To record inventory shrinkage, debit an expense account and credit the inventory asset account for the amount of the shortage found in a physical count. In most cases the debit goes to cost of goods sold, which lowers your ending inventory on the balance sheet and increases COGS on the income statement. That higher COGS then carries through to your federal tax return, reducing taxable income for the period.
The specifics — which expense account to use, which tax form the number lands on, and what documentation you need — depend on the size of the loss and how your business is structured.
Calculate the Shrinkage Before You Post Anything
The journal entry needs a verified dollar figure. Pull the book inventory value from your general ledger, then run a physical count of what is actually on hand. Subtract the physical count from the book value. If your records show $50,000 in goods but the count totals $48,000, the $2,000 gap is your shrinkage.
For businesses that track SKUs individually, multiply the missing quantity of each item by its verified cost per unit and add the results across every product line. Twenty missing units at $15 each is $300 of shrinkage on that item alone.
Before finalizing the number, confirm that recent purchases, returns, and transfers between locations have all been posted. Unrecorded transactions are one of the most common reasons a count appears to show shrinkage when nothing was actually lost.
The Journal Entry
The entry is a single debit and a single credit. The credit is always to the Inventory asset account for the shrinkage amount. The debit depends on whether the loss is routine or exceptional.
Routine shrinkage. Debit Cost of Goods Sold, or a sub-account such as “COGS — Shrinkage.” Use this when the loss is within the range your business normally sees: minor theft, handling breakage, small counting errors.
Abnormal shrinkage. Debit a separate Inventory Shrinkage Expense or Inventory Loss account. Use this when the loss is unusually large or tied to a specific event, such as a warehouse flood or a large-scale theft. Keeping it in its own line makes the one-time hit visible to anyone reading the income statement.
A $2,000 routine shrinkage entry looks like this:
Debit: Cost of Goods Sold — Shrinkage $2,000
Credit: Inventory $2,000
Most accounting systems will accept this as a standard journal entry. Many also offer a dedicated inventory adjustment screen where you select the specific items and enter the quantity decrease, and the software builds the entry for you.
When Market Value Drops Below Cost, That’s a Different Entry
A market-value write-down is not the same as shrinkage and should not be combined with it. The IRS allows taxpayers to value inventory at cost or at the lower of cost or market, and businesses using the lower-of-cost-or-market method must write inventory down when market value falls below recorded cost.1Internal Revenue Service. Lower of Cost or Market (LCM) Damaged, outdated, or otherwise unsalable goods — sometimes called subnormal goods — must be valued at their realistic selling price minus disposal cost.
The mechanics look similar: debit a loss account such as “Loss from Decline in Inventory Value” and credit Inventory. Document the current market value with recent comparable sales or vendor quotes, and keep the entry separate from your physical-shrinkage entry.
How the Shrinkage Flows to Your Tax Return
You do not report shrinkage as a stand-alone deduction. It reaches your tax return through the ending inventory figure in your cost of goods sold calculation. Lower ending inventory means higher COGS, which means lower taxable income.
Corporations, S Corporations, and Partnerships
C corporations (Form 1120), S corporations (Form 1120-S), and partnerships (Form 1065) all report COGS on Form 1125-A.2Internal Revenue Service. Form 1125-A – Cost of Goods Sold The shrinkage-adjusted inventory goes on Line 7 (inventory at end of year). Line 8 subtracts Line 7 from the totals on Line 6 (beginning inventory, purchases, labor, and other costs) to produce cost of goods sold. That lower ending inventory pushes COGS up and taxable income down on the entity’s return.3Internal Revenue Service. 2025 Instructions for Form 1120 – U.S. Corporation Income Tax Return
Sole Proprietors
Sole proprietors report COGS in Part III of Schedule C (Form 1040). The shrinkage-adjusted ending inventory goes on Line 41, and Line 42 subtracts it from beginning inventory plus purchases to yield COGS.4Internal Revenue Service. 2025 Schedule C (Form 1040) The year-end inventory figure must reflect the actual physical count rather than the unadjusted book value.5Internal Revenue Service. 2025 Instructions for Schedule C (Form 1040)
Under Internal Revenue Code Section 471, the method you use must clearly reflect income and conform to accepted accounting practice in your industry.6Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories Skipping the shrinkage adjustment overstates ending inventory, overstates profit, and leaves you paying more tax than the law requires.
