Auditing and Follow-Up
Chapter 18 Inventories*
RETAIL METHOD OF INVENTORY
As every retailer knowns, an annual physical inventory of all merchandise is required by federal income tax law. However, this should not be your only reason for taking inventory. A physical inventory serves several purposes that are as important as satisfying the legal requirement. But unless it is meticulously taken to ensure its accuracy, you will find that the information obtained is worthless and misleading.
By comparing the actual physical inventory with the book inventory, the retailer is able to check the accuracy of the record keeping that is being done, not only in the office but in the receiving and marking department and on the sales floor. Many things will affect the accuracy of the book inventory, such as unrecorded markdowns, unrecorded markdown cancellations or markups, merchandise sales that are recorded in a wrong class due to carelessness, or merchandise received and counted in the physical inventory without its invoice being recorded in the books. The list can go on an on. The important thing to remember is that careless record keeping and the resulting
"paper shortage" will hide real shortages caused by shoplifting and theft.
If the retailer will keep unit inventory information in addition to cost and retail, he/she will have a tool to be used to analyze the amount of shrinkage that has occurred since the last physical inventory was taken. This shrinkage can tell the retailer many things if he/shewill take the time to analyze it. By comparing the average retail dollars of shrinkage with the average retail price of merchandise sold and merchandise in the actual ending inventory, he/she will be able to determine how much of the shrinkage is due to unrecorded markdowns, merchandise recorded in a wrong classification, missing mer- chandise or employee theft.
Of course, if the physical inventory count is inaccurate, the information obtained will be useless. An inaccurate physical inventory has many far- reaching consequences that retailers often do not consider when actually
T h i s chapter was contributed by retail management consultant Gerald H. Smith and is printed with the permission of Gerald H. Smith and Associates of Dallas, TX.
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170 Testing and Follow-Up of the Loss Control Programs
preparing for and taking a physical inventory. An inaccurate physical inven- tory that overstates the total amount of merchandise actually in inventory at year-end will result in overstated gross profit and net profit for the current year, which in turn can result in the paying of excess income tax. This misstatement of gross profit and net profit will distort the company's finan- cial statement for two years, the year in which the inaccurate physical inven- tory took place, and the following year, when the inaccurate physical inven- tory is corrected by the taking of a correct physical inventory. Many retailers base their store manager's and/or buyer's compensation, in part, on the achievement of certain gross profits, stock turn rate and shrinkage goals.
When the physical inventory is incorrect, this causes the amount of compen- sation to be computed incorrectly. While one manager could be over- compensated, another could be unfairly penalized.
A bad physical inventory can also seriously affect a company's merchan- dising decisions by causing erroneous information at the classification level, even though the overall store figures look valid. If the actual inventory counts taken in the store for each class are incorrect, the buyers will be basing their purchases on figures that are distorted. For example, if the physical inventory erroneously shows that a particular classification's inventory level is too low, the buyer will mistakenly buy merchandise the store doesn't need. This can simultaneously work the other way, with the inventory showing that a class has too much inventory. In this case, the buyer will avoid placing needed orders and sales can be lost.
THE INVENTORY PROCESS
As shown in the above examples, it is easy to see that a physical inventory carelessly taken is worse than not taking one at all. Instead of bringing the book inventory back in line with what is actually in stock, a bad inventory just causes extra work and confusion, and results in a wealth of misleading information. Fortunately, there are steps the retailer can take to ensure the accuracy of a physical inventory.
The taking of a good physical inventory involves almost all of the store's employees, whether they work on the sales floor, in the receiving and mark- ing department or in the office. It is also requires careful advance prepara- tion. The merchandise on the sales floor must be checked to verify that the information on the garment tags is correct. Personnel must be scheduled for the actual count. The numbered inventory count sheets must be ordered, and written procedures must be established to ensure a clean cut-off of all move- ment of merchandise and the resulting paperwork. A store meeting must be held to review the procedures and emphasize their importance.
No matter how careful the retailer and his/her employees are, there are items that may be overlooked, which can result in a poor count. Following are some of the things to be aware of and watch out for in preparing for and
Inventories 171 taking a physical inventory. You can most likely add more based on your own experiences.
• Merchandise held for evidence
• Merchandise out for repair
• Merchandise on display
• Merchandise taken out of the store for use in developing advertising
• Hold merchandise
• Owned merchandise being repaired in the alteration shop
• Merchandise being stored in a seldom-used storage area
• Improperly counted interstore transfers
• Merchandise in the receiving area that is not counted, even though the paperwork was processed, or vice versa
• Merchandise taken off the sales floor by a buyer and left in the buyer's office
• Damaged merchandise that was taken off the sales floor for which the RTV has not been processed
• Merchandise returned by customers but not put back into stock
• Merchandise left in the layaway room, even though the paperwork has been processed to return it to return it to stock
• Merchandise stored in what inventory counters assume is an "empty" box
• An inaccurate cut-off of paperwork: receipts, interstore transfers, price changes and return-to-vendors
On the day the inventory is taken, inventory teams must be carefully in- structed concerning the appropriate manner for counting the merchandise and filling out the inventory count sheet. If outside help and non-sales employees are used, it is important that the person doing the actual counting is familiar with the merchandise, and can therefore spot any mismarked mer- chandise that otherwise might go unnoticed. All teams should be checked during the first half-hour to verify that the forms and being filled out cor- rectly, as this will prevent a large number of recounts. Finally, it is of the ut- most importance that all count sheets be left on the fixtures until unit counts are verified and the store manager is ready to begin picking them up. This helps to ensure that everything is counted.
The taking of an accurate physical inventory, because of the many details that must be attended to, can be an awesome task. But it is not impossible.
Remember, it takes no longer to take a good, accurate physical inventory than it does to take a sloppy, inaccurate physical inventory.
INVENTORY TIPS
• Conduct an inspection tour and prepare a listing and timetable of things to do in preparation for inventory.
• Train all personnel on inventory procedures.
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• Develop a floor plan—a drawing of the selling and stock areas.
• Arrange merchandise in the stockrooms and on the selling floor to facili- tate a timely and accurate inventory.
• Perform a careful review of store paperwork to be sure that all adjustments and corrections have been made.
• Clear up problem receipts before inventory.
• Do not allow merchandise to be moved during inventory.
• Provide adequate supervision for all inventory counting teams.
• Verify counts made on a random basis.
• Remember, communication and training are key elements to an accurate inventory!