How do I run a physical inventory count, what do I keep as proof of the count, and what do I do with the difference?

Should you run one full count or rolling cycle counts?

A full count covers every item on one date. AccountingTools' inventory count procedure says a business without accurate inventory records needs "to periodically conduct a complete count of the inventory". Cycle counting, in AccountingTools' definition of it, means "counting a small amount of inventory in the warehouse each day, with the intent of counting the entire inventory over a period of time".

If your books keep a running inventory account under a sound accounting system, charged with the actual cost of goods bought or made and credited, at actual cost, with goods used, transferred or sold, Treasury regulation §1.471-2 says those balances "should be verified by physical inventories at reasonable intervals and adjusted to conform therewith". The two approaches differ like this:

AccountingTools' cycle-counting definition says errors found in these counts "should result in an adjustment to the inventory accounting records" and that "an investigation into the reasons for each error found should be conducted". It adds that cycle counting "may lead to the elimination of physical inventory counts" once records are accurate enough. It also says to enter all pending transactions before a cycle count, and warns that one entered on top of a counter's adjustment can leave the record "more inaccurate" than before, so look for paperwork not yet entered before posting a difference. Keep each dated count sheet with the adjustment it produced; under cycle counts, use the separate account described below so the year's total builds up in one place.

How do you plan and run the count so the quantities hold up?

Three controls carry the count, alongside the freeze in the checklist below:

• Timing. AccountingTools' definition of taking inventory says the count is "commonly conducted after hours or on a weekend". AccountingTools' count procedure says a full count is usually done at the end of a month, quarter or year, "to coincide with the end of a reporting period".
• Separation. AccountingTools' count procedure says counters are typically "not directly responsible for maintaining inventory records", which "helps ensure objectivity". If a record keeper must be on a team, they only write the tags; the person who does not keep the records does the counting. The same procedure notes that third-party observers may verify a count; in a one-person business, have one, such as your accountant, recount a sample of tags against the shelves.
• Recounts. AccountingTools' guide to reconciling inventory starts with a recount: "have a different person count it again".

This checklist follows the order of AccountingTools' count procedure, with cut-off and evidence steps added:

1. Prepare. A few days ahead, fix missing part numbers, and pre-count and seal anything boxable, marking the quantity on the seal. On count day, check every seal, and recount the contents of any container whose seal is broken.
2. Control the tags. Order sequentially numbered two-part tags and log which numbered block each team takes; each team returns its whole block, used or not.
3. Notify outside holders. Ask each outside warehouse, fulfillment operator or consignee to count your goods as of the count date and send the result.
4. Post everything pending. Enter all receipts, shipments, returns and transfers first, and note the last receiving and shipping document numbers.
5. Freeze. Stop deliveries and "segregate all newly-received goods where they will not be counted", since otherwise "the inventory records will be in a state of flux during the inventory count".
6. Count in pairs. One person counts while the other writes the location, description, part number, quantity, unit of measure and condition (damaged, shop-worn, obsolete) on the tag; the original stays on the goods and the team keeps the copy.
7. Test and recount. A supervisor test-counts a sample of tags, and a different person recounts anything that disagrees, with both figures kept.
8. Close each area. Check that the area's tag block came back complete, unused and voided tags included, and mark the area on a floor map.
9. Enter and review. Enter the tags, list them by tag number, investigate any gap in the numbering, and look for unusual quantities.
10. File the evidence. Before anything is adjusted, file the tag copies returned to the clerk, the cut-off note and outside holders' statements; once the count is accepted, collect the originals from the goods and file them too.

Which goods belong in the count, and how do you control cut-off?

Count what you own on the count date, not what is on the shelf. IRS Publication 538 lists what an inventory includes and excludes, and those lists settle most cut-off cases. AccountingTools' list of inventory error types shows how cut-off fails: inventory may "arrive at the receiving dock during a physical count" before its supplier invoice reaches the accounts, and customers' goods at your site get counted "as though it is your own inventory".

