Lesson 70 - Beginner accounting course

70. Inventory Shrinkage and Losses: How to Account for Them

Inventory shrinkage refers to the loss of inventory that is not due to sales. It can result from theft, damage, miscounts, supplier fraud, or administrative errors. Shrinkage affects a company’s financial statements, reducing both assets and net income.

1. Causes of Inventory Shrinkage 

2. How to Detect Inventory Shrinkage

Businesses identify shrinkage through physical inventory counts compared to recorded inventory levels in accounting software.

Example:

• Accounting records show $50,000 in inventory.

• Physical count reveals only $48,000 available.

• Shrinkage = $50,000 - $48,000 = $2,000 loss.

The shrinkage percentage can be calculated as:

Using the example above:
($2,000 ÷ $50,000) × 100 = 4% shrinkage

A high shrinkage rate may indicate security or process issues.

3. Accounting for Inventory Shrinkage

Shrinkage is recorded as an expense on the income statement, reducing net profit. The journal entry depends on the inventory system used.

a) Perpetual Inventory System

In a perpetual system, inventory updates automatically. When shrinkage occurs, the loss is recorded with this journal entry:

This reduces inventory on the balance sheet and increases expenses on the income statement.

b) Periodic Inventory System

In a periodic system, inventory adjustments occur at the end of an accounting period. Shrinkage is accounted for when calculating Cost of Goods Sold (COGS):

If shrinkage is detected, the ending inventory is lower, increasing COGS, which reduces net income.

4. Preventing Inventory Shrinkage

To minimize inventory losses, businesses implement strong internal controls and security measures:

5. Financial Impact of Shrinkage

Shrinkage affects a company's profitability, cash flow, and tax reporting:

Companies must track shrinkage carefully to avoid overstating assets and misreporting financials. 

6. Key Takeaways

• Inventory shrinkage is the loss of stock due to theft, damage, errors, or fraud.

• It is detected through physical inventory counts compared to accounting records.

• Shrinkage is recorded as an expense, reducing net income.

• Businesses can minimize shrinkage through security, audits, and better inventory controls.

• High shrinkage rates can signal operational inefficiencies or fraud risk.

Proper shrinkage management ensures accurate financial reporting and helps maintain business profitability.