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.
Inventory Shrinkage Example
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
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 Accounting Equation
The Accounting Equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities plus the equity of the business. This is true at any time and applies to each transaction. For this transaction the Accounting equation is shown in the following table.
In this case on the left side of the accounting equation the asset of inventory has been decreased by the 1,470 credit to the inventory account. On the right side of the accounting equation the debit to the shrinkage expense account of 1,470 decreases the net income which decreases the retained earnings and therefore the owners equity in the business.
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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About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.