Whether a small business taxpayer can stop keeping an inventory for tax, and how to change an inventory method (Publication 538 says that takes Form 3115), belong to the related question on inventory costing methods. Who owns goods under a consignment arrangement is a separate question; the table says only which side counts them.

How do you evidence goods held at another site or by someone else?

AccountingTools' count procedure asks outside storage locations to count your goods "as of the official count date" and forward the result. AS 2510, the Public Company Accounting Oversight Board's inventory auditing standard, says that when inventories are "in the hands of public warehouses or other outside custodians", an auditor "ordinarily would obtain direct confirmation in writing from the custodian". Get a written statement of quantities by item as of the count date from each holder, record each holder's quantities on its own count sheet, and file the statements with the tags. If those goods are "a significant proportion of current or total assets", the standard adds procedures such as to "Observe physical counts of the goods, if practicable and reasonable"; then arrange with the holder in advance for you or your auditor to test-count there, and file those counts with the statement. Count any second site you run yourself on the same date, under the same freeze.

What must the count record contain, and who signs it?

Treasury regulation §1.471-2 says inventories "should be recorded in a legible manner, properly computed and summarized, and should be preserved as a part of the accounting records of the taxpayer", and that inventories are subject to investigation, with the taxpayer required to "satisfy the district director of the correctness of the prices adopted". Keep these together:

• Both parts of every tag, or the count sheets, and for scanner counts the device's own export file, not only an edited spreadsheet
• The tag log of blocks issued and returned, the floor map and the list of who counted each area
• Test-count and recount sheets showing both figures
• The cut-off note and the outside holders' written statements
• Evidence of the condition of goods flagged as damaged, shop-worn or obsolete
• The priced summary, showing the unit cost used for each line
• The bridge from the count as first priced to the final counted value, showing each correction as in the worked example, and the corrected priced summary
• The investigation notes, the adjusting entry and its written approval

AccountingTools' count procedure lists "signed count sheets or tags" and "adjustment approvals" among the records to retain: have each team sign its tags, and approve the adjustment in writing before posting it. Keep the tags and sheets after the adjustment is posted: without them the entry is a journal line nobody can check.

How long must you keep the count record, and why?

The retention serves federal income tax recordkeeping. Treasury regulation §1.6001-1 says required records "shall be kept at all times available for inspection by authorized internal revenue officers or employees" and "shall be retained so long as the contents thereof may become material in the administration of any internal revenue law", so keep the count record where you can produce it on request, including files held by a scanner vendor or an outside holder. The IRS page "How long should I keep records?" says that, generally, you must keep records that support an item of income, deduction or credit shown on your tax return until the period of limitations for that return runs out: the period in which "you can amend your tax return to claim a credit or refund, or the IRS can assess additional tax". For income tax returns it lists:

Unless the page says otherwise, the years run from the date the return was filed, and a return filed before its due date is treated as filed on the due date. Publication 538 says you "must value your inventory at the beginning and end of each tax year", so a year-end count supports two returns; keep it until the later of the two periods runs out. If you have chosen, as a small business taxpayer, not to keep an inventory for tax, settle with your tax adviser how these periods apply to your count records.

How do counted quantities become a value?

Price each counted line at the unit cost your existing costing method gives that item, the same cost your records carry; choosing or changing the method is a separate question. Treasury regulation §1.471-2 sets a different value for goods unsalable at normal prices because of damage, imperfections, shop wear, changes of style or similar causes; flag them on the tag and value them under the separate question on damaged or unsaleable inventory. Treasury regulation §1.471-2 says a taxpayer's inventory practice "should be consistent from year to year". AccountingTools' definition of shrinkage measures the difference the same way: count the inventory, "calculate its cost, and then subtract this cost from the cost listed in the accounting records".

