Your accounting software says you have:

$185,000 of inventory

Your warehouse count says:

$143,000

That is a difference of:

$42,000

Where did it go?

Was inventory sold but never removed from the system?

Were purchases entered twice?

Did products get damaged, stolen or written off?

Are supplier costs wrong?

Did someone receive inventory into the wrong SKU?

Or has nobody completed a proper physical inventory count for months?

This is not just a warehouse problem.

When your inventory records are wrong, your Cost of Goods Sold, gross profit, net income, taxes, margins and financial reports can also be wrong.

CRA requires businesses that hold goods for sale to determine inventory and use opening inventory, closing inventory and purchasing information when calculating cost of goods sold. Manufacturers may also need to account for raw materials, work in progress, finished goods and relevant production costs.

That means inventory errors can move directly into your income statement.

A business can appear more profitable than it really is.

Or less profitable than it really is.

It can also make owners believe certain products have strong margins when those margins are based on incorrect costs.

This guide explains why inventory records stop matching physical stock, how those differences affect COGS, and how Canadian businesses can build a better inventory reconciliation process.

Important: This article provides general bookkeeping, accounting and tax information. Inventory treatment depends on your business model, accounting framework, valuation method and tax circumstances. Material year-end adjustments should be reviewed with a qualified accountant.

Why Inventory and COGS Are Connected

For a simple product-resale business, the basic relationship can be illustrated as:

Opening Inventory + Purchases – Closing Inventory = Cost of Goods Sold

For manufacturing businesses, the calculation can become more detailed because direct labour, subcontracting and other production costs may also need to be considered.

CRA’s business-income guidance specifically requires businesses that buy or make goods for sale to calculate cost of goods sold using inventory and purchasing information.

This means the closing inventory number matters enormously.

Example

Suppose your records show:

Opening inventory: $100,000

Purchases: $400,000

Closing inventory: $150,000

Simplified COGS:

$100,000 + $400,000 – $150,000 = $350,000

Now imagine the real closing inventory was only:

$110,000

Corrected COGS becomes:

$100,000 + $400,000 – $110,000 = $390,000

That is a:

$40,000 difference in COGS.

If everything else stays the same, gross profit was previously overstated by $40,000.

One inventory error changed your reported profitability without changing a single customer sale.

What Happens When Closing Inventory Is Too High?

If your books say you have more inventory than you actually have, closing inventory can be overstated.

Since closing inventory reduces COGS in the formula, overstated inventory can produce:

Lower COGS

and therefore:

Higher gross profit

and potentially:

Higher net income

Your business may look healthier than it actually is.

That can affect decisions involving:

• Bonuses
• Dividends
• Hiring
• Pricing
• Financing
• Purchasing
• Tax planning

What Happens When Closing Inventory Is Too Low?

The opposite can happen.

If inventory is understated:

COGS may become too high.

Gross profit may become too low.

Management may believe products are less profitable than they actually are.

That could lead to:

• Incorrect price increases
• Product discontinuation
• Cost-cutting decisions
• Reduced bonuses
• Incorrect forecasts

This is why inventory reconciliation is not just an accounting exercise.

It is a management tool.

Problem 1: Purchases Were Recorded but Inventory Was Never Properly Received

Suppose your business purchases:

100 units at $200 each

Total:

$20,000

The supplier invoice is entered.

But nobody updates the inventory system.

Now your accounting system may recognize the purchase while your inventory quantities remain unchanged.

The opposite can also happen.

Warehouse staff may receive the stock into the inventory system, while accounting also imports the purchase incorrectly and duplicates part of the cost.

The Fix

Create a three-way process between:

1. Purchase order
2. Goods received
3. Supplier invoice

Before a large inventory bill is finalized, confirm:

What did we order?

What actually arrived?

What did the supplier charge?

These three records should agree or differences should be investigated.

Problem 2: Products Were Sold but Never Removed From Inventory

This is common when the sales system and inventory system are not properly connected.

Suppose your ecommerce store sells:

50 units

Revenue is recorded.

Payment reaches the bank.

But the inventory quantities never decrease.

Your accounting records may now show:

• Correct revenue
• Incorrect inventory
• Incorrect COGS

The business appears to own products that have already left the building.

Example

Book inventory:

500 units

Physical inventory:

430 units

Difference:

70 units

At $100 per unit, inventory could be overstated by:

$7,000

If this happens every month, the year-end difference can become significant.

