Physical Inventory Counts: Turn Differences Into Documented Adjustments

Your inventory report says 120 units, but the shelf holds 113. Posting a seven-unit reduction may make the report match the shelf, but it does not explain whether the cause was a receiving error, an unrecorded sale, damage, a unit-of-measure problem or an earlier count mistake.

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Define the count before it starts

Choose the locations, items and cutoff time. Decide whether inventory movement will pause or whether receipts, transfers and shipments during the count will be logged separately. Give each counter clear units: one case of 12 is not the same as one individual unit.

Use a count record that identifies the item, location, quantity, counter and time. When practical, keep the expected system quantity out of the initial count so the counter records what is physically present rather than trying to reach a familiar number.

Separate the physical count from the reconciliation

The University of Arizona's physical-inventory process separates preparation, the count, issue reporting with backup documentation, certification and a later review-and-reconciliation period. Its process governs university property, not every small business. Still, the sequence supports a useful control principle: complete and document the observation before resolving differences in the records.

After the count, compare physical quantities with the inventory subledger as of the same cutoff. Recount material differences. Check open receiving, shipments, transfers, returns, assemblies, damaged goods and unit conversions. Keep the original count and the investigation notes instead of overwriting the first result.

Use a difference log

A short log can include item, location, book quantity, counted quantity, difference, unit cost used, dollar effect, likely cause, supporting document, reviewer and adjustment reference. “Shrinkage” should not become a catch-all when a specific transaction error can be corrected.

For example, the system shows 120 units and the count finds 113. A recount confirms 113. Two units were shipped before cutoff but not relieved from inventory, three damaged units were set aside without a write-off, and two units remain unexplained. The business may need separate entries or corrections for those causes rather than one unsupported seven-unit plug.

Post only what the evidence supports

Confirm the quantity and cost basis before recording an adjustment. A quantity difference multiplied by the latest purchase price is not automatically the correct accounting amount. Costing methods, freight, production costs and prior layers can change the value. Escalate material or unusual differences for review before posting.

Record the adjustment date, accounts, amount, explanation and approver. If the cause is timing, correct the underlying receipt, sale or transfer when appropriate instead of creating a second transaction that duplicates the activity.

Turn recurring differences into process changes

Group differences by cause and location. Repeated receiving gaps may point to a cutoff or training issue; repeated unit-conversion errors may point to item setup; repeated unexplained losses may require tighter access and review. The useful outcome is not merely a clean total—it is a process that produces fewer unexplained differences next time.

Counting frequency should fit the business. High-value, fast-moving or error-prone items may justify more frequent counts, while a low-volume operation may use a different schedule. This guide does not prescribe a universal frequency or replace advice about the accounting framework, taxes or assurance requirements that apply to a particular business.

Sources and factual boundaries

University of Arizona, Finance & Budget, “Physical Inventory” supports the staged process of preparation, counting, issue reporting with backup documentation, certification and subsequent reconciliation. The university page concerns its own property process; Summer Peaks does not present it as a rule for small-business merchandise inventory. Source reviewed October 9, 2026. The example and workflow above are original Summer Peaks guidance, not a client result.