During a physical inventory count, a company’s assets are determined as of a specific date; this provides concrete evidence of assets and liabilities. Such an inventory count is a prerequisite for proper bookkeeping and financial reporting.
Inventory is a key foundation for a company’s annual financial statements; therefore, it is typically conducted at the end of a fiscal year. The German Commercial Code also requires an inventory at the start or end of a business activity or in the event of a change of company name.
Important: For an intralogistics inventory, the warehouse management system or the integrated inventory management integrated into it; the monetary valuation of the inventory determined based on the physical inventory is usually performed in the ERP system.
The physical inventory serves as a means of internal control for the company and provides a certain degree of protection for creditors; furthermore, it acts as a check on the accounting system, since inventory levels are recorded independently of it. For this reason, a proper physical inventory is also subject to certain principles, which include, in particular, the following:
- truthfulness of the balance sheet (complete inventory count)
- accuracy (correct inventory count)
- consistency (regular counts)
- clarity of the balance sheet (verifiability of the inventory count)
- item-by-item recording during the inventory count
If these principles are not adhered to, then the accounting records are not maintained properly, and the financial statements based on them are void.
Inventory Items
Tangible assets are counted, measured, or weighed during the inventory count. Intangible assets, on the other hand, are documented through a book inventory (balance sheets). Business buildings or, for example, seasonal goods are subject to depreciation; for such assets, depreciation is recorded during the inventory count. During this inventory count, the assets are reconciled with the accumulated accounting entries. If there is a discrepancy (inventory variance) between the theoretical and actual inventory, the actual inventory is considered correct. The aforementioned inventory variances must therefore be corrected retrospectively in the accounting records. The differences thus affect the operating result via the income statement.
Inventory in intralogistics
To conduct a proper inventory in accordance with the principles, internal organizational guidelines must be established that cover process, space, schedule, and personnel planning, as well as documentation. In intralogistics, the most common types of inventory include the periodic inventory, the continuous inventory, and the deferred inventory.
Periodic Inventory
In a point-in-time inventory, inventory levels are recorded by quantity on a specified date at the end of the fiscal year, as required by the German Commercial Code. This inventory should be conducted close to the balance sheet date. The count may be conducted within a ten-day window before or after this date. Any changes in inventory levels within this period must then be adjusted forward or backward to the balance sheet date.
Advantage: The determined inventory levels and values can be assigned to a balance sheet date or a specific period close to the balance sheet date.
Disadvantage: On the balance sheet date, operations must be suspended to conduct the inventory count. Additionally, a significant number of staff members are required.
Continuous Inventory
With perpetual inventory, stock levels and all receipts and issues are continuously recorded and documented throughout the fiscal year. The quantities and transaction data are maintained in a stock ledger (today often in the form of a merchandise management system). While older warehouses required a complete count of all inventory items once a year for the economic valuation of stock (see periodic inventory), continuous inventory is the norm in modern warehouses. Every count that takes place as part of normal operations is treated as an inventory count. In this process, counts need to be initiated only for those pallets whose last count was more than one year prior to the inventory cutoff date—provided that the warehouse management system in use supports this feature. As a rule, such a count is handled through the warehouse’s inventory management system.
Advantage: There is no need for a backlog of work or operational downtime to conduct the inventory. Worth noting: Continuous inventory is less time-consuming because inventory-related checks are handled, for example, as part of the picking process (see also Picking)—electronic reconciliation with inventory management.
Disadvantage: To ensure continuous inventory, proper warehouse accounting is required.
Deferred Inventory
With deferred inventory (postponed inventory), the timing of the inventory count can be shifted up to three months before or two months after the balance sheet date. However, this type of inventory is rarely used in practice.
Advantage: The operator of a distribution center, for example, has complete freedom in choosing the timing of the inventory. Consequently, they can plan it in detail and schedule counts outside of peak warehouse activity periods. Another point concerns inventory discrepancies; they can generally be identified, analyzed, and, if necessary, resolved without haste.
Disadvantage: With a recording period of up to three months, this process involves additional effort and represents a potential source of error. Furthermore, this type of inventory is not permitted for valuable items. It also cannot be used for perishable goods or products subject to shrinkage.