The Fix

Test the entire transaction flow:

Customer order → Sale → Shipment → Inventory reduction → COGS entry

Do not assume that because Shopify, QuickBooks or another system is connected, every transaction is flowing correctly.

Test several real transactions manually.

Problem 3: Duplicate SKUs Are Splitting the Same Product Into Two Inventory Records

A very common inventory problem starts with something small.

One employee creates:

CHAIR-BLK

Another employee later creates:

BLACK-CHAIR

Both refer to the same product.

Now the physical warehouse contains one product, but the accounting system treats it as two.

Other examples include:

• Different spelling
• Different capitalization
• Old SKU vs new SKU
• Supplier code vs internal code
• Product variants entered incorrectly

The Result

One SKU might show:

Negative 12 units

while another shows:

40 units available

The total inventory reports become unreliable.

The Fix

Create a controlled product master list.

Every item should have:

• One SKU
• One description
• One unit of measure
• One standard category
• One active cost method

Do not allow every user to create new SKUs without review.

Problem 4: Damaged, Expired or Obsolete Inventory Is Still Recorded at Full Value

This is a major issue for:

• Food businesses
• Fashion retailers
• Electronics companies
• Auto parts businesses
• Seasonal retailers
• Manufacturers
• Ecommerce businesses

Your system may show inventory worth:

$100,000

But part of that stock may include:

• Expired products
• Broken products
• Outdated models
• Unsellable returns
• Discontinued items
• Slow-moving products

That inventory may not be worth what your records say.

CRA states that inventory valuation affects business income and allows certain acceptable valuation methods. Generally, businesses may value the entire inventory at fair market value, or value individual items or classes at cost or fair market value, whichever is lower, subject to applicable rules. Once a valuation method is chosen, it generally needs to be applied consistently in later years.

The Fix

Create an inventory-aging report.

Separate stock into categories such as:

0 to 90 days

91 to 180 days

181 to 365 days

Over one year

Then ask:

Can we still sell this product normally?

Does it need a discount?

Is it damaged?

Is it obsolete?

Does its current value support the amount shown in the books?

Do not leave dead inventory at its original value simply because nobody reviewed it.

Problem 5: Theft, Shrinkage and Unrecorded Losses Are Building Up

Sometimes inventory disappears for reasons unrelated to normal sales.

Examples include:

• Theft
• Employee theft
• Shoplifting
• Shipping damage
• Warehouse damage
• Counting errors
• Supplier shortages
• Products used internally
• Free samples
• Promotional giveaways

If those movements are not recorded, your system continues to show inventory that physically does not exist.

Example

Books show:

10,000 units

Physical count:

9,650 units

Difference:

350 units

If the average cost is:

$40 per unit

the inventory difference is:

$14,000

That should not be dismissed as:

“Probably just inventory adjustment.”

Management should understand why $14,000 of stock disappeared.

The Fix

Track inventory adjustments by reason.

For example:

• Damage
• Theft
• Samples
• Expiry
• Count correction
• Supplier shortage
• Customer return

If the same reason keeps appearing, you may have an operational problem rather than an accounting problem.

Problem 6: Customer Returns Were Recorded Incorrectly

Returns can cause major inventory confusion.

A customer returns a product.

Accounting issues the refund.

But what happens to the item?

Was it:

• Returned to sellable stock?
• Damaged?
• Sent back to the supplier?
• Scrapped?
• Refurbished?
• Never physically received?

If the financial refund and physical inventory movement are not connected, your quantities and costs can drift apart.

The Fix

Use a clear return process.

Every return should have a status:

Sellable

Damaged

Supplier return

Scrap

Pending inspection

Do not automatically place every customer return back into normal inventory.

Problem 7: Inventory Costs Are Wrong

Quantity is only half the problem.

You may physically have the correct number of units but still have the wrong inventory value.

Suppose your accounting system shows:

100 units × $50 = $5,000

But your actual landed cost is:

100 units × $62 = $6,200

Difference:

$1,200

Why?

Maybe the system ignored:

• Freight
• Customs
• Duties
• Supplier price increases
• Currency changes
• Other costs required to bring inventory to its location and condition

CRA states that inventory cost generally includes the price incurred for the item plus expenses required to bring it to the business location and put it in a condition of use for the business.

The Fix

Review your inventory costing method.

