An annual inventory count is necessary to determine the actual value of your inventory at the end of the year. Merchandise inventory value and physical quantity can decrease over time even if they are not sold. Failing to identify and reflect such shrinkage would undermine the reliability and accuracy of your financial statements. Conducting an inventory count will help keep your inventory compliant with generally accepted accounting principles.
Generally accepted accounting principles,commonly known by the acronym GAAP, refer to the set of rules used by accountants to prepare, present and report financial statements for businesses, non-profit organizations and government authorities. Generally, GAAP encompasses all prevailing accounting rules used worldwide. GAAP rules that are accepted in the U.S. are normally referred to as U.S. GAAP. Establishing business practices that observe GAAP will help you avoid accounting related problems.
GAAP requires amounts shown in financial statements to reflect the historical cost of assets. Merchandise inventory, which is a current asset, is normally valued at cost. When inventory shrinkage is not reflected due to an absence of physical inventory count, total ending inventory cost becomes overstated. Although the inventory reflects the historical value per unit, total value of inventory reflected in the financial statements reflects an overstated historical cost. Consequently, an overstated ending inventory causes an understated cost of goods sold and an overstated gross profit.
Matching expenses with revenues is another GAAP principle with which a company must comply when dealing with inventory shrinkage. Losses from inventory caused by a combination of factors such as employee theft, shoplifting, vendor fraud and administrative error must be recorded as loss during the current year. Postponing the annual inventory count would mean that such losses would go undetected and unrecorded until the following years. Income generated during the year in which the inventory losses occurred would not reflect the additional expense caused by the inventory shrinkage.
Under GAAP, the principle of conservatism directs accountants to choose the alternative that will result in less net income or less asset amount when faced with two or more acceptable alternatives for reporting an item. Between reporting an inventory that reflects the adjusted balance and the unadjusted balance, accountants must choose to present the one that has been diminished by certain losses. Conducting the yearly inventory and adjusting such inventory to reflect any shrinkage complies with this provision.
