Physical inventory procedures
After you have identified all differences, it's time to investigate them. First of all, you need to determine the source of discrepancies, and, then decide how to reduce them in the future. Let's consider possible sources of differences. They can be the following:
- Internal theft is a typical problem for retailers. As we mentioned above, you should use external inventory specialists to identify internal theft. Good internal control is needed to prevent this issue in the future. Such internal control includes use of security cameras, control over store access, the receiving room and the back door, and control over trash disposal. Also, the owner (a manager) should lead by example and maintain appropriate discipline over recording the transactions.
- Shoplifting. Use of security cameras and sensor tags will be very helpful to significantly reduce this problem; and certainly proper customer service can prevent shoplifting.
- Administrative error can be identified through comparison of the differences among locations (may be there is a shortage in one and the overage in another location at the same time).
- Vendor fraud. For example, a vendor sends a shipment of inventories and indicates a quantity sent (in packed boxes) higher than what is actually in the shipment. In such cases, the best control is to count all inventories received to ensure that the actual quantity matches the number provided by the vendor in the shipping documents.
Analysing the differences, you should estimate the effect they have on your business. Some of them may have little effect; other may have significant effect and show the areas where improvements are needed. You should have your method to trace an accuracy of your inventory and identify the weaknesses. Two methods of accuracy tracking are on-hand method and transactional method. On-hand method shows you a percentage of error at the concrete point of time. Using this method, you divide total difference amount by the total on-hand inventory amount. For example, after counting you have a shortage of 15 items, when your total inventory amounted 150 items; thus, the accuracy rate is 10% (=15 ÷ 150 x100%). Transactional method shows the accuracy of your operations; it is a correlation of the difference amount and total consumed inventory amount during the period. For instance, you have the same shortage of 15 units, and you determined that the consumed inventory amount during the count period is 250 units, so the accuracy rate is 6% (=15 ÷ 250 x 100%). In practice, if inventory accuracy is within 3%, you may consider your inventory management to be effective.
You are also recommended to save the results of previous physical counts for the reason of comparing current and last count results and seeing the effect of improvements in inventory management process.
After you have carefully investigated the discrepancies, you need to make adjustments. Adjustments need to be made in the inventory listing (sub-ledger, perpetual inventory records) and the ledger. For example, your physical inventory result shows $17,200, while book inventory is $17,500. The $300 difference will be adjusted in the sub-ledger (detailed inventory listing) by changing inventory parts with differences for correct unit quantities. You should also make a following entry: debit inventory shortage and credit inventory for $300. Note, however, that sometimes accounting software will make an adjusting entry in the ledger automatically after you have made necessary changes in the inventory sub-ledger. Consult your accounting software documentation for more guidance.
Finally, it will be useful for you to analyze the inventory count process in total and receive feedback from your employees. You can take into account this information when planning the count for the next year and updating your inventory count policies and procedures.
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