Avoid Critical Inventory Accounting Lapses

Nov. 1, 2008
Whether a company is a manufacturer, a distributor or a hybrid, inventory is a significant component of its financial structure.

Accurate inventory accounting is vital, especially in the globalized world of low-cost competition. Five critical inventory accounting control lapses threaten a company’s long-term survival.

Management that focuses exclusively or excessively on top-line growth (sales for sales sake), rather than on the cost of inventory, or that bases decisions on the wrong information regarding cost of sales is the first lapse.

In the short term, simply emphasizing greater sales may lead to increased production and larger gross revenues, giving an appearance of healthy growth. Inventory-based businesses, however, face ever-increasing competitive pressures from domestic and global sources. To withstand those pressures and adapt to marketplace changes, the company must be aware of its actual inventory expenses, its true costs of sales, and the price points it needs to attain when entering into customer and vendor agreements.

The next lapse occurs when accounting is not fully engaged on inventory, and accounting management has an attitude that “inventory is not my problem,” letting operations managers handle inventory accounting.

Understand implications
While operations managers are connected to inventory throughout the inventory cycle, they are often not equipped to fully understand the implications of their actions on inventory accounting, and therefore apply inconsistent or incorrect accounting methodology. When the accounting department abdicates its responsibility, it accepts whatever inventory data operations managers provide.

A product manufacturer or distributor cannot afford such neglect. The accounting department must work with operations managers to establish appropriate policies, procedures, practices and monitoring to ensure that inventory expenses are properly defined and recognized. Inventory valuations and costs of sales can then be properly validated.

Poor inventory management systems or a lack of any inventory management system lead to the third lapse. In a large, state-of-the-art manufacturing or distribution company, inventory is constantly tracked with the help of online supply chain portals, radio frequency identification (RFID) tags and other technological tools. A smaller manufacturer or distributor may not need or be able to afford all of those capabilities, but a company should have industry-specific software that corresponds to steps in its inventory processes and captures critical financial information.

Cost methods and processes that give management an inaccurate picture of cost of sales is the fourth lapse. Most inventory-based businesses do not operate a perfect-world version of inventory accounting as it relates to application of overhead and other direct cost components, variances from expected average cost components or other considerations.

Deviations from the best-valuation practices are usually not significant, and therefore still reflect Generally Accepted Accounting Principles. However, when business conditions change, the real-world impact is quite significant, and costing methods must be evaluated to ensure inventory is valued correctly and that costs are expensed properly in the period they are incurred. For example, the 1 cent per unit of unapplied overhead incurred on a product with a $10 gross margin is not significant in managing cost of sales right after the product is launched, but as the product’s gross margin falls during its life cycle to 10 cents, the 1 cent per unit is crucial.

Unrealistic or unsupported estimates used to determine the costs of inventory impairment, returns and discounts is yet another lapse. Inventory accounting requires significant estimates related to impairment and expected returns and discounts. Estimates are often developed using informal and inconsistent methods, creating substantial room for cost of sales errors or manipulation. All inventory and sales estimates should be formally documented, supported and developed using consistent methodology and data.

Don’t let accounting considerations be an afterthought. Quality inventory accounting is critical for remaining competitive and staying in business.

Jody Allred, CPA, is a Risk Advisory Services Senior Manager for Weaver and Tidwell, L.L.P.
He can be reached at [email protected].

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