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Why It's Important to Perform a Year-End Physical Inventory

As we end one year and prepare for the next, it’s a good time to review your physical inventory and take appropriate action to position yourself for the coming year.
performing inventory audit

Inventory is the linchpin of any retail business. As we end one year and prepare to head into the next, it’s a good time to review your physical inventory and take appropriate action to position yourself for the coming year. Inventory accounting is also a necessary component for an accurate balance sheet, so sticking to the books can pay off.

What is inventory accounting? Let's take a look at the basics:

Taking physical inventory

Even if you use inventory management software or other systems to track inventory throughout the year, only an actual count can reveal what you have on hand and make sure it matches what's in your system. For example, it is important to detect "shrinkage," which is a reduction in the inventory due to items being damaged, miscounted, or stolen, so that you can address it.

Be prepared to do a physical inventory on a day you are ordinarily closed or close solely for this purpose. Educate your staff on their responsibilities so that every item gets counted.

If year-end is a slow time for your business, then as close to the end of the year as possible is a great time to conduct a business inventory. If the holiday season is a peak time, then perform an inventory estimate (factoring in shrinkage) and wait until after post-holiday sales have been completed to do an actual inventory.

Actions to improve inventory

The goal of any retail business is to have enough inventory on hand to meet customer needs but not too much so that items expire, lose popularity, become obsolete, or needlessly take up expensive warehouse space.

Classify your inventory

Use your ABCs to classify items:

  • A is for high-demand products you expect to move fast.
  • B is for items that are somewhat important in terms of price and frequency of orders.
  • C is for goods that are less important to you because they are low-profit items and have infrequency of orders.

Project inventory needs for next year 

After reviewing your current physical count and your ABCs, budget for your inventory needs for the coming year. Of course, your inventory budget may change with customer demand, the economy, the introduction of new items, and other factors, but this can help you get started.

Dispose of unwanted inventory

You don't want to tie up warehouse and shelf space for items that likely won't be profitable to you. Now is the time to hold sales and do mark-downs to move items off your shelves. Other ways to dispose of items you can't or don't expect to sell include:

  • Selling to a liquidator. While you'll likely realize a small sum, you'll open up your shelves as well as generating cash to help buy new inventory.
  • Donating items. You may gain a tax deduction.
  • Using items as promotions. If you can't sell items, consider using them to promote the sale of other items.

Tie your inventory to tax accounting

Reporting inventory on your tax return is essential to determine your income or loss for the year. More specifically, you need to figure your cost of goods sold (COGS). This is the cost of items or materials to make them (i.e., the cost of buying or manufacturing inventory). At tax time, COGS is determined annually by starting with your opening inventory and usually closing inventory for the previous year.

COGS is an important factor in inventory accounting. The simple formula for determining the value of your goods at hand at the end of an accounting period is as follows:

Infographic showing a Cost of Goods Solds equation

Ending inventory




Since costs associated with merchandise purchased for resale or materials purchased to create products do not become a part of COGS until the items are sold, valuing beginning and ending inventory accurately is very important. When there are errors in the inventory valuation, COGS will also be inaccurate.




Use an inventory identification method:




  • FIFO (first in, first out) assumes that the first items bouht or produced are the first items sold. The items in inventory at the end of the tax year are matched with the costs of similar items that you most recently purchased or produced.
  • LIFO (last in, first out) assumes the opposite; the last items bought or produced are the first items sold. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and from those acquired during the year. There's a simplified dollar-value LIFO method for small businesses.
  • Specific identification method uses the actual cost of each item sold. This generally is used for businesses that sell large or unique items (e.g., automobiles, antiques) where the item can be matched to actual cost.

Use a valuation method:




  • Cost (what was paid for the item, plus shipping fees). This method must be used if you've chosen LIFO.
  • Lower of cost or market method (lower of the actual cost or current retail value). This method must be used if you're using FIFO.
  • Retail. The total retail selling price of goods on hand at the end of the tax year in each department or of each class of goods is reduced to approximate cost by using an average markup expressed as a percentage of the total retail selling price.

Details of inventory identification and valuation methods can be found in IRS Publication 538.




Note: If your average annual gross receipts in the three prior years is not more than $25 million, you can opt to be exempt from inventory reporting for tax purposes. Instead of figuring COGS and valuing inventory, you treat items as non-incidental materials and supplies. This means keeping track of items and taking a physical inventory but deducting them when they are purchased or sold, whichever is later.




Inventory accounting doesn't have to be complicated. By tracking stock and managing materials you can gain insight into your business' purchase decisions. More importantly, it grants you to tools to help you succeed.




While attending to your inventory won’t guarantee success, it is certainly a key task for many businesses. You can also take advantage of other help available to help gain insights into your company’s financial health.




barbara weltman
Barbara Weltman is a tax and business attorney and the author of J.K. Lasser's Tax Deductions for Small Business as well as 25 other small business books.
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* This content is for educational purposes only, is not intended to provide specific legal advice, and should not be used as a substitute for the legal advice of a qualified attorney or other professional. The information may not reflect the most current legal developments, may be changed without notice and is not guaranteed to be complete, correct, or up-to-date.

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