Large Casualty and Theft Losses Are Handled Differently
Day-to-day shrinkage runs through COGS as described above. When inventory is destroyed by a casualty (fire, storm, flood) or lost in a large-scale theft, the IRS gives you two options.7Internal Revenue Service. Publication 547 (2025), Casualties, Disasters, and Thefts
- Report the loss through COGS by letting the lower ending inventory do the work. If you take this route, include any insurance or reimbursement in gross income, and do not also claim a separate casualty or theft deduction.
- Deduct the loss separately. Remove the affected items from COGS (by adjusting opening inventory or purchases downward) and claim the loss under the casualty and theft loss rules, reduced by any reimbursement. Business casualty and theft losses are reported in Section B of Form 4684.8Internal Revenue Service. Instructions for Form 4684 (2025)
If the loss came from a federally declared disaster, you can elect to deduct it on the prior year’s return instead of the year of the loss. When you make that election, you must decrease opening inventory for the year the loss actually occurred so the same amount is not counted twice.7Internal Revenue Service. Publication 547 (2025), Casualties, Disasters, and Thefts
To support a theft loss, the IRS says you should be able to show that you owned the property, that it was stolen, and when you discovered it was missing, along with whether any insurance or reimbursement is in play. A police report is not explicitly required, but filing one creates strong evidence and is widely considered best practice if you are audited.
Estimating Shrinkage Between Physical Counts
Few businesses can afford a full physical count every day. Section 471(b) allows the use of estimated shrinkage figures that are confirmed by a physical count only after year-end, provided two conditions are met: physical counts are performed at each location on a regular, consistent schedule, and both the inventory records and the estimating method are adjusted whenever an actual count shows the estimates were off.6Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
In practice, a retailer applies a historical shrinkage rate throughout the year, then trues up the numbers when the annual count is done. If the count shows the estimates were high or low, correct the balance and update the formula going forward.
Some Small Businesses Don’t Have to Keep Formal Inventories
Under Section 471(c), a business that meets the gross receipts test in Section 448(c) is exempt from the general inventory rules. For tax years beginning in 2026, the threshold is $32 million in average annual gross receipts over the prior three years.9Internal Revenue Service. Rev. Proc. 2025-32 A qualifying business can either treat inventory as non-incidental materials and supplies (deducting the cost when the items are used or sold) or follow the inventory method it uses on its financial statements.6Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
You still need a method that clearly reflects income. The Schedule C instructions confirm that a small business taxpayer who chooses not to keep an inventory must still use an accounting method that clearly reflects income.5Internal Revenue Service. 2025 Instructions for Schedule C (Form 1040) Missing goods cannot simply be ignored.
What to Keep for the File
The IRS requires records that support every item of income or deduction on your return, and shrinkage adjustments are no exception.10Internal Revenue Service. Topic No. 305, Recordkeeping In an audit, the count sheets and the journal entry that followed will be your primary evidence.
For each shrinkage adjustment, retain:
- Physical count sheets or digital logs showing every item tallied, the date, and the person who counted.
- Purchase invoices establishing the cost per unit, including any freight or handling included in inventory value.
- Reconciliation worksheets comparing book inventory to physical count line by line.
- A copy of the posted journal entry with date, accounts, and amounts.
- Disposal records — destruction certificates, liquidator receipts, donation acknowledgments — if damaged or obsolete goods were removed.
- Police reports, internal investigation notes, and insurance claim records for any theft.
Keep these records at least three years from the date you filed the return that claimed the deduction, or six years if there is a risk that unreported income exceeds 25% of what was shown on the return.11Internal Revenue Service. Publication 583 – Starting a Business and Keeping Records Many tax professionals recommend a six-year hold on inventory records as a matter of course.