Shrinkage

In inventory accounting, shrinkage is the shortfall between the inventory quantity a business’s records show and the quantity a physical count actually finds, and the loss recognized when the books are written down to that count. The cause does not change what it is, so theft, breakage and posting errors all arrive at the same place, a count that comes in below the ledger. The shortfall is a quantity difference first, and it gets priced afterwards by whichever cost flow assumption the business already runs on, FIFO, LIFO or average cost.

How Shrinkage Is Measured

Take the counted quantity away from the recorded quantity, then value the difference at the cost carried for those units. Stated as a rate, shrinkage can be expressed against sales rather than against the inventory balance, and a sales-based ratio is the one the federal tax safe harbor uses. The retail safe harbor method uses a historical ratio of shrinkage to sales to estimate the inventory shrinkage that occurred between the date of the last physical inventory and the end of the taxable year (IRS, Rev. Proc. 98-29, section 4.02).

Where the Shortfall Shows Up in the Close

The inventory system decides whether anyone sees it. A business on a periodic system builds cost of goods sold from the opening balance, purchases and the closing count, so missing units leave through the count and land inside cost of goods sold with no line of their own. A business on a perpetual system carries a running book quantity, so the count produces a visible difference that somebody has to write off on purpose. Either way the shortfall reduces the inventory carried at the close and, unless it is charged to a separate loss account, increases cost of goods sold, which is why the effect reaches gross profit before it reaches anything below it.

Say a client counts its warehouse at year end on the figures below.

Perpetual book quantity                                 4,200 units
Physical count                                          4,050 units
Shrinkage                                                 150 units
Cost carried per unit                                        $18
Shrinkage, valued                                         $2,700
Rest of the warehouse, counted and agreed               $187,100

The same year, run on a periodic system
  Opening inventory                                    $240,000
  Purchases                                            $900,000
  Closing inventory, per the count                     $260,000
  Cost of goods sold   240,000 + 900,000 - 260,000     $880,000

  Had the count agreed with a book figure of $262,700,
  cost of goods sold would have been                   $877,300

One set of facts, and the shortfall is a deliberate write-off in the first case and a silent part of cost of goods sold in the second, where there is no book quantity for the count to disagree with.

What the Count Rules Actually Require

Counting is not a housekeeping preference. Where a taxpayer keeps book inventories under a sound accounting system, the net value shown by those accounts is deemed to be the cost of the goods on hand, and the balances shown by such book inventories should be verified by physical inventories at reasonable intervals and adjusted to conform therewith (26 CFR 1.471-2(d)). The adjusted figure is what reaches the return, on line 7 of Form 1125-A, the inventory at end of year line of the cost of goods sold computation.

Estimating between counts is allowed, on conditions the statute sets. A method of determining inventories is not treated as failing to clearly reflect income solely because it uses estimates of inventory shrinkage confirmed by a physical count only after the last day of the taxable year, provided the taxpayer normally counts inventories at each location on a regular and consistent basis and adjusts both those inventories and its estimating methods to the extent the estimates run above or below the actual shrinkage (26 U.S.C. 471(b)). The retail safe harbor built on that permission is available for computing ending store inventory to taxpayers primarily engaged in retail trade, the resale of personal property to the general public, where physical inventories are normally taken at each location at least annually (IRS, Rev. Proc. 98-29, section 4.01). It is still current, carried at section 22.02 of the automatic accounting method change list (IRS, Rev. Proc. 2025-23).

An audited client meets the count from the other side. If inventory is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence about its existence and condition by attending physical inventory counting, unless impracticable, and by testing whether the entity’s final inventory records accurately reflect actual inventory count results (AU-C 501, Audit Evidence, Specific Considerations for Selected Items, .12). What the auditor does standing at the count is set out in vouching.

What Shrinkage Is Commonly Confused With

Shrinkage is units that are gone. A write-down is units that are still on the shelf and worth less than they cost. Under US GAAP a departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost, whether the loss of utility comes from physical deterioration, obsolescence, changes in price levels or other causes (Accounting Research Bulletin No. 43, Chapter 4, Statement 5). The tax side splits the same way. Goods that are unsalable at normal prices or unusable in the normal way, because of damage, imperfections, shop wear, changes of style, odd or broken lots or other similar causes, should be valued at bona fide selling prices less direct cost of disposition, and if those goods are raw materials or partly finished goods held for use or consumption they are instead valued on a reasonable basis that takes their usability and condition into account, in no case below scrap value (26 CFR 1.471-2(c)). Both rules assume the goods are present to be looked at. The carrying-amount version of the same idea, applied to assets outside inventory, is in impairment losses.

Common Questions

Accountably places trained offshore accountants inside US CPA and EA firms, and a firm can put a block of its own inventory reconciliation and close work through a trial task before anything client facing depends on it.