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


Why bother performing a year-end physical inventory? Chances are, if you're a small business owner, you're busy. And finding time at the end of the year to count everything in your inventory can be difficult. However, there are several reasons why it's important to take a physical inventory including IRS requirements and the possibility of reducing your tax liability.

For example, according to the IRS, you are required to take a physical inventory and, as a result of that physical count, you must adjust the book value of your inventory to actual. This must be done at reasonable intervals.

What is a reasonable interval?

Since you file your income taxes on an annual basis, the most conservative approach is to perform a physical inventory every year on the last day of your fiscal year. Whether or not doing so less often would be considered reasonable by the IRS may depend on other factors such as the value of your total inventory, the accuracy of your perpetual inventory, or if you have a demonstrated cycle count program in place.

Physical inventory basics

There are essentially three factors involved in taking a physical inventory:

Specific Identification Method used when you can match the actual cost of each item individually. Typically works best for high dollar individual items such as automobiles, furniture, and equipment.

FIFO or LIFO Methods used when you cannot easily match the cost to each item or the same type of items are mixed throughout your inventory. The FIFO method, meaning first-in first out, assumes the first items you buy or produce are the first items you sell so that what's currently in inventory would be matched to the costs most recently paid. LIFO, meaning last-in, first-out, assumes the opposite.

  1. Count — first you count all of the items in your inventory
  2. Identification — next you choose a method of identification which basically means how you match the inventory items to the cost. There are certain identification methods allowed by the IRS.
  3. Valuation — finally you need to value the inventory and this is an area that can have the greatest impact on calculating your taxable income. The following methods are acceptable in putting a value on your inventory: 
  • Cost — the actual cost you paid for the items
  • Lower — of cost or market - the lower of the actual cost or the current market
  • Retail — the retail or selling price of your items

What should I include in inventory?

  • Raw materials
  • Work in process
  • Finished product
  • Supplies that will become a part of items for sale
  • Merchandise for resale including:
    • Items in transit if title has passed to you
    • Items under contract or out on consignment
    • Items held for sale even if on display or located away from your place of business
  • For C.O.D. sales items sold should remain in your inventory counts until payment is received.
  • Containers should be included in inventory if title of the contents has not passed to the buyer.

What not to include in inventory?

  • Items you have sold and title has passed to the buyer
  • Items you hold on consignment
  • Items you have ordered, but have not yet taken title to

How does the value of my inventory affect taxable income?

Cost of goods sold is a deduction from income and the higher the value on your cost of goods sold, the lower the taxable income. Cost of goods sold is a calculation that includes ending inventory as follows:





If your ending inventory is overstated, your cost of goods sold will be understated and you will pay more in income taxes. It can be more likely that you inventory will be overstated rather than understated due to things such as damaged goods, goods discarded due to obsolescence, or goods donated. Taking a physical inventory on a regular basis will keep you IRS compliant, but there is also a good chance it will work to your advantage when paying income taxes.

Things that can cause your inventory to be inaccurate:

  • Withdrawing inventory for personal use
  • Withdrawing inventory for donations
  • Sending the customer the wrong quantity
  • Discrepancies in quantity received and quantity ordered
  • Damaged or obsolete inventory discarded
  • Inventory used for demonstration purposes
  • Inventory issued as free samples
  • Erroneous adjustments based on inaccurate cycle counts
This website contains articles posted for informational and educational value. Paychex is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, Paychex. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant.
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