Why and How to Audit Your Company Inventory

By Megan Sullivan

6 min read

If you’re a small business owner and maintain an inventory, you’ll want to regularly conduct an inventory audit. While most small businesses are not required to do an audit, it’s still a good business practice, as your inventory is typically one of your most expensive assets. Additionally, the value of your inventory is taken into account by the IRS every year on your tax return, so having an accurate inventory count will enable you to more precisely report its value.

In order to arrive at a fair valuation, you must hire a third party to observe your inventory audit, or else you are simply taking inventory. By having a third party on-site, there is much less of a chance for any dishonesty as well as a higher degree of accuracy. Third-party auditors will not conduct the inventory audit for you; they will simply observe the auditing process.

Why Conduct an Inventory Audit?

There are a few reasons why you might find yourself conducting an audit.

  1. Monitor Internal Theft: Internal theft at a company can turn into a big problem. Unfortunately, there may be people on the payroll in charge of tracking your products or materials who are less than honest. By conducting an audit, you will have an objective third party on-site to monitor how inventory is maintained and identify any problem areas.
  2. Proper Valuation: Valuing your inventory allows you to best determine the cost of goods sold during the tax year, which is a figure that must be reported on your business’ tax return. The IRS provides detailed information on why and how to value your inventory on its website.
  3. Reconcile Accounts: While keeping track of your actual sales does inform your inventory counts, it’s always a good idea to take stock of what products and materials you have on hand. Doing so helps to monitor any products or materials that were destroyed or lost in the past year due to unforeseen events (e.g. a flood in your warehouse) and helps you monitor materials from vendors. While every shipment should be checked against the order upon receipt, it’s easy to forget this step in the hustle of everyday business. You want to be sure your vendors are sending you the materials you’ve asked for.

How to Prepare for an Inventory Audit

Taking inventory is a multi-step process, and maintaining attention to detail is key. Auditors will need to review the inventory site and may also want to see your retail location to understand how goods and materials are used. Additionally, you’ll need to provide information on the following:

Inventory Locations

If you keep your inventory in more than one place, the auditor will need to observe inventory counts at each location.

Cut-Off Procedures

Inventory levels are always changing. Product is sold, raw materials are delivered and products are in production. Because of this, you will need to establish a cut-off date, after which any inventory or raw materials received after said date will not count toward the current audit.

If you’re expecting incoming inventory that won’t be part of your audit, you will need to keep these items in a separate and secure location so there isn’t any chance of it being counted. If possible, halt shipments of products or materials for a few days before your inventory, so the amount of “uncountable” inventory stays low.

Product Ownership

It’s possible that there is inventory in your warehouse or at your location that you don’t actually own, but are simply managing. This happens quite frequently with retailers that offer consignment services. The most common example is a car dealership; the dealer owns some of the vehicles on the lot, but is also selling others on consignment for the manufacturer. You will need to provide documentation to the auditor that proves ownership of materials so everything is counted correctly.

Accurate Counting Procedures

The auditor will want to know how you intend to count the inventory and what, if any, checks and balances are in place to ensure counts are accurate. Many inventory companies scan barcodes, then compare the scan results with shipping manifests.

If your products do not have barcodes or something similar, a manual count may be necessary. These can be tricky, so be sure to have a clear idea in mind of who will conduct the inventory, who will check it and how you will verify that the numbers are correct.

Inventory Value

The valuation of your inventory is important, primarily because it affects how you file your business taxes with the IRS. There are three primary philosophies that can be applied to inventory to assess its value:

  • First In, First Out (FIFO): Typically, this is used for newer inventory that is valued closely to its replacement cost.
  • Last In, First Out (LIFO): This is normally for older inventory that is valued closer to its original purchase cost.
  • Weighted Average: All inventory costs are averaged, and this average is taken and applied to what was purchased during the period to determine the value.

Process for Damaged or Broken Inventory

While this inventory may be unusable—or unsellable—it still needs to be accounted for. Be sure that you have a method in place for keeping track of damaged or broken inventory and its value so that it can accurately be recorded during your audit.

Conducting an inventory audit involves preparation as well as time for the actual inventory itself. But having an accurate accounting of what is in your warehouse and on your store shelves is well worth the effort.

Process for Damaged or Broken Inventory

While this inventory may be unusable—or unsellable—it still needs to be accounted for. Be sure that you have a method in place for keeping track of damaged or broken inventory and its value so that it can accurately be recorded during your audit.

Conducting an inventory audit involves preparation as well as time for the actual inventory itself. But having an accurate accounting of what is in your warehouse and on your store shelves is well worth the effort.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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