For both merchandising and manufacturing companies, inventory can be a substantial portion of a small-business balance sheet. By understanding the major controls surrounding inventory and how the auditor plans to audit the inventory balance, both you and your auditor can be assured that your company's inventory balance is fairly stated.

Annual Physical Inventory Count

A company's major control over the inventory balance is the annual inventory count. It is generally accepted that companies should complete a physical count of all of its inventory at least once a year.

This can be done in two ways. One method is to count all of the inventory at once. This method is usually done as close to the end of the fiscal year as possible.

Another method is called cycle counting. When cycle counting, companies will count parts of their inventory at different times based upon products or locations in the warehouse. Companies that use cycle counts will count inventory several times a year but in much smaller pieces.

Auditor's Inventory Observation

Coinciding with the annual inventory account, the auditor's inventory observation provides assurance over the quantity of inventory owned by the company, as well as some assurance over the condition of the inventory observed.

To perform an inventory observation, the auditor will arrive at the company's business as the count begins and make selections from a listing of inventory that is supposed to the be in the warehouse. Once theses items are selected, the auditor will count them, comparing them to the counts made by the company. These are called "sheet-to-floor" selections.

Also, the auditor will walk around the warehouse and select items from the shelf. Once selected, these items are counted and traced into the listing of inventory. These are called "floor-to-sheet" selections.

Testing the Inventory Cost per Unit

Because inventory observations only provide assurance about the quantity of inventory - along with some assessment of the condition of the inventory - auditors also must test the client's inventory cost per unit.

For manufacturing companies, this includes the testing of raw materials costs as well as the cost incurred for labor and overhead to produce products.

Small-business owners can help the auditor by making sure accurate and organized records are kept and provided to the auditor when requested.

Inventory Roll-Forward

If the company's inventory count is not made at the end of the day on the last day of the fiscal year, inventory roll-forward procedures must be conducted by both the company and the auditor.

Roll-forward is the process of using the inventory count, sales figures and purchases of inventory to determine what the year-end inventory balance should be. Once this is determined, this balance is compared with the inventory balance given by the company. Any discrepancies are noted and investigated.