Stock Count Came Up Short? How to Record Inventory Shrinkage (and Fix the Books)

The system says 300 inner tubes. The shelf holds 240. Sixty tubes didn't walk out on a receipt, and until you deal with them your accounts are describing a shop that doesn't exist. Learning how to record inventory shrinkage is the routine that reconciles the two, and every business that holds stock needs it at least once a year. Leave it undone and the balance sheet overstates what you own while the profit and loss flatters what you earned.

What follows is the whole process: where shrinkage comes from, how to put a cost on it, the entry itself, what an overage means, and how to handle stock that's still sitting there but has lost its value.

Where the Missing Stock Goes

Shrinkage is simply the gap between what your records say you hold and what a physical count finds. It starts life as a quantity and becomes money only once you value it. It tends to come from four places:

• Theft, whether from shoppers, employees or somewhere between the supplier and your door.
• Breakage and waste, meaning dropped, crushed, spoiled or expired goods that were binned without anyone recording it.
• Short deliveries, where the invoice said 100, the box held 94, and the receipt was entered as 100.
• Recording mistakes: the wrong product picked on a sale, a refund never booked, a delivery keyed in twice.

Owners tend to assume theft, but recording mistakes account for a surprising amount of it, and a recording mistake can be found and fixed. That's why the steps below put investigation before posting. As a benchmark, the National Retail Federation's annual security survey has placed average retail shrink at about 1.4% to 1.6% of sales in recent years. That sounds modest until you set it against a net margin of a few percent.

The Five-Step Routine to Record Inventory Shrinkage

1. Count it. Physically count every item, location by location. Pause deliveries and dispatches while you count, or record exactly where the cutoff falls.
2. Cost the count. Value it at what the goods cost you, using the same method as your books, never at shelf price.
3. Find the gap. Book value of inventory less counted value equals shrinkage.
4. Chase the big variances. Recount anything large and check recent deliveries, returns and sales for mis-keyed lines. Correct those at the source.
5. Post what's left as a single adjustment.

Take a bicycle shop whose records show $212,800 of inventory at cost. Its year-end count, costed the same way, totals $208,940. A recount and a review of the month's deliveries leave $3,860 unexplained. The inventory shrinkage journal entry:

The inventory line on your balance sheet now agrees with the stockroom, and the $3,860 is recognized as a cost of the period. It's one of the routine adjusting journal entries for any business that carries stock.

Which part of the profit and loss does shrinkage hit?

Everyday shrinkage goes in cost of goods sold. Losing some stock is part of what it costs to hold stock, so it should reduce gross margin. Keep it in its own sub-account under COGS so the number stays visible month after month. A one-time disaster, such as a flood, fire or burglary that takes out a large chunk of inventory, is better reported as a separate loss so one event doesn't make an ordinary month look broken. Insurance proceeds are recorded against that loss.

What does it mean when the count is higher than the records?

It almost always means a recording mistake. If the count shows $615 more than the books and you genuinely can't find out why, debit inventory and credit an adjustment account:

Before posting it, look for a delivery recorded twice, a return that never made it into the books, or a sale charged to the wrong item. One product over and a near-identical product under by the same quantity is a picking error, not two separate adjustments.

Putting the Right Cost on Missing Items

Counted item by item, each shortfall is valued at that product's cost under your inventory costing method. For those 60 inner tubes:

• Weighted average: at an average cost of $6.40, shrinkage is 60 × $6.40 = $384.00.
• FIFO: the oldest layers go first. With 45 tubes left from a batch at $6.10 and the rest from a batch at $6.90, it's (45 × $6.10) + (15 × $6.90) = $378.00.

What matters is that missing stock leaves your records at the same cost a sale of it would have. Otherwise the stock that remains is carried at a cost that doesn't match the batches really on the shelf, and your cost of goods sold slowly drifts away from reality.

When Stock Is There but Worth Less: Writing Inventory Down

Shrinkage deals with stock that's gone. Its close cousin deals with stock that's present but has lost value: last year's models, scuffed packaging, goods close to their use-by date. U.S. GAAP (ASC 330) requires inventory costed on FIFO or average cost to be carried at the lower of cost and net realizable value, meaning the price you can realistically get, less what it will cost to sell. Inventory on LIFO or the retail method still applies the older “lower of cost or market” rule.

Say you're holding 80 helmets from last season that cost $52 each. The best realistic price is $35, and it will cost about $5 a helmet to sell them. Net realizable value is $30, so each helmet is overstated by $22, or $1,760 in total:

$30 is now those helmets' cost for every future calculation. U.S. GAAP doesn't let you reverse the write-down if prices recover later, though IFRS does. Goods that are completely unsellable and thrown away are written off at full cost in the same way, with the quantity removed from stock.

