What Is an Inventory Adjustment in Accounting?

An inventory adjustment in accounting is a corrective measure taken to align a company’s recorded inventory balances with the actual physical count of goods on hand. It ensures financial records accurately reflect the true quantities and values of products available for sale. This process is a routine part of maintaining accurate financial statements for businesses that deal with physical goods.

What an Inventory Adjustment Involves

An inventory adjustment involves increasing or decreasing the value and quantity of goods recorded in a company’s inventory system. This process ensures financial records reflect the true value and physical quantity of items available. Alignment is achieved by comparing a physical count of inventory with the company’s perpetual inventory records.

When a discrepancy is identified between the physical count and the book records, an adjustment becomes necessary. If the physical count reveals more items than recorded, an upward adjustment is made. Conversely, if fewer items are found, a downward adjustment is required to correct the discrepancy. This reconciliation helps maintain the integrity of inventory data for operational efficiency and accurate financial reporting.

Common Causes for Adjustments

Inventory adjustments become necessary for various reasons. One frequent cause is shrinkage, which refers to the loss of inventory due to factors like theft, damage, or spoilage. This includes items that are shoplifted, stolen by employees, or lost within the warehouse.

Errors in counting or recording inventory are another reason for adjustments. Mistakes can occur during manual physical counts, data entry into inventory systems, or during receiving and shipping processes. These administrative errors can lead to miscounted items, incorrect unit conversions, or issues with inventory tracking systems.

Inventory may also require adjustment due to breakage or damage, where goods become unusable while in storage or transit. Obsolescence means products can become outdated or unsellable, necessitating a write-off. Returns, whether from customers or to vendors, also affect inventory levels and require adjustments.

How Adjustments Are Recorded

Recording an inventory adjustment involves a journal entry in a company’s accounting system. For a scenario where inventory needs to decrease, such as due to shrinkage or damage, the entry involves debiting an expense account. This expense might be “Cost of Goods Sold,” “Inventory Shrinkage Expense,” or “Loss on Inventory Write-Down.”

The “Inventory” asset account is simultaneously credited, reducing its balance to reflect the decreased physical quantity. If a physical count reveals more inventory than recorded, an increase is necessary. The “Inventory” asset account would be debited, and an income account or “Cost of Goods Sold” would be credited to reflect the gain.

Reflection on Financial Statements

Inventory adjustments directly impact a company’s financial statements. On the balance sheet, the “Inventory” asset account is updated to reflect the corrected physical count and value. This adjustment influences total current assets and, consequently, the company’s overall equity.

On the income statement, a decrease in inventory, recognized as an expense, increases the “Cost of Goods Sold” (COGS). Increased COGS reduces gross profit and net income for the reporting period. Conversely, an upward adjustment to inventory would decrease COGS, leading to a higher gross profit and net income.