How to Prepare for Year-End Physical Inventory Counts

As year-end approaches, it’s time for calendar-year entities to perform physical inventory counts. This activity is more than a compliance chore. Proactive companies see it as an opportunity to improve operational efficiency.

Under U.S. Generally Accepted Accounting Principles (GAAP), inventory is recorded at the lower of cost or market value. There are three types of inventory:

Estimating the value of inventory may involve subjective judgment calls, especially if your company converts raw materials into finished goods available for sale. The value of work-in-progress inventory can be especially hard to assess, because it includes overhead allocations and, in some cases, may require percentage-of-completion assessments.

A physical inventory count gives a snapshot of how much inventory your company has on hand at year-end. For example, a manufacturing plant might need to count what’s on its warehouse shelves, on the shop floor and shipping dock, on consignment, at the repair shop, at remote or public warehouses, and in transit from suppliers and between company locations.

Before counting starts, you should consider:

It’s essential that business operations “freeze” while the count takes place. Usually, inventory is counted during off-hours to minimize the disruption to business operations.

Though physical counts may be considered time-consuming and disruptive, a well-executed count of what’s on hand can provide valuable insight into operational efficiency. Here are five tips on preparing for your count to maximize the benefits and minimize the hassle.

Most companies use two-part tags to count inventory. One tag stays with the item on the shelf; the other is returned to the manager at the end of the count. Tags are numbered sequentially to ensure the manager can account for every tag issued. Using a tagging system prevents items from being counted twice or omitted.

Each tag should identify the part number, location, quantity, and person who performed the count. To avoid scrambling around last minute, assign someone in your accounting department to complete this task at least a month before your count is scheduled to start.

Most companies do a dry run a few days before the count to identify potential roadblocks and determine how many workers to schedule. This makes the count more efficient and gives warehouse personnel the opportunity to correct any foreseeable problems, such as missing part numbers, unbagged supplies, and an insufficient amount of inventory tags.

Assemble two-person teams to prevent fraudulent counts. Assign each team a specific area of the warehouse to count. (A map often helps workers identify count zones.) Never give employees inventory listings to reference during the count — otherwise, they may be tempted to duplicate the amount from the listing, rather than bring attention to a possible discrepancy.

All defective or obsolete items should be discarded or recycled before the inventory count begins. There’s no sense in counting items that will be written off.

To make the physical count faster, some items that aren’t expected to be used before year-end can be counted a few days in advance. Pre-counted items should be tagged and placed in sealed containers. If a broken seal is noticed on the day of the actual physical count, the items in the container should be recounted.

If your company issues audited financial statements, one or more members of your external audit team will be present during your physical inventory count. They aren’t there to help you count inventory. Instead, they’ll observe the procedures, review written inventory processes, evaluate internal controls over inventory, and perform independent counts to compare to your inventory listing and counts made by your employees.

Be ready to provide auditors with invoices and shipping/receiving reports. They review these documents to evaluate cutoff procedures for year-end deliveries and confirm the values reported on your inventory listing.

Regarding physical inventory counts, our auditors have seen the best (and worst) practices over the years. For more information on how to perform an effective inventory count, contact us before year-end.

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