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Inventory Losses- Why Guess When you Can Count?

Posted by Meaden & Moore on Nov 21, 2016 8:00:00 AM

IAG image -1.jpgFollowing a loss in which a company sustains damage to its inventory, the first thought may be to remove the damaged inventory, perform repairs and resume normal business operations as soon as possible. However, skipping the physical inventory count, even when perpetual inventory records exist, can lead to consideration of inaccurate inventory quantities and result in an overpayment or underpayment of the loss. An accountant, salvor, or an independent inventory company can perform a physical inventory count to verify the inventory on-hand, both damaged and undamaged.

Let’s consider the insured with a perpetual inventory system. The company’s books and records related to inventory may be sophisticated, but often do not address the following issues: 

“Honest and Dishonest” Shrinkage

From the date of a company’s last physical inventory count, the perpetual inventory is typically updated by increasing the inventory for each purchase or unit produced and decreasing the inventory for each sale or shipment. However, this may not account for “honest” shrinkage. For example, goods damaged by forklift movement may be discarded by operators at fault, without a record of such. Honest mistakes, like mistakenly shipping ten units, but recording the intended eight units would result in an overstated perpetual balance. Clerical errors of data input may overstate or understate receipts or shipments, leading to an inaccurate balance.

“Dishonest” shrinkage, possibly an intentional diversion of goods by internal or external forces (think shoplifting) would also not be recorded, leaving the perpetual inventory balance misstated. 

Using historical shrinkage rates can be a good estimate of the shrinkage at the location, but beware, this amount or rate can vary from year to year. The best way to accurately determine the inventory quantities on hand is through a physical inventory count.

Obsolete or Outdated Inventory

During the course of the year, a company may identify items that no longer have customer demand and thus have reduced or no value. However, these items may remain in the perpetual inventory value at above-market values.  During a physical inventory count, the storage location of the insured’s inventory may indicate whether or not there is demand for a given product. Further review would help confirm the activity of the items to assess their value.

Potential Discovery of Fraud

In a manufacturing setting, employees may record items as completed finished goods for bonus or incentive purposes when the goods are not 100% complete. During a physical inventory count, segregating items between work-in-process and finished goods could reveal such activity.

Counting Selling Price Inventory

Inventories insured at selling price are likely not accounted for at selling price. Physical counts conducted in these settings should note the selling price and any indication of sales and other promotions that would diminish the value from the tag price.

In a setting of all items being countable, a physical count could address the issues and concerns already discussed. In a setting in which some items cannot be counted because of their destruction, a count of remaining goods would be necessary to determine the amount of loss as the difference between “total available” inventory from perpetual inventory records or roll-forward calculations and the observable undamaged goods. Issues of shrinkage, obsolescence and improperly categorized goods are still valid issues and a physical count may still assist with the assessment of them.

Hiring an independent company to count the physical quantity of inventory subsequent to a loss event will aid in confirming that the inventory amount considered in a claim is an accurate representation of the inventory on hand at the time of the loss or of the goods remaining after the loss. If the insured’s employees perform the physical inventory count, it is a good idea to have an independent party verify the count as it is being completed. A physical inventory count may have large implications in the overall assessment of the loss. Consideration of these issues will help to assure an accurate inventory valuation and reasonable compensation to the insured.

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Topics: Investigative and Forensic Accounting

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