How to Proper Inventory RecordkeepingInformation about the proper time period over which to retain accounting documents is difficult to find, as are procedures and documentation for organizing and destroying documents. I have discussed about record keeping in general scope so far. From now on, I am going to discuss recordkeeping for specific area, and in this post is recordkeeping for inventory. “Goods in Transit” has unique characteristic, let’s start from this. Read on…

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Goods in Transit Inventory Recordkeeping

A company receiving inventory typically records it as soon as it arrives. This way both the inventory and liability accounts increase at the same time, thereby resulting in no net change in the statement of financial position and no impact on profit or loss. Consequently, there is no particular need for recordkeeping.

The situation is different for companies shipping goods for which they retain title until some point in the shipment process. Shipping documents, such as a shipping log or bill of lading, should be stored that indicate the date of shipment from the facility, as well as a notification form from the shipping entity that describes the date on which title passed to the buyer. The shipping log or bill of lading can be used to estimate the date on which title passes by adding a standard number of days to the ship date, based on the distance of the buyer from the shipper’s facility; thus it is a critical document for affirming the timing of any revenue transactions.

 

Recordkeeping for Tracking of Consignment Inventory

A particular problem for adequate recordkeeping is the tracking of consignment inventory. A company receiving such inventory should make a notation in its computer system at the time of receipt that clearly identifies this inventory. Preferably, there should also be a flag in the software that prevents the consignment inventory from being assigned a value.

If the consignment inventory matches company-owned inventory, then it will be particularly difficult to segregate it; therefore one should create a unique inventory number for the item. For example, a wash basin might normally be inventory number 11479, so an identical item received on consignment could be given the number 11479-C.

If a company has sent inventory on consignment to a third-party location, then the inventory tracking system in its software should contain an off-site inventory location code clearly identifying where it has been sent. A reasonable location code would be the name of the company to which it was sent, truncated to match the size of the inventory location field in the computer system.

 

 

“Accounting for Inventory” Recordkeeping

 

Recordkeeping for Perpetual Inventory SystemRecordkeeping for perpetual inventory systems is accomplished most easily by having the computer system store a transaction log that shows what transactions were entered, who made the entries, and the date they were made. This log can be subdivided into a variety of reports that reveal only certain types of transactions or only transactions for particular inventory items. If the perpetual records are stored on paper, these documents should be kept for at least one year following year-end, so inventory levels can be reconstructed manually at a later date.

Note: Tax regulations in most countries require at least one physical inventory count per year; thus, these records should be stored in the event of a tax audit. If continuous cycle counting is used instead of a single physical inventory count, then these records must also be stored.

 

Recordkeeping for Periodic Inventory SystemsRecordkeeping for periodic systems is more complex, since the systems usually are manual ones. First, the counting records for each physical inventory count must be stored. Also, all purchasing records for the year should be retained, which can be as minimal as the general ledger detail for the purchasing account. However, this approach reveals nothing about who ordered goods, what goods were ordered, and from whom they were bought.

Accordingly, one should also retain the purchase order and the receiving documentation, which can be quite voluminous. The reason for this much document retention is that the calculation of the cost of goods sold requires one to add purchases to the beginning inventory and then subtract out the ending inventory, calling for backup information on all three parts of the calculation. If inventory is tracked using the specific identification method, then the computer system should contain a unique identifying number for each item tracked, such as a serial number. This identification number should be included in the standard inventory valuation report, which should be printed at the fiscal year-end and stored.

 

Recordkeeping for Valuation of Inventories

There are a number of recordkeeping issues related to the valuation of inventory. In all cases, the main issue is creating a paper trail that can be traced back to the source documents at any point in the future, so that anyone (especially an auditor) can easily determine the reason why a specific cost was assigned to an inventory item.

The discussion that follows covers recordkeeping issues for the standard costing of work-in-process and finished goods inventory, as well as inventory layering, spoilage, and the cost reductions for the lower of cost or net realizable value rule. In all cases, it is crucial to maintain accurate records of these transactions because they have a major impact on corporate expenses.

 

When auditors review the raw material costs listed on the statement of financial position, their first source of evidentiary material for affirming this cost will be the invoices received from suppliers. These are normally stored in the accounts payable files, so no additional recordkeeping is necessary. The main point is to ensure that the supplier name and invoice number are recorded in the raw materials valuation report, or easily traced from there, so the auditors have a clear documentation path from the inventory valuation report to the backup materials.

Many manufactured goods move through the production process so fast that there is no reason to track their progress from workstation to workstation, since they arrive in finished goods inventory so quickly. In other cases, materials may plod through the production process for weeks or months, traveling from workstation to workstation. In these latter cases, their recorded work-in-process (WIP) cost will gradually increase as value is added to them. 

