Avoiding Inventory Audit Adjustment

With year-end audits in progress, one focus area for nearly every manufacturing and distribution company is inventory. Inventory typically makes up a majority of a company’s total assets. Due to the amount of judgement inventory is subject to, it is highly scrutinized by auditors. Inventory is one of the biggest drivers for a company’s profit margins and cash flow, so accuracy is vital for management decision making. The valuation of the inventory is the main cause for audit adjustments.

Common Causes for Adjustments

Valuing inventory is difficult for companies due to various factors constantly changing throughout the year. Standard costing and overhead allocation calculations are where the most common valuation issues lie. These issues may be caused by companies using old pricing data for raw material purchases and old labor cost amounts. In addition, companies may have incorrect total costs for their overhead calculation. For example, companies may be neglecting to include freight and tariff costs or including expenses that are not production related. It is also important to ensure companies are using the proper basis for their overhead calculation; companies need to decide if direct labor or machine hours are more appropriate for their company.

Other areas where companies could see issues that would cause inventory adjustments include not identifying obsolescent inventory, recording inventory using the incorrect value, and physical count differences. Companies may have slow-moving or damaged inventory that may be overstated and should be valued at the lower of cost or net realizable value. Also, companies may fail to correct physical inventory counts to actual, which would lead to audit adjustments.

How to Stay Ahead

Inventory valuation is a high-risk audit area and management can mitigate the risk by having strong internal controls in place. There are numerous steps that management can take throughout the year to be proactive to avoid year-end audit adjustments. Implementing cycle counts throughout the year will allow companies to adjust inventory on a timely basis for any variances from the counts to the system records.

Companies should review and update standard costs and overhead allocations on a monthly or quarterly basis. Key items that may require updating the calculations include significant changes to the cost of materials, a shift in expenses from direct or indirect (this can occur when an employee’s role changes due to promotion), and updating rates during low and high production periods.

Another important step management can take is adopting a reserve policy. Having a process and methodology for identifying at-risk inventory based on historical data and future projections will eliminate any surprise entries during the audit. An additional step management can take is establishing strong internal controls and processes related to cut-off. These controls will ensure shipping and receiving inventory surrounding the days at year-end are recorded in the proper period and the proper documentation is retained.

By taking the steps mentioned above, a company will be able to have a more accurate assessment of their inventory and allow management to make critical decisions that will help the company grow and be successful in the future.

Please reach out to a member of our Manufacturing & Distribution team for more information on the topic outlined above. For more information regarding our Manufacturing & Distribution experience, visit our Manufacturing & Distribution industry page.

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