Physical inventory taking

As the end of the fiscal year approaches, the physical taking of inventories is one of the most critical procedures for the integrity of the financial information and full fiscal compliance. This process should not be seen as a mere operational formality; it is a fundamental pillar that validates the existence, condition and valuation of one of the most sensitive items in the statement of financial position. Its correct execution has a direct impact on the determination of the cost of sales, the profit for the year and, consequently, the taxable income tax base.

What assets should be considered in this procedure?

Inventories comprise items acquired, tangible or intangible, and held for sale including, for example, merchandise acquired by a retailer, land and other property, software or video games developed for sale. Inventories also include items produced or being manufactured by the entity, whether tangible or intangible, as well as raw materials and other materials awaiting use in the manufacturing process. (NIF C-4, Inventories, paragraph 30.2).

Inventory types

Raw materials and materials: Raw materials and materials are items that are transformed to produce consumer goods or other items that will become finished products or components of products of a manufacturing entity.

Production in process: Due to the continuous nature of the manufacturing process and the need to prepare information at certain dates. For accounting purposes, a cut-off of operations must be made and, therefore, the items that are not yet finished constitute the production in process inventory and must be valued in proportion to the different degrees of progress made in each of the elements that make up its cost.

Finished goods: Includes those items intended for sale in the normal course of the entity's operations and the amount recognized should be the production cost in the case of industries and the purchase cost in the case of businesses. (NIF C-4, Inventories, paragraph 44.7).

Physical inventory is the primary control for:

• Detect and deter theft.
• Identify operational inefficiencies (e.g. poor storage that damages the product).
• Correct errors in the warehouse input/output record

‍

Why does taking physical inventory help my company?

Companies in Mexico must plan and execute a physical inventory taking at the end of the fiscal year to comply with the tax obligation to take inventory, maintain perpetual control and determine the cost of goods sold under absorbed costing, in addition to documenting everything in the accounting required by the Federal Tax Code (CFF).

In order to properly structure your procedure, it is essential to consider the following legal bases:

Income Tax Law: Article 76 of the Income Tax Law establishes the formal obligation for taxpayers to prepare an inventory of inventories at the end of the fiscal year.

Income Tax Law Regulation: Introduces a relevant flexibility for its operation, allowing two modalities:

‍

• Anticipation of the count: The practice of the inventory may be anticipated until the last day of the previous month (i.e., November 30).
• Partial counting: This can be done by partial physical counts during the exercise, eliminating the need for simultaneous counting at all locations.

Audit firms support by observing and testing the physical intake in accordance with ISA 501 "Audit Evidence-Specific Considerations for Certain Areas" to generate sufficient evidence of existence and condition.

There is a common confusion among people not involved with management who contract audit services, and that is that the physical inventory taking is the responsibility of the auditors. The auditors do not perform the physical inventory, the responsibility for planning and executing the count is 100% the company's responsibility.

What impact can it have on the fiscal aspects?

Undoubtedly, the monetary impact can be significant; what is an "expense" for accounting purposes may be "non-deductible" for tax purposes.

Shrinkage vs. theft

The physical count will reveal differences and the shortage has two treatments:

‍

• Shrinkage: Losses inherent to the production process or to the material (e.g. evaporation of a liquid, drying of a solid). These losses are deductible provided they are normal for the industry and are properly documented.
• Shortages due to theft or loss: If the shortage is due to theft (internal or external) or a force majeure event (flood, fire), it is NOT automatically deductible.
  
  • In order to deduct this loss, the company must file a timely report with the Public Ministry (a criminal complaint). Without this report, the SAT will reject the deduction, assuming that the missing product was sold without an invoice (omitted sale), and will demand the payment of the corresponding ISR and VAT.

Technical recommendations for physical inventory taking

Poor execution, lack of adequate controls or inadequate planning can result in material misstatements in the financial statements, generating tax contingencies, penalties and an erosion of stakeholder confidence (shareholders, board of directors and authorities). To transform this obligation into a robust control exercise and ensure the accuracy of its records, it is imperative to adopt a technical and methodological approach.

Recommended best practices are described below:

1. Preliminary Stage - Inventory Planning and Coordination

‍

• Define specific dates and times for physical examinations.
• Schedule counting in advance, preferably during periods of low operation.
• Define the order of the areas/sections/locations to be counted.
• Designate a general coordinator and counting teams, ensuring segregation of duties.
• Train personnel on procedures, tools (bar code scanners) and incident management.