Ask:

1. What cost does the system use?
2. When is that cost updated?
3. Are freight and duties treated correctly?
4. Are supplier discounts included?
5. Are foreign exchange effects handled appropriately?
6. Are manufacturing costs allocated correctly?

A perfect physical count with incorrect unit costs still produces incorrect financial statements.

Problem 8: You Have Negative Inventory

Your inventory software says:

-17 units available

But physically you have products on the shelf.

This usually means transactions happened in the wrong sequence.

Possible causes include:

• Sale entered before purchase receipt
• Incorrect transaction dates
• Duplicate sales
• Missing purchase receipt
• Wrong SKU
• System integration failure

Negative inventory can also distort COGS because the system may calculate product costs before it knows what the actual purchase cost was.

The Fix

Do not simply change:

-17

to:

0

Investigate the transactions that created the negative quantity.

Find the first date where the balance became negative.

Then trace:

• Purchases
• Sales
• Transfers
• Returns
• Adjustments

from that date forward.

Fix the cause, not only the final number.

Problem 9: Inventory Transfers Between Locations Are Missing

Multi-location businesses face another problem.

Warehouse A sends:

$25,000 of inventory

to Store B.

Warehouse A removes it.

Store B forgets to receive it.

Now the company appears to have lost $25,000 of stock.

Or both locations record the inventory.

Now inventory is overstated by $25,000.

The Fix

Every transfer should have:

1. Transfer-out record
2. In-transit status
3. Transfer-in confirmation

Large transfers should be reconciled regularly.

One location should never simply write inventory off while another manually adds it.

Physical Counts Are Still Important

CRA states that businesses need to perform an annual inventory, generally listing goods held for sale. For manufacturers, this can include raw materials, packaging and supplies, work in progress and finished goods.

Historical CRA inventory guidance also notes that physical stocktaking is normally expected unless a reliable perpetual inventory system is maintained and periodically verified against actual quantities.

Even if you use advanced inventory software, physical verification still matters.

Software knows what people entered.

It does not know what is actually sitting on the shelf.

Annual Counts May Not Be Enough

If you carry:

$2 million of inventory

waiting until year-end to discover a:

$150,000 discrepancy

is too late.

Higher-risk businesses should consider cycle counting.

Instead of counting everything once per year, count selected inventory throughout the year.

Example

A items

High-value or high-volume stock

Count monthly.

B items

Medium-value products

Count quarterly.

C items

Low-value and slow-moving items

Count once or twice per year.

This helps detect errors while they are still small enough to investigate.

The Inventory Reconciliation Process

A good inventory reconciliation compares:

Book quantity

with:

Physical quantity

Then compares:

Book value

with:

Correct accounting value

Use a schedule like this:

SKU	Book Qty	Physical Qty	Difference	Unit Cost	Value Difference
Product A	500	485	-15	$40	-$600
Product B	120	126	+6	$90	+$540
Product C	80	65	-15	$150	-$2,250

Do not stop at the final adjustment.

Add another column:

Reason

Examples:

• Receiving error
• Damage
• Duplicate SKU
• Theft
• Return error
• Counting mistake
• Unknown

The goal is to reduce the number of unknown adjustments over time.

How Inventory Errors Change Gross Margin

Suppose your business reports:

Sales:

$1,000,000

COGS:

$600,000

Gross profit:

$400,000

Gross margin:

40%

Now a physical inventory count reveals that ending inventory was overstated by:

$50,000

Correct COGS becomes:

$650,000

Correct gross profit:

$350,000

Correct gross margin:

35%

That five-percentage-point change could completely alter management’s view of the business.

You might discover:

• Prices are too low
• Supplier costs increased
• Inventory losses are significant
• Product margins were overstated
• A location is performing poorly

This is why inventory accuracy is essential for decision-making.

Inventory Errors Can Also Distort Taxable Income

Because inventory affects COGS and business income, an incorrect year-end inventory value can affect taxable income.

CRA’s audit guidance specifically considers inventory valuation and inventory turnover when reviewing whether reported cost of goods sold may contain material errors. In one CRA example, inventory-turnover analysis is used to identify a potential COGS overstatement of hundreds of thousands of dollars.

That means inventory should not be treated as a year-end number created only to make the financial statements work.

It should be supported by:

• Physical counts
• Purchase records
• Cost calculations
• Inventory reports
• Adjustment records

Use the Same Inventory Valuation Method Consistently

CRA currently recognizes two common inventory valuation approaches for many businesses:

1. Fair market value of the entire inventory
2. Individual items or classes valued at cost or fair market value, whichever is lower

CRA also states that after choosing an inventory valuation method, businesses generally need to continue using that method in later years.

