If you are like most family business owners, you don’t question your computer-generated financial statements. If the profit and loss statement says you made money at the bottom line, you believe it.
How would you feel, however, if that bottom-line profit was incorrect? Would you want to pay income taxes on money you didn’t really earn? Unfortunately, inaccurate profit statements are unknowingly happening to business owners nationwide. In fact, in some instances, computer-generated statements are showing less profit than a company has actually earned.
Are you asking yourself how this can happen? Good! That’s the right question! The answer is inventory valuation problems in almost all general ledger systems.
To determine if you may have a problem with the accuracy of your bottom-line profit, check your financial statements to see if they contain any unexplained inventory adjustments. Specifically, review the details of your cost of goods sold and operating expenses. Look for accounts that may be titled Adjustments, Over/Short, Miscellaneous or any other title you can not easily identify.
Most business owners are unaware that general ledger systems contain a way to automatically adjust costs of goods sold for inventory valuation changes, which in turn, affects bottom-line profit. It is far too easy to miss these adjustments when reviewing your financial statements. Therefore, pay careful attention, to any account that could be an inventory adjustment.
Here are the root causes of and solutions for common inventory adjustments:
Repackaging – When you buy in bulk, then repackage, the original bulk product cost should be the basis for the repackaged cost. In some instances, small businesses attempt to mark-up the product cost with repackaging labor and materials. This can be an accounting nightmare and absolutely ruin the cost basis in your inventory.
Check your physical inventory (an actual count) against your general ledger inventory. The number of units should be the same. Then, check with your software vendor to see how your computer system is handling costs.
Some accounting systems (particularly off-the-shelf systems) apply a package cost to repackaged product. The result is understated profit. Solution – make sure your accounting system is accurately handling all repackaging, keeping original bulk product costs intact.
Bookkeeping Timing – Particularly in systems where transactions are entered in modules separate from the wholesale business and then merged into the main general ledger at month-end, timing of store sales and costs entries into the computer can cause inventory valuation problems. Solution – check with your software vendor for the correct month-end closing sequences and follow the procedures rigorously. If you are always “over” or always “short”, the problem is likely your month-end closing procedure.
Human Error – If your physical inventory count is off from your general ledger count, the most common cause is inaccurate counting. Physical count problems often show up in see-saw inventory adjustments — a negative adjustment one month followed by a positive offsetting adjustment the next month. Solution – stress with staff that when the physical inventory count deviates from the general ledger, recount. If still off, have a different person conduct the count.
Other human error problems include sales entered incorrectly (wrong product codes) or costs entered incorrectly. Intercompany product transfers between branches can also cause inventory variations if not recorded accurately and immediately.
System Inventory Value Methods – Sometimes the entire inventory problem lies in how your computer system values your inventory. Does your system use an average cost method or specific cost method? Solution – accounting systems that use specific cost are less susceptible to error than systems using average cost .
It’s vitally important to be able to rely on your accounting system to provide accurate profit information. Any unexplained inventory adjustments should be researched until the root cause is identified and corrected.