2. Warehouse organization

• Maintain the warehouse orderly and identified.
• Classify and label merchandise uniformly.
• Prepare a map of the warehouse to guide the teams and avoid omissions or duplications.
• Clearly separate damaged, obsolete or slow-moving items.
• Suspend merchandise movements during counting.

3. Documentation and systems control

• Update the inventory system days in advance and freeze movements during the count.
• Use pre-numbered lists for control and auditing.
• Confirm stocks held by third parties or in transit by means of written evidence.

4. Activities during the physical examination - rigorous counting

• Allow access only to authorized personnel.
• Involve the warehouse and accounting areas.
• Record all relevant details (series, lot, condition, location).
• Perform counts in pairs and apply a double blind count to validate accuracy.
• Resolve differences on the spot by a third count, if necessary.

5. Supervision and control of movements

• Prevent inventory movements during counting, except in urgent cases under strict control.
• Actively supervise the process with internal or external auditors, performing selective test counts.

6. Subsequent actions - Reconciliation and accounting records

• Deliver count results to accounting for review and valuation.
• Compare with accounting records and systems.
• Document the causes of differences and make the necessary adjustments.
• Formalize disposal due to obsolescence or damage by means of destruction certificates in accordance with fiscal requirements.

7. Evaluation and continuous improvement

• Analyze discrepancies to identify internal control failures.
• Implement corrective action plans.
• Retain all supporting documentation:
  
  • Planning memos or mailings.
  • Attendance lists.
  • Survey reports and differences.
  • Signed minutes of adjustment.
  • Photographic evidence.
  • Mailings with information and follow-up.

If inventory is a material (important) item in the financial statements, the auditor is required to witness the physical count.

This is where the audit firm helps the company:

1. Process Evaluation (Before the Count):

The auditing firm requests and reviews the company's "Instructions for Physical Inventory Taking".

Evaluate the adequacy of the plan: Are the warehouse areas well delimited? Are the personnel involved adequate? Will labels (tags) be used with sequential control, or by means of an electronic system? Will production and warehouse movement be stopped?

How this helps: Identifies weaknesses in planning before they occur, avoiding a chaotic or unreliable count.

2. Observation and selective testing (during counting):

• On the day of the count, the audit team attends the warehouse and observes the company's equipment.
• They verify that the instructions are followed.
• They perform "test counts". This involves the auditor taking a sample of items and counting them himself, then comparing his count with that of the company's team. They test in two directions:
  
  • From Floor to Listing: They select a physical item on the shelf and verify that it is in the count records.
    
  • From List to Floor: They select an item from the register and ask to be taken to their physical location for validation.

Additionally, with the rigor of the audit standard, audit teams may make particular selections based on risk (high value, high volume, easy subtraction, etc.), as well as a combination of both (Floor to Listing and Listing to Floor).

3. Verification of the condition and cut:

Condition: The auditor doesn't just count. He actively looks for signs of obsolescence (dusty boxes, broken packaging, expired expiration dates) and questions management as to why these items have not been written off or provisioned.

Operations Cutting: This is one of the most technical aids. The auditor ensures that the company has strict control over the last in (receiving from supplier) and last out (shipping to customer) before starting the count. This prevents goods from being double counted or skipped.

4. Letter of recommendations (after the count):

At the end of the audit, the firm provides a "Letter of Observations and Recommendations on the Company's Internal Control" (or letter to management) detailing all internal control weaknesses observed during the audit.

How this helps: It is a professional roadmap for the company to improve its process for the next year.

If the auditor is unable to witness the count (and the inventory is material), it is considered a scope limitation and the auditor may be forced to issue a qualified opinion or even a disclaimer of opinion on the financial statements, which is very serious.

More than a simple accompaniment, at PGA we implement proactive solutions. Our specialized professionals are ready to shield your fiscal closing on December 31, 2025. We lead the process of observing the physical inventory taking and provide practical solutions that ensure your full fiscal and accounting compliance in the face of the risks of the 2025 closing. Our purpose is clear: to relieve your management of this technical burden so that you can focus entirely on maximizing operating results.

Don't wait until the end of the fiscal year. Contact our team for an evaluation and let us support you in the successful completion of this activity.

‍

Written by Juan Carlos Arroyo Guevara.

‍