Inventory shrinkage is the general term for lost, stolen or damaged inventory. Any business that sells inventory items can encounter shrinkage, which can stem from causes such as theft, poor management practices and natural disasters. You enter an expense for inventory losses on your financial books. You can receive a tax deduction for your loss in two different ways.

Accounting for the Loss

To account for a loss of inventory, you create a transaction that credits the inventory asset account for the loss. The offsetting debit depends on the size of the loss. For relatively small losses, you can debit your cost of goods sold account directly. However, for large losses such as those arising from natural disasters, debiting COGS substantially reduces your gross profits and requires explanation. In this case, you might prefer to debit an expense account especially created to record losses from shrinkage. In this way, you don’t distort your gross profits with an extraordinary loss.

Shrinkage Reserve

Generally accepted accounting principles require you to match expenses to the periods in which they occur. For this reason, companies might establish special reserve accounts for shrinkage losses. You first must estimate your shrinkage loss at the beginning of the period. Credit a contra-asset account with a name like “allowance for inventory losses” or “shrinkage reserve” for your estimated loss, and debit an expense account or COGS for the same amount. When you discover actual losses, debit your reserve account and credit inventory by the loss amount.

Deducting the Loss in COGS

The Internal Revenue Service allows you to deduct shrinkage losses. You have the option of incorporating the loss into your COGS or reporting it separately. Shrinkage reduces your ending inventory and thus increases your COGS, which is the cost of beginning inventory plus inventory purchases minus ending inventory. This has the effect of lowering your gross profit and your taxable income. The net effect is a tax savings: the amount of loss multiplied by your tax bracket. For example, if $10,000 of uninsured inventory disappears and you are in the 25 percent bracket, you’ll save $2,500 in taxes.

Deducting the Loss Separately

If you prefer, you can deduct inventory shrinkage costs separately using IRS Form 4684. If you take this route, you must reduce your beginning inventory or purchases by the amount of the loss. This will lower your COGS so that you don’t double count the loss. With either method, you must first file a claim if your lost inventory was insured, but lack of insurance will not bar you from taking the deduction. If you expect reimbursement, reduce your loss by this amount and exclude the reimbursement from gross income. If the year ends before you receive your insurance reimbursement, estimate and deduct the unreimbursed loss.

Recoveries

Sometimes, you recover stolen inventory. If this occurs after you’ve taken a deduction for the loss, you must refigure your loss. The IRS has you revalue the recovered inventory at the lesser of its cost basis or its decrease in fair market value, or FMV. The cost basis is the amount you paid for the inventory minus any reimbursement you receive for its loss. FMV is the amount the inventory would fetch in the free marketplace. You measure the loss of FMV from the date you discover the theft to the date the inventory is recovered. If your refigured loss is less than your deducted loss, report the difference as income in the recovery year.