A value difference comes from quantity, price or both, and each needs a different fix. AccountingTools' list of inventory error types separates an incorrect unit count, "resulting in an excessively high or low inventory quantity", from costing errors, such as a standard cost left unadjusted so that "the inventory will be valued at a cost that does not match actual costs". Split any large line before investigating it. Suppose the records hold 1,200 units of item B at 12.50 (15,000.00), the count finds 1,160, and the count sheet prices them at 12.00 (13,920.00). The 1,080.00 gap is two problems:

• The quantity difference is 40 units at the records' 12.50, or 500.00, and the investigation must explain it.
• The price difference is 0.50 on the 1,160 units counted, or 580.00; it says nothing about missing goods, and if the records' cost is the wrong one, fixing it is a costing correction, not a count adjustment.

How do you find the cause of a difference before posting it?

Adjusting the records to the count without a cause writes off the same recording fault at every count, and because the books balance afterwards, nothing flags it. After splitting quantity from price, work through the checks in AccountingTools' guide to reconciling inventory and its list of inventory error types:

• Have a different person recount the item.
• If the count is well below the records, look for the item in a second location.
• Confirm that the count and the records use the same unit of measure.
• Confirm that the goods were counted under the right part number.
• Look for a receipt, shipment, return or transfer that happened but was never logged.
• Look for scrap that was never recorded, a likely cause when the records always run slightly above the count.
• Check whether counted goods are on consignment from a supplier or belong to a customer.

Only when every check fails does the reconciling guide accept the count: "If all forms of investigation fail, then you really have no choice but to alter the inventory record to match the physical count".

The causes fall into counting errors, recording errors, cut-off and ownership errors, costing errors, and physical loss; AccountingTools' definition of shrinkage names "inventory theft, damage, miscounting, incorrect units of measure, evaporation" among them. Correct a recording or cut-off error by fixing the transaction itself, not through the adjustment account. Damaged, spoiled or stolen goods found this way, and software balances that are negative or plainly wrong, are separate questions.

Which accounts and which period does the adjustment go to?

After the investigation, adjust the inventory account to the counted value.

Date the entry on the count date: AccountingTools' definition of a physical count says updating the records "will change the recorded inventory valuation as of the physical count date". Post it before you close that period. If the count is not on the period end, or that period has closed, settle with your accountant which period the difference belongs to before posting it. Under cycle counting, each count's difference posts once that count's check for unentered transactions is done.

You choose where the debit for a shortfall lands:

• Absorbed. AccountingTools' definition of shrinkage says that when the recorded asset total on the balance sheet is reduced, "the amount of the reduction is charged to expense through the firm’s income statement", and its cycle-counting definition says the adjustments made after a cycle count "ensure that cost of goods sold, gross profit, and ending inventory are accurately stated". Leaving that charge in cost of goods sold is simplest, but the loss disappears into margin and no trend shows.
• Separate account. Debit an expense account of its own instead, such as Inventory shrinkage, reported with cost of goods sold. The named account and where it is reported are a suggestion, not a rule. Gross margin is unchanged, but the amount shows each period, and cycle-count differences accumulate there through the year.

Which to use is a judgment; a sensible test is to use the separate account when differences recur, when they are large enough to move your margin, or when an owner or lender reviews margin.

In this worked example the books keep a running inventory account, and recorded inventory on the count date is 48,200.00:

The remaining 500.00 is item B's 40 missing units at 12.50. With no cause found, it is posted, dated the count date:

Inventory then stands at 47,700.00, the counted value. The 580.00 and 750.00 corrected the count, not the books, so neither is posted. Books with no running inventory balance have no recorded value to adjust; the related question on recording inventory purchases covers how inventory reaches cost of goods sold there.

What changes if a lender or an auditor will observe the count?

Agree the date and your count instructions with the observer in advance, and keep a copy of their test counts with your record. AS 2510, the Public Company Accounting Oversight Board's inventory auditing standard, says that when quantities are determined solely by a physical count, with all counts made as of the balance-sheet date or a single date within a reasonable time before or after it, "it is ordinarily necessary for the independent auditor to be present at the time of count". When well-kept perpetual records are checked "periodically by comparisons with physical counts", the standard says the observation "usually can be performed either during or after the end of the period under audit". Ask your auditor whether this standard governs their audit and what they need from the count. A lender's own examiner may ask for something different, so get their requirements in writing before the count.