Is an obsolescence reserve worth setting up?

For a business with plenty of slow sellers, yes. Rather than writing items down one at a time, estimate the expected obsolescence and post it ahead of time: debit COGS, credit an Inventory Reserve, a contra-asset shown just below inventory. When specific goods are eventually scrapped, the loss is taken against the reserve. The mechanics mirror the allowance method in our guide to writing off bad debt, and they keep inventory from being overstated between counts.

Why Some Businesses Never See Their Shrinkage

A periodic inventory system works out cost of goods sold once a period: opening stock, plus purchases, minus the closing count. Anything stolen or binned simply disappears into that result. There's never a separate shrinkage figure, so even a serious problem stays invisible.

A perpetual system relieves inventory at cost every time a sale is posted, so your records always carry an expected quantity for every product. The count then checks those records, and the difference is measured and visible. That visibility is the strongest argument for perpetual inventory: a loss you can't see is a loss you can't manage.

Practical Ways to Shrink the Shrinkage

• Count deliveries against the purchase order before you enter the receipt, not after.
• Run cycle counts. Count a rotating group of products every week or month, with expensive and easily pocketed items counted most often. Frequent small counts catch problems while there's still a trail.
• Split the jobs. Whoever receives stock shouldn't be the one who posts adjustments. Our piece on internal controls for a three-person business shows how to manage that with a small team.
• Require a reason on every adjustment (damaged, expired, count variance) and review the totals by reason and location as part of your monthly close.

How often should stock be counted?

A full count at least once a year, at year end, so your statements and tax return are built on real numbers. In between, cycle-count fast movers and high-value items monthly or quarterly. Businesses with tight controls and little shrinkage can count less; a business with a shrinkage problem should count more until it knows where the stock is going.

The Takeaway

Shrinkage is a short routine once you've done it once: count, cost the count, investigate, then book a single entry that debits shrinkage and credits inventory. Overages run the other way, and stock that's still there but worth less is written down to net realizable value. Keep at it and your balance sheet reflects what you actually hold, your gross margin reflects what selling it actually cost, and the loss becomes a figure you can work on instead of one buried in COGS.

Would you rather try the entries before they count? Our free interactive accounting course lets you post inventory and cost of goods sold entries in a hands-on sandbox.

Frequently Asked Questions

How do I book inventory shrinkage in my accounts?

Post one adjusting entry: debit a shrinkage expense account, normally held under cost of goods sold, and credit the inventory asset account. The amount is what your records say the stock is worth minus what the count says it is worth, with both figures at cost rather than selling price. When the count is the larger number, the entry runs the other way: debit inventory, credit an inventory adjustment account.

Does shrinkage belong in cost of goods sold?

Ordinary, ongoing shrinkage does. Losing some stock is part of the cost of holding it, so it belongs in gross margin, preferably in a dedicated sub-account where you can track it. A single large event, such as a fire, flood or break-in, is usually better shown as a separate loss so it does not make an ordinary month's margin look broken.

What is the formula for shrinkage rate?

The retail convention is shrinkage at cost divided by net sales for the period. A shop that loses $3,860 of stock on $386,000 of sales has a 1.0% shrink rate. An alternative is shrinkage divided by the inventory value on your books, which tells you what fraction of your stock disappeared. Either works, as long as you stick to the same one each period.

Is writing down obsolete stock the same as shrinkage?

No. Shrinkage is a missing-quantity problem: the items are gone. A write-down is a value problem: the items are still there but will sell for less than they cost, because they are damaged, outdated or close to expiry. U.S. GAAP requires FIFO and average-cost inventory to be carried at the lower of cost and net realizable value, so the loss in value is booked as soon as it is known.

What should I do if the count finds more stock than my records?

First hunt for the error, because extra stock nearly always means a recording mistake: a delivery entered twice, a return never booked, or a sale charged to the wrong product. Correct the original transaction if you find it. Only if the cause stays unknown should you debit inventory and credit an inventory adjustment account for the cost of the surplus.

Can I deduct inventory shrinkage on my taxes?

In the U.S., usually yes. Recording shrinkage lowers closing inventory, which raises cost of goods sold and reduces taxable income, so the deduction happens through COGS and should not be claimed again as a separate theft loss. Obsolete or excess stock is stricter: write-downs are generally only allowed once the goods are actually scrapped or offered for sale at the lower price. Your tax preparer can confirm the details.

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• FIFO, LIFO or Average Cost? Choosing an Inventory Costing Method
• Adjusting Journal Entries, Explained: What to Post Before You Close the Month
• Internal Controls for Small Business When You Only Have Three People
• How to Close Your Books Every Month: A Small Business Month-End Routine
• How to Write Off Bad Debt: Clearing the Invoices That Will Never Be Paid