Physical inventory count in business activity

16. December 2020
  • Kateřina Vavrečková
  • Karolina Vernerová

The topic of this article is the physical inventory count in business activity. Inventory count is a current topic in this period, because for most companies the balance sheet date, that is the last date of the accounting period, is approaching. First we need to say, what inventory count means. The Accounting Act (act no. 563/1991 Coll., article 29 and further) tells us inventory count is used to identify the actual condition of all assets and liabilities and to verify, if the identified condition corresponds to the condition of assets and liabilities stated in the accounting. Identification of the actual condition takes place in two ways, by means of physical inventory count or book inventory. In this article we will only focus on physical inventory count.

In this context, assets are understood to mean noncurrent tangible assets, stock, cash count and liquid valuables. These are assets, the existence and amount of which can be physically determined.

The process of physical inventory count                 

Physical inventory count is performed as of balance sheet date, as of which the company compiles a regular or extraordinary/interim financial statement. Most companies have an accounting period identical with the calendar year and perform inventory count as of the last day of the year, i.e. 31 December. Companies can choose a different accounting period than a calendar year, however, and their accounting period may end as of 31 March, for example. Here we speak about an accounting period in the form of fiscal year. The rules of inventory count as well as the total inventory apply the same for any accounting period, though.

The Accounting Act enables starting asset inventory (the count itself, measuring etc.) in the period of four months before balance sheet date at the earliest and ending two months after that date, at the latest. It is necessary to realise, however, that all changes in the amount of assets, which took place in the period between the performed physical inventory count and balance sheet date, need to be substantiated and maintained within the financial statement. If the company owns multiple branches or warehouses or has assets located at its suppliers/ customers and the company cannot possibly arrange for inventory count to take place on one day, it is possible to perform inventory count in stages, but all statutory deadlines need to be observed.

The chief aim of physical inventory count is to identify the actual condition and compare it with the condition recorded in the accounting. Compare the condition does not include only identification of the number of pieces (kg, meters etc.), though, but also identification of the current condition of a given asset (if it is obsolete, damaged, unneeded).

The company should also have internal guidelines containing the necessary information and inventory procedures, so the procedure would be unified in all accounting periods. Important information means: who gives the instruction that inventory be performed, who sets the date for performing physical inventory count, how are inventory committees formed (who can be their member, how many members does an inventory committee need to have), which assets physical inventory count relates to, how physical inventory count will be performed (the way of identifying assets), recording of detected condition, evaluation of inventory results (identification of inventory differences, substitutions and shortfalls to standard) and their subsequent entering into the accounting for the period, for which inventory count is performed.

The inventory committee should not include only persons responsible for the given area, but also persons from other departments of the company, in order to ensure the inventory committee is objective. If the inventory committee only consists of persons concerned, or on the contrary only persons not familiar with the given area that is subject to inventory count, physical inventory count may be performed incorrectly in both cases (identification for the way of counting assets may be incorrect).

Evaluation of the inventory count

An essential part of a performed inventory count should be the inventory list, stating the individual items of information required by the law, i.e. the following:

  • balance sheet date
  • time of beginning and ending inventory count
  • identified assets subject to inventory count
  • how was the inventory performed (physical or book inventory)
  • the way of identifying the actual condition
  • signature of the person responsible for the identified amount (condition) and persons responsible for performing the inventory count (count sheets).

The accounting balance of the given assets before and after inventory count, identified inventory differences and their subsequent evaluation (for example the performance/non-performance of prescription of the detected shortfall to the responsible person, division of the value of the total detected shortfall into expected shortfall and beyond etc.) should also be available, and the company should further also be able to substantiate the entering of inventory differences in the ledgers. 

All companies are obliged to perform inventory count and companies are also obliged to substantiate that inventory was performed for a period of 5 years after it has been performed.

We will now focus on three fundamental areas, in which physical inventory count is performed, stating the basic information and recommendations.

Physical inventory count of cash and liquid valuables

Physical inventory count of cash (in the individual currencies) and liquid valuables (i.e. luncheon vouchers, stamps) is the most frequent of all types of inventory count, and should therefore be performed by all companies, which have  cash count or liquid valuables in their accounting, even if the cash count balance or their balance of liquid valuables is zero. The result of physical inventory count of cash is an inventory protocol stating the results of the findings, with a signature of the person identifying the physical amount and the person in charge of physical inventory count.

Physical inventory count of stock

Physical inventory count of stock is frequent among production and trade companies, which register materials, semi-finished products / unfinished production, own products or goods in stock. During the inventory count (in the given units), the actual balance of the individual types of stock is identified, as well as their condition (if they are damaged, obsolete etc.).

