Internal Controls over Inventory

Learning Outcomes

  • Illustrate how inventory counts are used as an internal control under a perpetual system

In the prior section, we discussed internal controls on periodic inventory:

  • authorized purchase orders and a tracking system for those POs
  • verifying receipt of inventory
  • a process to approve the payment to the vendor
  • inventory management such as:
    • reorder points
    • quality control
    • shipping and billing procedures
A worker holding a clipboard in a factory.

In addition to these controls, one of the main internal controls over inventory when using the perpetual system is the physical count. Unlike periodic inventory, where we count at the very end of the accounting period in order to calculate COGS, under perpetual inventory we constantly take test counts. We don’t count everything all at once though. In January, we count one class of items or category, and then another in February, and so on, or at random times, unannounced.

Ideally, the physical count and the accounting records will be the same, but sometimes they are not, in which case we make an adjusting journal entry AND we assess our other internal controls to see if we are lax in some area. Maybe something got broken, missed in the count, or stolen. In our sound system warehouse example, we might consider installing webcams to watch over our employees, reducing the opportunity for theft.

Here is our official inventory list from our accounting records (this is the subsidiary ledger):

Inventory List
Geyer, Co.
Product ID Description Cost Quantity in Stock Total Inventory Value
A101 Wiring harness 99.00 30 2,970.00
CAB 500 HQ Speakers 58.00 500 29,000.00
CAB 600 HQ Speakers 99.00 15 1,485.00
MMM 333 GPS enabled sound system 1,255.50 64 80,352.00
Rel 5 HQ Speakers 110.00 100 11,000.00
RFS-212 GPS enabled sound system 650.00 150 97,500.00
XPS-101 GPS enabled sound system 102.375 160 16,380.00
Total Inventory Value $ 238,687.00

Under the perpetual inventory system, when the actual physical counts don’t agree with the accounting records, we have to make an adjustment to the accounting records. It’s usually not “swelling,” which means there is more inventory on hand than in the records. It’s usually “shrinkage.” Let’s say the actual physical count revealed there were only 63 MMM 333 in stock. We would probably post the shrinkage to COGS:

JournalPage 101
Date Description Post. Ref. Debit Credit
Dec 19 Cost of goods sold 1,255.50
Dec 19       Inventory 1,255.50
Dec 19 To adjust inventory subsidiary ledger to physical count

If shrinkage was significant, we should do two things:

  1. Find out why by more closely monitoring the at-risk items.
  2. Record shrinkage in a separate GL account in order to more closely monitor the materiality of the loss.

Sometimes things just break or are damaged and it’s just a cost of doing business, but sometimes we can and should mitigate that loss—that’s what internal controls are all about.

Practice Question