Inventory by Sampling
Another common type of inventory count is the sample inventory; conducting a sample inventory has been legally permitted since 1977. Accordingly, pursuant to Section 241 of the German Commercial Code (HGB), it is permitted to determine the inventory of assets through sampling, subject to the following conditions:
- Recognized mathematical and statistical methods must be used.
- The principles of proper accounting must be observed.
- The sample inventory must be as reliable as, for example, conventional inventory methods (counting, measuring, weighing).
The principles listed above are expanded upon or specified in more detail as follows for inventory by sampling:
- For a physical inventory, it is recommended that three to five percent of the most valuable inventory items be counted in order to capture 45–50 percent of the total value.
Special Case: The Sequential Test in Automated Warehouses
If an inventory count is scheduled within an automated warehouse—that is, where a high level of inventory accuracy can be assumed—a so-called sequential test is appropriate. This test does not determine the total value of the warehouse in question; rather, it verifies whether the error rate is acceptable. Either quantitative (heterograde) or qualitative (homograde) characteristics can be used for this purpose. A homograde sequential test differs from a heterograde sequential test in that, in the homograde test, only the quantity is relevant; in the heterograde test, the difference value is taken into account in addition to the quantity*. However, the latter is irrelevant in warehouse management, since only stock levels are managed there, not individual values.
For sampling, the prerequisite is that individual units, such as products, are selected at random from elements, such as inventory items. However, the individual inventory items must be clearly distinguishable from one another within a population. A distinction is made between an unrestricted random sample and a simple random sample.
- In an unrestricted random sample, each inventory item has the same probability of being included in the sample. Items are drawn without replacement.
- In a simple random sample, each inventory item also has an equal probability of being included in the sample—an independent draw from the population. This means that the items are drawn and then returned to the population.
Important: First, in a sequential test, general inventory accounting must be aligned with this inventory procedure; second, the procedure requires official approval from the relevant tax office or the responsible auditor.
Mathematical Foundations of Sampling Inventory
Two approaches are possible for using recognized mathematical-statistical methods:
- the free mean methods—these are methods that employ various approaches to business valuation. The income approach and the net asset value are determined using these various methods. The income approach generally represents the actual value of the business; however, due to its sometimes uncertain factors, it is not 100% suitable for a correct valuation. Therefore, the net asset value—that is, the tangible assets of the business—is also factored into the valuation. The result is a key figure that varies depending on the industry, company size, and duration of operation. Possible approaches/methods include the Berlin Method, the Swiss Method, and the Stuttgart Method.
- The constrained methods—these types of methods aim to produce business valuations that are subject to specified criteria. Such a method seeks to provide an extrapolation or an estimated mean value; the deviations between the sample results and the inventory book values are determined through a comparison (averaging/comparison) using the following estimates: difference estimates, ratio estimates, and regression estimates. Ultimately, the key figure yields what is known as the total deviation. Difference estimates are the simplest methods to perform, in which differences between actual and target inventory levels are determined.
In both procedures, the null hypothesis (also referred to as H0) is tested against the alternative hypothesis (also referred to as H1), which serves as the contrast, using a random sample.
Example:
- Initial hypothesis = “Inventory records are reliable”
- Alternative hypothesis = “Inventory records are not reliable”
Inventory reliability is too low if the actual values deviate too significantly from the book values. In this case, the inventory must be completely rejected, even if the total value is within acceptable limits. As a rule, however, this depends on the auditor and the value of the missing items. Example: If a counting error is discovered during an inventory audit involving copy paper, this error carries a different weight than if the error were found in high-priced products. In any case, during an audit, the inventory quantity is reconciled using a zero-tolerance threshold.
Summary of Inventory
Under commercial law, inventory is a physical count used to record the type and quantity of assets and liabilities as of a specific cutoff date. This is typically done through a cutoff-date inventory, a continuous or periodic inventory, or a sample inventory. Certain principles must be followed to ensure that financial reporting and accounting are conducted properly.
*Source: Vahlens großes Auditing-Lexikon, page 638, “Homogeneous Sample.”
You can also find more information on the topic of inventory under inventory holding costs and under inventory costs.
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