Internal control for inventory is especially important so we protect against theft and waste.
An effective internal control structure for inventory includes a company’s plan of organization and all the procedures and actions it takes to:
- Protect its assets against theft and waste.
- Ensure compliance with company policies and federal law.
- Evaluate the performance of all personnel to promote efficient operations.
- Ensure accurate and reliable operating data and accounting reports.
Companies protect their assets by (1) segregating employee duties, (2) assigning specific duties to each employee, (3) rotating employee job assignments, and (4) using mechanical devices.
Segregation of employee duties Segregation of duties requires that someone other than the employee responsible for safeguarding an asset must maintain the accounting records for that asset. Also, employees share responsibility for related transactions so that one employee’s work serves as a check on the work of other employees.
When a company segregates the duties of employees, it minimizes the probability of an employee being able to steal assets and cover up the theft. For example, an employee could not steal inventory from a company and have the theft go undetected unless someone else changes the inventory records to cover the shortage. To change the records, the employee stealing the inventory must also maintain the inventory records or be in collusion with the employee who maintains the inventory records.
Assignment of specific duties to each employee When the responsibility for a particular work function is assigned to one employee, that employee is accountable for specific tasks. Should a problem occur, the company can quickly identify the responsible employee.
When a company gives each employee specific duties, it can trace lost documents or determine how a particular transaction was recorded. Also, the employee responsible for a given task can provide information about that task. Being responsible for specific duties gives people a sense of pride and importance that usually makes them want to perform to the best of their ability.
Rotation of employee job assignments Some companies rotate job assignments to discourage employees from engaging in long-term schemes to steal from them. Employees realize that if they steal from the company, the next employees assigned to their positions may discover the theft.
Frequently, companies have the policy that all employees must take an annual vacation. This policy also discourages theft because many dishonest schemes collapse when the employee does not attend to the scheme on a daily basis.
Use of mechanical devices Companies use several mechanical devices to help protect their assets. Bar codes scanners make it difficult for employees to steal inventory and alter company documents and records.
Accurate and Reliable Inventory Records
Companies should maintain complete and accurate accounting records. The best method to ensure such accounting records is to hire and train competent and honest individuals. Periodically, supervisors evaluate an employee’s performance to make sure the employee is following company policies. Inaccurate or inadequate accounting records serve as an invitation to theft by dishonest employees because theft can be concealed more easily.
One or more business documents support most accounting transactions. These source documents are an integral part of the internal control structure. For optimal control, source documents should be serially numbered.
Since source documents serve as documentation of business transactions, from time to time firms check the validity of these documents. For example, to review a purchase transaction, they check the documents used to record the transaction against the proper accounting records. When the accounting department records a purchase transaction, it should receive copies of the following four documents:
- A purchase requisition is a written request from an employee inside the company to the purchasing department to purchase certain items.
|BRYAN WHOLESALE COMPANY||Date: November20|
|Fro: Automotive Supplies Department|
|To: Purchasing Department||Suggested supplier: Wilkes Radio Company|
|Please purchase the following items:|
|Description||Item Number||Quantity||Estimated Price|
|Model No. 5868–24393||200||$50perunit|
|Reason for request:||To be filled in by purchasing department:|
|Customer order||Dated ordered November 29|
|Baier Company||Purchase order number N-MS|
- A purchase order is a document sent from the purchasing department to a supplier requesting that merchandise or other items be shipped to the purchaser.
|BRYAN WHOLESALE COMPANY||Date: November 21|
|476 Mason Street||Ship by: December 20|
|Detroit, Michigan 48823|
|To: Wilkes Radio Company||
|2515 West Peachtree Street|
|Atlanta, Georgia 30303|
|Ship to: Above address||FOB terms requested:||Destination|
|Discount terms requested: 2/10, n/30|
|Please send the foil owing item;|
|True-tone stereo radios||Model No. 5868-24393||200||$50||$10,000|
|Ordered by: Jane Knight||Please include order number on all|
|invoice and shipments.|
- An invoice is the statement sent by the supplier to the purchaser requesting payment for the merchandise shipped.
|INVOICE||Invoice No. 1574
Date: Dec. 15
|WILXES RADIO COMPANY
2515 West Peachtree Street
Atlanta, Georgia 30303
|Customer’s Orders No.||N-14S|
|Sold to: Bryan Wholesale Co.|
|Address: 475 Mason Street|
|Detroit, Michigan 4S823|
|Terms: 2/10, n/30, FOB destination||Date shipped: December 15|
|Shipped by: Nagel Trucking Co.|
|Description||Item Number||Quantity||Price Per Unit||Total Amount|
|Model No. 5868-24393||200||$50||$10,000|
- A receiving report is a document prepared by the receiving department showing the descriptions and quantities of all items received from a supplier in a particular shipment. A copy of the purchase order can serve as a receiving report if the quantity ordered is omitted. Then, because receiving department personnel do not know what quantity to expect, they will count the quantity received more accurately.
