Physical Inventory

A physical inventory, also called a stock count or stocktake, is the process of counting, weighing or measuring every item of inventory a business holds at a particular date and recording the quantities. The counted quantities are then priced at cost to produce the value of inventory for the balance sheet. Under a periodic inventory system, the count is the only way to determine ending inventory and cost of goods sold; under a perpetual system, it confirms the accuracy of the continuous records.

Physical inventories are usually carried out at or near the year end, often while operations are paused. Many businesses with reliable perpetual records replace a single annual count with cycle counting, in which a portion of the stock is counted every week or month so that all items are covered over the year.

• Planning: management issues written count instructions, assigns teams, sets a cut-off time, arranges for receiving and shipping to stop, and ensures stock is tidied and labeled.
• Counting: teams of two count each location using prenumbered tags or handheld scanners. One person counts and the other records, and a second team test-counts a sample.
• Cut-off: the last receiving and shipping documents before the count are recorded, so that goods are not counted twice or missed. Items in transit, consigned goods and goods held for customers need special attention.
• Reconciliation: counted quantities are compared with perpetual records, differences are investigated and recounted, and the final figures are priced using the company's cost method.

Ownership, not location, decides what is included. Goods shipped under FOB shipping point terms that are still on a truck belong to the buyer and must be added; consigned goods held for another company must be excluded; and goods in transit must be assigned to the right party.

A wholesaler's perpetual records show inventory with a cost of $412,000 at year end. The physical inventory finds goods costing $405,500. Investigation shows that $1,500 relates to a supplier delivery received but not yet entered, which is added to the books, and that a $2,000 shipment to a customer under FOB destination terms was wrongly excluded from the count. After these corrections, the book figure is $413,500 and the count is $407,500. The remaining $6,000 is unexplained shrinkage. The shrinkage rate is:

Here $\text{Book inventory}$ is the corrected value per the records and $\text{Physical inventory}$ is the corrected counted value. The rate is $6,000 divided by $413,500, or about 1.5 percent. The company debits inventory shrinkage or cost of goods sold $6,000 and credits inventory $6,000, so the balance sheet shows the counted amount of $407,500.

Observing the physical inventory has been a standard audit procedure in the United States since the McKesson and Robbins fraud, uncovered in 1938, in which about $19 million of fictitious inventory and receivables had gone undetected. Today, when inventory is material, an independent auditor must attend the count or, for public companies, follow PCAOB standard AS 2510. The auditor observes counting procedures, makes test counts in both directions (from records to floor and from floor to records), checks cut-off documents and reviews the treatment of damaged or obsolete stock. If the auditor cannot observe the count or perform alternative procedures, the auditor's report may have to be modified.

Typical issues include poor cut-off, double counting, missed storage areas, unrecorded consignment stock, counting errors under time pressure and inadequate identification of obsolete items. Fraud schemes have included moving stock between locations so it is counted twice, inflating counts after the auditor has left and inventing "in-transit" goods. Strong count procedures, segregated responsibilities and timely inventory valuation reviews reduce these risks.