What is Inventory Shrinkage?
When a business takes a physical count of its inventory there is normally an unexplained difference between the physical count and the inventory accounting records. These differences might be due to inventory being stolen by employees, shoplifting by customers, or inventory damaged and disposed of without being recorded. Whatever the reason there is a discrepancy referred to as inventory shrinkage which needs to be accounted for to reconcile the accounting records with the physical count.
Under the matching principle, the shrinkage should be recorded as an expense in the accounting period in which the shrinkage occurred to match it against the revenue earned during that period.
Suppose for example a business has inventory records showing 2,000 units of a product on hand, but a physical count of the inventory shows only 1,895 units. The business has inventory shrinkage of 105 (2,000 – 1,895) units which might be due to employee theft, shoplifting by customers (retail shrinkage) or a number of other reasons.
If the unit cost of the product is 14.00, giving a total inventory shrink at cost of 105 x 14.00 = 1,470, then the business will record the expense in the inventory shrinkage account in the general ledger as follows:
|Inventory shrinkage expense||1,470|
The journal entry above reduces the inventory account by 1,470 bringing it down to the same value shown by the physical count.
The inventory shrinkage expense account will form part of the cost of goods sold account, when the shrinkage is minor is may not be recorded to a separate account but simply posted direct to cost of goods sold.
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