instructions used?

iv) Do the inventory instructions include procedures to ensure that no items are double-counted?

v) Is production halted or is movement of inventory between areas controlled?

vi) Is inventory at remote locations counted?

vii) Is slow-moving, obsolete or damaged inventory identified?

viii) Is inventory on hand that belongs to others segregated and excluded from counts?

ix) Are all tags or count sheets accounted for as used, unused, or voided when the company performs cycle counting or a full year-end physical count?

x) Are the reconciliations of physical counts or cycle counts to the general ledger and perpetual records reviewed by the appropriate person?

b) Are copies of receiving reports forwarded to the accounting department for matching with purchase orders and invoices?

c) Are all shipments leaving the warehouse checked for shipping documents?

d) Are all past-due open orders investigated to determine if goods were erroneously shipped without invoicing?

e) Are the inventory items identified as excess, slow-moving, obsolete, and defective accounted for on a timely basis?

f) If inventory becomes damaged in the warehouse are the causes investigated in order to prevent future damage?

g) Are there procedures in place to ensure that inventory is properly rotated to prevent it from becoming too old to use or obsolete?

Having these internal controls in place will improve the accuracy of inventory records, as well as minimize or prevent potentially devastating losses due to damage or theft. It is important to note that having good internal controls in all areas of your company is essential, not just with inventory. Having a good internal control structure will improve the overall reliability and accuracy of the company’s financial statements, as well as minimize losses. Please keep in mind that we have provided only an overview of some of the inventory controls that should be in place. If you have any questions or would like to further review your company’s internal controls, please call us at (425) 454-7990.

Jenn Raybon,
CPA Inventory Group Leader