Do not change valuation methods every year simply to produce a better tax result.

If a method needs to change because it better reflects the business, discuss the accounting and tax consequences with your accountant.

Your Opening Inventory Should Connect to Last Year’s Closing Inventory

Another common bookkeeping mistake occurs on January 1.

Last year’s closing inventory:

$300,000

This year’s opening inventory:

$275,000

Why?

If nobody can explain the $25,000 difference, there is a problem.

CRA states that the value of inventory at the beginning of a fiscal period should be the same as the value at the end of the previous fiscal period.

Always reconcile the opening balance before analysing current-year activity.

Otherwise, you may spend hours searching for a difference that originated in the previous year.

Too Much Inventory Can Create a Cash Flow Problem Even When the Books Are Correct

Sometimes inventory matches perfectly and the company still has a problem.

It simply owns too much stock.

You may have:

Inventory:

$800,000

Bank balance:

$40,000

Accounts payable:

$250,000

The business may appear asset-rich while struggling to pay suppliers and payroll.

Aterna’s How Poor Cash Flow Management Kills Growing Businesses specifically identifies excess inventory as a source of cash-flow pressure because money tied up on shelves cannot be used to pay immediate operating obligations.

This is also why inventory purchasing should be included in a rolling forecast. Aterna’s How to Build a 13-Week Cash Flow Forecast for Your Canadian Business explains how inventory purchases can create large short-term cash requirements even when the business remains profitable on paper.

Inventory Problems Can Be a Sign Your Business Has Outgrown Basic Bookkeeping

Aterna’s Signs Your Business Has Outgrown Basic Bookkeeping specifically identifies increasing inventory, locations and transaction volumes as factors that make financial management more complex.

A spreadsheet may work when you sell:

20 products

It becomes much harder when you have:

• 2,000 SKUs
• Three warehouses
• Ecommerce orders
• Retail locations
• Supplier returns
• Bundles
• Manufacturing
• Multiple currencies

At that stage, the solution is not to hire someone to “fix inventory at year-end.”

The business needs better systems.

How to Fix an Inventory Difference Step by Step

Step 1: Freeze Inventory Movements During the Count

If products continue moving while counting takes place, quantities become difficult to verify.

Where practical, pause movements or establish a clear cut-off time.

Step 2: Perform a Physical Count

Count what actually exists.

Do not start by changing the physical count to match the software.

Step 3: Compare Physical and Book Quantities

Create an exception report showing only differences.

Prioritize:

• High-dollar discrepancies
• High-volume products
• Negative quantities
• Unusual adjustments

Step 4: Investigate Each Material Difference

Review:

• Purchase orders
• Receiving records
• Sales
• Transfers
• Returns
• Damage reports
• Supplier credits

Step 5: Review Unit Costs

Even when quantities match, confirm that valuation is correct.

Step 6: Identify Obsolete or Damaged Stock

Separate usable inventory from stock that may require valuation adjustments.

Step 7: Approve Adjustments

Large inventory adjustments should require management approval.

Do not give every warehouse or bookkeeping employee unrestricted authority to write inventory up or down.

Step 8: Post the Accounting Adjustment

Once differences are understood, update the inventory records and related accounting accounts appropriately.

Step 9: Recalculate COGS and Gross Margin

Ask:

How did the adjustment change:

• COGS?
• Gross margin?
• Net profit?
• Taxes?

Step 10: Fix the Process That Created the Difference

If you only fix the number, the problem will return.

A Monthly Inventory Control Checklist

At month-end, review:

1. Negative inventory
2. High-value adjustments
3. Inventory in transit
4. Old purchase orders
5. Unreceived purchases
6. Customer returns
7. Supplier returns
8. Damaged stock
9. Obsolete inventory
10. Gross margin by product
11. Inventory turnover
12. Unusual SKU balances

Also compare inventory movement to sales trends.

If sales dropped 20% but inventory purchases increased 40%, ask why.

When Should You Worry About Inventory Turnover?

Inventory turnover measures how quickly stock moves through the business.

A simplified formula is:

COGS ÷ Average Inventory

Suppose:

Annual COGS:

$1,200,000

Average inventory:

$300,000

Inventory turnover:

4 times per year

This means the business cycles through approximately four times its average inventory value annually.