Prior to beginning physical inventory count, all tax documents, which have an impact on the balance of stock in the accounting, should be entered in the books and all stock in the stock details should be received in storage or removed from storage, in order for the stock evidence to be complete. While performing physical inventory count, all movement of stock (reception in storage, removal from storage, transfer between branches and other movement) needs to be interrupted, in order to prevent omission of stock in the inventory count or repeated inclusion of stock already included in the inventory count. In case transfer of stock is necessary for operational reasons, it is necessary to give good instructions to the members of the inventory committee and to specify the warehouse, in which stock will be counted / recorded. Another non-standard situation is the placement of stock of others in the warehouse. These may include stock of other entities that enter the production process and their economic possession is resolved subsequently after their use (invoicing of the quantity of used stock), or this may be stock already removed from storage and sold to a buyer, who has not collected it yet. In both cases, the stock needs to be marked visibly and the inventory committee needs to be instructed about this fact. In some case, it may also happen that inventory itself is performed in the course of production, i.e. that the production process cannot stop completely and can only be reduced. In this context, it is necessary to have adequate support arranged for all segments of production, meaning that during the identification of the balance of stock itself, it should be clear what is being counted, and in case some of the counted stock has already been used prior to the count, it is necessary to duly substantiate this fact as well.

The inventory count of stock may be performed in different ways – it is possible to use barcode readers or blind sheets printed on paper, in which the identified amount is entered. To ensure maximum objectivity of the identified balance of stock, it is recommended to use sheets that do not contain the amount of stock, so-called blind sheets. The actual balance of stock may also be identified in various ways – counting, measurement, or weighing. 

Physical inventory count of noncurrent tangible assets

Physical inventory count of noncurrent tangible assets is performed in the same way as physical inventory count of stock. It is a physical count of noncurrent tangible assets according to blind sheets and identification of their amount, and it is again necessary to perform preparation for the inventory count itself in the sense of identifying assets of others in the premises of the company and prevention of relocation of assets in these premises. Assets of others are usually rented assets (cars, technical office equipment, machines in production etc.). We can tell from our experience that while physical inventory count of stock is usually carefully documented, inventory count of noncurrent assets usually is not. The reason why these inventory counts may often be underestimated, may be the fact that the company does not perceive these entries as risky, i.e. that these assets may get lost (because these are mostly larger asset items – car, building, machines), or the movement of these assets in the course of the period is so scant or none at all that the company automatically expect no difference between the physical amount and the accounting amount. Here it is necessary to realise, however, that the Accounting Act lays down the obligation of performing this inventory count, and further that the inventory count serves not only to compare the amount, but also to identify the current condition of assets. It is therefore necessary to assess if a building, car, machines or other equipment are not losing their value more quickly than expected when the assets were put into use. Or a situation may occur, when an asset is damaged and can no longer be used, but this fact is not reflected in the accounting records.

Inventory count of noncurrent assets has one major specific feature compared to the inventory count of stocks, in that every item is unique. Every car has its license plate, every machine has a production number, every plot has a number in the land register and every building has its land registry number.

Above, we have described the information and the individual procedures, which companies ought to reflect when performing asset inventory count itself, of any type. In the final part of our article, we will also state a view of the issue from the perspective of an auditor.

Physical inventory count and the view of the auditor?

For an auditor, physical inventory count is a valuable source of information and audited companies should therefore expect that the auditor or his representative will wish to attend the inventory count. The task of the auditor during an inventory count consists in identifying, how inventory count takes place at the company, if the assets are correctly captured in the accounting according to the result of the inventory count. He will determine, for example, who participates in the inventory count, how the count itself takes place (or the measuring, weighing) and how the inventory count is subsequently evaluated. During the inventory count, the auditor only performs supervision or recounts already counted stock for his own verification, but he never participates in the company’s inventory count itself (for example by counting or by scanning barcodes of the stock).

In addition to the count itself, the auditor will also be interested in all processes relating to the assets that are subject to inventory count. That is the security of assets (who has access to assets), if material responsibility for entrusted assets has been negotiated, how the entering of stock into storage and their removal from storage work, or purchases of new noncurrent tangible assets and other relevant facts. All of this information will help the auditor understand the activities of the company.

Based on auditing practice, it can be said that the most frequent mistakes made by companies relating to physical inventory count of assets, are:

  • performing physical inventory count on incomplete assets (missing entering of stock into storage and their removal from storage, non-inclusion of assets into or non-elimination from use)
  • incorrect marking of assets of others in the warehouse or noncurrent tangible assets of others in the premises of the company
  • incorrectly identified measurement units, in which stock is recorded (pieces, kg, packaging, set, m, m2 and so on) – i.e. stock recorded in m2, but the amount is subject to inventory count in pieces
  • unsystematic performing of stock count resulting in duplicate counting or omission of inventory counting of some asset items
  • underestimation of the writing of the recording obligation, which serves not only to substantiate physical inventory count, but also for identification of inventory differences

All above-mentioned misconduct influences the accounting and its conclusiveness. With regard to the fact that the above-mentioned assets usually represent a significant part of the assets of a company, the influence on accounting may be significant, not to mention the possibility of penalties being imposed by state authorities due to failure to comply with the specified obligations. This fact may also have an impact on the overall view of the auditor regarding the accuracy of compilation of the financial statement and may subsequently be reflected in his opinion stated in the audit of the financial statement of the company.

What to say to conclude……

Physical inventory count may be viewed as a menace for the company mainly due to the great time demands and the demands on work, both during the actual identification and counting of assets and during the subsequent evaluation and entering of the results of inventory count into the books. If the company prepares well for physical inventory count, there is no reason for such fear. The foundation of each inventory count is to be well-prepared in terms of methods and, where in doubt, to consult the process of physical inventory count with an expert and thus to avoid potential mistakes during the performing of inventory count itself.

Author: Kateřina Vavrečková, Karolina Vernerová