Warning signs in inventory and cost of sales
The patterns in a client's figures that suggest inventory or cost of sales is misstated, and the questions to ask before the statements are finalised.
By Achekam · · 4 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
A draft set lands on a manager's desk. Revenue is roughly flat, gross margin has improved noticeably, and stock is up on last year. The client says it has had a good year. That may be true. It is also exactly the pattern an overstated closing inventory produces.
Inventory errors rarely announce themselves. They hide inside cost of sales, which is a calculated figure on most small clients' books, and they flatter profit in the year they happen. A preparer who knows what the patterns look like can catch most of them with a few comparisons and a handful of pointed questions, before the statements reach the partner.
How closing inventory drives the result
Investopedia gives the cost of goods sold formula as beginning inventory plus purchases during the period minus ending inventory. Because closing inventory is deducted, any overstatement of it reduces cost of sales by the same amount and increases profit by the same amount.
IAS 2 adds the rules on when stock must come out of the balance sheet. When inventories are sold, their carrying amount is recognised as an expense in the period the related revenue is recognised. Any write-down to net realisable value, and all losses of inventories, are recognised as an expense in the period the write-down or loss occurs. ACCA's year-end adjustments article puts it in practical terms: IAS 2 requires inventories at the lower of cost and net realisable value, so damaged or slow-moving items may need to be written down, which increases cost of sales and reduces inventory.
So there are two directions to look in: stock counted or valued too high, and losses or write-downs not recognised.
Ways cost of sales ends up too low
Investopedia's article on cost of goods sold lists ways it can be manipulated: over-allocating manufacturing overhead to inventory, overstating discounts or supplier returns, altering or overvaluing closing inventory, and failing to write off obsolete inventory. It notes that inflated inventory understates cost of goods sold and inflates profit.
Most misstatements a firm finds in small clients are not deliberate. The same mechanisms appear through error:
- a count sheet totalled twice, or a page counted by two teams;
- stock valued at selling price instead of cost;
- old stock valued at its original cost although it can only be sold at a discount;
- supplier credit notes for returns recorded, while the returned goods were also counted;
- goods received before year end counted, with the supplier's invoice left for next year;
- overhead added to manufactured stock without a sound basis.
Whether error or intent, the effect on the statements is the same, and so is the need to correct it.
Patterns to read from the draft
Before speaking to the client, compare the draft with last year and with what the business says about itself:
| Pattern | Why it matters |
|---|---|
| Inventory rising faster than revenue | Investopedia suggests this check: stock building up without matching sales can mean overvaluation or unsold, ageing goods |
| Inventory rising faster than total assets | Same signal, from the balance sheet side |
| Gross margin up with no change in prices or mix | Cost of sales may be understated |
| Days of stock on hand lengthening | Slow-moving or obsolete stock that may need writing down |
| No write-down at all in a year of product changes | Old lines may still be carried at cost |
| Large credit notes from suppliers near year end | Returns or discounts may be overstated |
None of these proves a misstatement. Each is a reason to ask.
Questions to put to the client
- How was the count done, who did it, and can we see the signed sheets?
- How was each item valued, and what cost basis was used?
- Which lines have not sold in recent months, and what can they be sold for now?
- Were any goods damaged, returned or set aside at year end?
- What overheads, if any, were added to manufactured stock, and on what basis?
- Were there any large supplier credits near year end, and were the goods physically returned?
- What explains the change in margin this year?
Keep the answers on the working paper. If an answer is vague, that is evidence in itself.
Prompts from Achekam, and corrections that leave a trail
Achekam lets staff run an automated review of a draft that lists findings for a person to accept, resolve or dismiss. It is advice only and does not block signing. Separately, the Validation & Math Engine runs fixed, non-AI checks such as double entry and note ties. Treat findings from both as prompts to look at the figures again; the judgement about whether inventory is right stays with the team.
Where the review leads to a correction, such as a write-down of obsolete stock or a cut-off adjustment, staff can post a year-end adjusting entry in the Studio. If the adjustment later proves wrong, it is reversed with a record of who did it and why, never deleted. A reviewer can then see the original figure, the correction and the reasoning in one place.
Before sign-off
- Inventory and margin movements compared with last year and explained.
- Valuation basis confirmed, and a sample of items traced to purchase cost.
- Slow-moving and damaged stock considered for write-down.
- Cut-off checked against the first purchases and sales of the new year.
- Any correction posted, with its reason on file.
Reviewing the statement of financial position sets these checks in the wider analytical review, and net realisable value for inventory covers the write-down test in depth. On the next file with a margin that improved without a clear reason, start with the stock.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