A falling turnover rate may indicate:

• Overstocking
• Slower sales
• Obsolete stock
• Poor purchasing
• Incorrect inventory records

CRA audit guidance itself uses inventory turnover as one method for assessing whether inventory and COGS appear reasonable.

Do Not Use Inventory Adjustments as a Plug

This is one of the worst bookkeeping habits.

Books say:

$400,000

Count says:

$350,000

Someone posts:

Inventory adjustment: -$50,000

Done.

But nobody asks where the $50,000 went.

Large unexplained inventory adjustments can hide:

• Theft
• Purchasing errors
• Sales-entry failures
• Damaged stock
• Incorrect costing
• System integrations that are not working

The accounting adjustment corrects the number.

It does not fix the business.

Inventory Needs to Reconcile Like a Bank Account

Businesses understand that a bank account should be reconciled.

Inventory deserves similar discipline.

Aterna’s Why Your Bank Balance Does Not Match Your Bookkeeping explains why unexplained differences between external records and accounting records need to be investigated rather than forced to zero.

The same principle applies here.

Do not ask only:

“What adjustment makes inventory balance?”

Ask:

“Why does the difference exist?”

That second question improves the business.

Frequently Asked Questions

Why does my inventory report not match my physical inventory?

Common causes include:

• Missing purchases
• Unrecorded sales
• Returns
• Duplicate SKUs
• Damage
• Theft
• Transfer errors
• Incorrect transaction dates
• Counting mistakes

Start with a physical count and trace material differences back to source transactions.

How does inventory affect Cost of Goods Sold?

For a straightforward reseller, a simplified formula is:

Opening inventory + purchases – closing inventory = COGS

Therefore, an incorrect closing inventory balance can directly distort COGS and gross profit. CRA requires inventory information as part of calculating cost of goods sold for businesses selling goods.

Does CRA require a physical inventory count?

CRA says businesses need to conduct an annual inventory. Historical CRA inventory guidance also notes that physical stocktaking would normally be performed unless a reliable perpetual inventory system is used and periodically verified against actual quantities.

How should Canadian businesses value inventory for tax?

CRA currently identifies two common acceptable methods for many businesses:

• Fair market value of the entire inventory
• Individual items or classes at cost or fair market value, whichever is lower

Other rules can apply to specific businesses or property.

Can I write down obsolete inventory?

Potentially, depending on the facts and inventory valuation method.

CRA’s inventory rules recognize fair market value as part of the permitted valuation methods for many businesses. The adjustment should be supportable rather than based on an arbitrary percentage.

Why is my gross margin changing dramatically every month?

Possible causes include:

• Wrong inventory counts
• Incorrect product costs
• Purchase timing
• Missing COGS entries
• Returns
• Discounts
• Inventory adjustments

Review both inventory quantities and unit costs rather than focusing only on sales.

How often should inventory be reconciled?

At minimum, inventory should receive proper year-end attention, but businesses with high-value or high-volume stock should consider monthly reconciliations and periodic cycle counts.

Waiting until year-end makes old errors much harder to investigate.

Accurate Inventory Means More Than Knowing What Is on the Shelf

Inventory accuracy affects much more than warehouse operations.

It affects:

COGS

Gross profit

Taxable income

Cash flow

Product margins

Purchasing decisions

Financing

Financial reporting

A business can have excellent sales and still make poor decisions if management does not know what inventory it actually owns or what that inventory really costs.

The goal should not be:

“Make the inventory number match before year-end.”

The goal should be:

“Build a system where inventory quantities, costs and accounting records stay aligned throughout the year.”

Start with accurate purchasing.

Control SKU creation.

Record transfers and returns properly.

Count inventory regularly.

Investigate shrinkage.

Review obsolete stock.

Reconcile your inventory system to the general ledger.

Then examine what the results tell you about margins, purchasing and cash flow.

Aterna Advisors provides bookkeeping, accounting, financial reporting and advisory support for Canadian businesses. Companies with growing inventory, multiple locations or complex product flows should strengthen inventory controls before unexplained differences begin affecting taxes, financing and business decisions.

For related guidance, read Aterna’s Signs Your Business Has Outgrown Basic Bookkeeping, Why Your Bank Balance Does Not Match Your Bookkeeping, How Poor Cash Flow Management Kills Growing Businesses, and How to Build a 13-Week Cash Flow Forecast for Your Canadian Business.