Physical inventory is required to comply with accounting rules and legal or regulatory requirements and to confirm the accuracy of company records. It is an opportunity to check the actual number of inventory items against accounting records and to adjust for differences and allow for shrinkage so the ledger reflects accurate values. Auditors observe and test physical inventory procedures to establish confidence in the accuracy of their counts. Important physical inventories are conducted at or near the end of the year.

Reliability and Accuracy

Auditors are expected to observe the physical inventory for a number of reasons. An auditor should be satisfied that a company is using a reliable service or employees who can be trusted. Confirm that no company employee is conducting physical inventory counts on inventory that is within his care, custody or control in the course of his normal duties. Assist in drafting accurate instructions and verify that people conducting physical inventory comply with the instructions and procedures. Auditors also need to verify that physical inventory is conducted in an orderly manner and that employees conducting inventory are properly supervised. Make sure that inventory records are not provided to those conducting physical inventory counts.

Segregation of Duties

Items selected for physical counts should be chosen by people other than those who will actually perform a count. People who count inventory should also be responsible for recording the counts. When auditing physical inventory, keep incoming shipments of additional items separate from the physical inventory counts. People who have regular access to master files and records of inventory delivered, defective goods and shipping should be segregated and have no overlapping access to such records.

Reconciliation and Adjustments

Investigation of any major discrepancies between inventory records and physical counts should be initiated as soon as possible to identify any evidence of missing records, posting errors or other administrative explanations. If perpetual inventory record keeping is in place, any major differences between recorded numbers and physical counts should be investigated and researched thoroughly before posting adjusting entries in the accounting system. Perpetual records should be reconciled to physical counts.

Reliability Testing

Take steps to observe counting and recording activity during physical inventory. Develop a program to verify counts by having test counts conducted by different personnel. Make any corrections or adjustments needed. If entire areas of the physical counts are in doubt, have them recounted and conduct additional test counts to verify their accuracy. Determine if there are obsolete inventory items that cannot be sold or otherwise slow moving products that are not likely to be sold in the future.