These four documents together serve as authorization to pay for merchandise and should be checked against the accounting records. Without these documents, a company might fail to pay a legitimate invoice, pay fictitious invoices, or pay an invoice more than once. Companies can accomplish proper internal control only by periodically checking the source documents of business transactions with the accounting records of those transactions.
Unfortunately, even though a company implements all of these features in its internal control structure, theft may still occur. If employees are dishonest, they can usually figure out a way to steal from a company, thus circumventing even the most effective internal control structure. Therefore, companies should carry adequate casualty insurance on assets. This insurance reimburses the company for loss of a nonmonetary asset such as specialized equipment.
Inventory Management Systems
An inventory management system is a series of procedures, often aided by computer software, that tracks assets progression through inventory. For example, assume a set amount of raw material is acquired by the company. When the company receives that material, the amount should be noted in the inventory management system. As the material is processed into the goods for resale, the amount of raw material used should be deducted from the “raw material inventory” and the amount of goods that result from the process should be added to the “finished goods inventory. ” As each finished item is sold, the “finished goods inventory” should be decreased by that amount.
The benefit of a properly used and maintained inventory management system is that it allows management to be able to know how much inventory it has at any given time.
Physical Inventory Count
Physical inventory counts are a way of ensuring that a company’s inventory management system is accurate and as a check to make sure goods are not being lost or stolen. A detailed physical count of a company’s entire inventory is generally taken prior to the issuance of a company’s balance sheet, to ensure that the company accurately report its inventory levels.
Companies usually conduct cycle counts periodically throughout an accounting period as a means to ensure that the information in its inventory management system is correct. To conduct a cycle count, an auditor will select a small subset of inventory, in a specific location, and count it on a specified day. The auditor will then compare the count to the related information in the inventory management system. If the counts match, no further action is taken. If the numbers differ, the auditor will take additional steps to determine why the counts do not match.
Cycle counts contrast with traditional physical inventory in that a full physical inventory may stop operation at a facility while all items are counted at one time. Cycle counts are less disruptive to daily operations, provide an ongoing measure of inventory accuracy and procedure execution, and can be tailored to focus on items with higher value, higher movement volume, or that are critical to business processes. Cycle counting should only be performed in facilities with a high degree of inventory accuracy.
Accounting in the Headlines
What internal controls might have prevented a former Smucker employee from stealing $4.1 million over 16 years?
Kershey was the chief airplane mechanic at the company’s hangar at the Akron-Canton Airport in Ohio from 1990 until he was discharged by Smucker in 2013. From 1997 until he left Smucker, Kershey invoiced Smucker for more than $4.1 million by using a fictitious entity he created. He billed Smucker for nonexistent parts and/or work that he himself actually performed as part of his duties as a salaried employee. Most of these invoices were for less than $10,000, which Kershey himself was authorized to approve. A supervisor to Kershey approved the few invoices that were for more than $10,000 based on his trust in Kershey.
To carry out his false billing scheme, Kershey set up a post office box in Lake Township in Ohio using the fictitious entity name of Aircraft Parts Services Co (APS). He (as APS) would then invoice Smucker using non-sequential invoice numbers, so it looked like APS was invoicing other companies too.
Kershey used the proceeds to purchase and maintain two planes, several automobiles, and to make payments on his house.
Kershey was eventually caught in late 2012 when three checks written by Smucker to APS totaling $44,000 were not cashed. When a Smucker employee questioned Kershey about the APS uncashed checks, Kershey indicated that APS had been sold to another Smucker vendor. The false billing scheme began to unravel and Kershey was fired by Smucker. The Special Assistant United States Attorney has charged Kershey with mail fraud following an investigation by the Federal Bureau of Investigation, Canton, Ohio. Charges were filed in October 2014 and the case is pending.
- What internal controls could have been used to prevent Kershey from carrying out the false billing scheme?
- What factors might have contributed to the weak internal control environment that allowed this scheme to exist for 16 years?