If so, there must be a way to record the stage of completion of all WIP inventory at the end of a reporting period and to consistently assign a value to each stage of completion. This is done through a labor cost assignment routine—usually a computer record assigned to each product in the computer system’s item master file, itemizing the work processes that must be performed on the product and the cost of those processes.

When a reporting period ends, the accounting staff must itemize in the computer system the last workstation through which work has been completed on each inventory item; the computer then increases the cost of the inventory by the incremental production work completed, based on the standard costs used in the labor routings.

Accordingly, one must store copies of the labor cost assignments used for the period-end report, either in the computer system or as printed copies. If they are to be stored on the computer, there should be an archiving function or a change-tracking feature, so that one can find the correct version of a routing.

Once completed units of production are shifted into finished goods inventory, they are assigned a cost that usually is based on a bill of materials, which is a list of standard parts included in each product. Given its importance in the valuation process, one should keep a record of the bill of materials as proof of how costs were derived at the end of each accounting period. The bills can be printed and kept separately or stored in the computer under an appropriate archiving or change control methodology. That way, one can scroll back in time through various changes to the bills in order to find the version used to calculate the cost of inventory on a specific date.

Both labor cost assignments and bills of materials assign a standard amount of cost to either WIP or finished goods inventories, using a standard list of work centers and parts that are comprised of standard costs. Actual costs may vary somewhat from the standard costs used, due to variations in the market prices of parts, changing labor rates, different parts or work center configurations, and so on.

The standard costs used in a labor routing and a bill of materials are always incrementally varying from actual costs, requiring periodic adjustments to the standards in order to bring them more in line with actual costs. Whenever this happens, one should create and store a record of the changes made or use a computer system that stores this information whenever changes are made. When the actual amount of material scrap used to create a product varies substantially from the amount included in a bill of materials, it is considered abnormal scrap, and it will drop directly into the cost of goods sold in the current period. There is no need from an accounting perspective to track the exact items lost to scrap, since they are no longer stored in inventory.

Nonetheless, it may be useful for operational reasons to know where this scrap is occurring, which products are most likely to generate scrap, or what workstations in which scrap is most likely to occur. By tracking this information on a trend line, one can direct the attention of production engineers to those areas of the production process where their efforts can result in the greatest decrease in scrap costs. There is no further need to retain records in this area, however.

Overhead is a major component of inventory cost, in some cases comprising far more than the cost of labor or materials in a product. The overhead rate is compiled in one or more cost pools within the general ledger and then allocated to work in process, finished goods, or the cost of goods sold using some sort of activity measure—such as the amount of direct labor or machine time used by a product, or perhaps a combination of several activity measures.

Given the large amount of money being allocated, this is an extremely important area in which to have accurate recordkeeping. Records should itemize what costs are included in the overhead cost pool and the exact derivation of the allocation methodology. The method by which the allocated costs are assigned to inventory, such as through a journal entry or an alteration in the standard overhead rate used in the bills of material, should also be noted.

If the FIFO method is used to value inventory, the computer system should maintain a database of all cost layers used to derive the inventory valuation. Unless the inventory is very small, maintaining this information manually usually is very labor intensive; thus, it is not recommended. However, computer databases typically store data for only a few years into the past, so adequate recordkeeping in this area will require one to print out the layering records when old computer files are about to be deleted from the system.

If a lower of cost or net realizable value review is made that results in a reduction in the recorded cost of inventory, then the adjustment typically is made as a journal entry that reduces the cost of inventory in a single lump sum. If so, there is no way to tell which costs were reduced or what calculation was used to determine the reduction. Consequently, the journal entry records should include complete documentation of the comparison of standard costs to market costs, unfavorable variances between the two, and the total cost of these variances incorporated into the journal entry. If the purchasing department has entered into any material long-term purchasing commitments with suppliers, the amount of these commitments must be included in the footnotes to the financial statements.

Accordingly, the purchasing staff should be recording all of its purchase orders in the corporate computer system, while all receipts against those purchase orders should be logged into the system by the receiving staff. By netting out the receipts against the purchase orders, one can easily determine the total amount of long-term purchasing commitments. This report should be printed and stored at the fiscal year-end.

The one problem with this recordkeeping approach is when long-term commitments are contained within legal agreements only and they have not yet been converted into purchase orders. Though some companies have stored this information in separate computer databases, many more keep legal agreements only in paper format, which makes them much more difficult to summarize (or even locate). If this is the case, the accounting staff should either maintain the master file of legal contracts or at least be given access to it, and schedule regular reviews of new or modified contracts in order to determine the amount of purchase commitments. Notes from these reviews should be stored as supporting documentation for the footnote disclosure.