When it comes to inventory, events like spoilage, damage or obsolescence, along with theft and loss of market value can reduce or even eliminate its value. When businesses experience these losses, writing it off correctly for accounting purposes can reduce their overall tax liability and help them stay compliant with regulations and best accounting practices.
Inventory is an asset, and write-offs impact your balance sheet and income statement, ultimately lowering the net income and retained earnings. However, some write-offs may be eligible for a tax deduction to alleviate the loss.
What Is an Inventory Write-Off?
First, what is inventory? Inventory is a company’s raw materials, component parts or finished product. If inventory loses all its value because it’s spoiled, damaged, obsolete or stolen, the accounting process required to reflect that loss is known as a write-off.
When inventory value is totally eliminated, that loss is recorded in the contra account or cost of goods sold (COGS) accounting, depending on the significance of the write-off. A contra account is an entry on your general ledger that shows the original value and the new reduced value. Rather than simply change the original entry, it’s a cleaner way of showing the reduction in value and can be useful for tracking historical costs. It’s especially useful when calculating your taxable income. And the COGS is an accounting of all the indirect and direct costs that go into making a product.
Inventory Write-Off Example
A meat distributor has many expensive cuts of meat in the freezer. Unfortunately, the freezer breaks down and the meat spoils, rendering it unsellable and unsalvageable. Because the meat has entirely lost value, it must be written off. This can be done in one of two ways.
Let’s say the loss is considered insignificant, in this case $500. Only one freezer broke and it didn’t have much meat in it—the large majority of the inventory was unaffected. The inventory write-down process will debit the COGS and credit inventory. Usually a loss is considered immaterial if it amounts to less than 5% of total inventory on hand. The journal entry would appear as such:
|Debit Entry||Credit Entry|
|Cost of goods sold||500|
To calculate COGS, follow this formula:
COGS = Beginning inventory + purchases – ending inventory
If the ending inventory value decreases as it does with a write down, the COGS will increase.
On the other hand, let’s say the inventory loss is considered material. It was multiple freezers with the most expensive cuts of meat. The damage is $5,000. In that case, a large inventory write-off will debit a loss on a separate inventory write-off account and credit inventory. This approach is taken because a large charge to COGS would distort the gross margin of the business.
|Debit Entry||Credit Entry|
Inventory Write-Off vs. Write-Down
An inventory write-off is nearly identical to an inventory write-down—it only differs in the severity of the loss. When inventory decreases in value but doesn’t lose all it’s worth, it’s written down. It could still be sold—just not at as high of a price. A write-off occurs when inventory has lost all of its value. While the degree of loss differs, the actual circumstances that cause the loss and the accounting process that must occur remain the same.
When Should Inventory Be Written Off?
Inventory items might lose all their worth due to a multitude of circumstances, including:
- Changes in market demand
- Internal or external theft
Many of these situations constitute inventory shrinkage, which means loss of inventory due to issues like theft, damage, administrative error and fraud.
In all cases, a write-off must be performed to remove the no-value inventory from the accounting records to reflect the loss.
Generally Accepted Accounting Principles (GAAP) requires that inventory be written off as an expense as soon as it is determined to have lost all value. Companies are not allowed to wait until it might be more advantageous to address it or spread it out over multiple periods, like they might treat a depreciating asset.
5 Steps to Write-Off Inventory
- Assess value loss: Determine if the inventory has any remaining market value. If it does, it can be treated as a write-down. If all value has been lost, proceed with the inventory write-off process.
- Determine significance of loss: If an inventory write-off is considered immaterial to the company, it will be recorded in COGS. If it is significant, it will be documented in a separate account for tracking purposes and to avoid distorting gross margins.
- Create journal entry: Depending on the significance of the loss determined in the previous step, a business will either debit the COGS and credit inventory or debit the loss on a separate inventory write-off account and credit inventory. This step must be taken immediately because, according to GAAP, inventory cannot be written off at a future date or spread out over several periods. The entire write-off must be recognized and documented as an expense at once. Inventory management software can help you correctly write-off lost goods and maintain GAAP compliance.
- Determine best method of disposal: Businesses do not have to get rid of written-off inventory right away. But it’s important to follow IRS-methods of disposal.
- Document disposal: Whether a company liquidates, donates or destroys its written-off inventory, they should ensure proper documentation (i.e. receipts, pictures, etc.) to provide as proof to the IRS if needed.
How to Write-Off Damaged Inventory
Broken or damaged inventory can be written off or written down. But it’s best to catch it as early as possible and take appropriate steps right away.
Carefully examine inventory as it arrives and while it’s stored in a warehouse. If you find damaged inventory, start by setting it aside so it doesn’t get mistaken for unbroken goods. Inspect the damaged inventory and prepare a damage report for each item that’s broken. Could it be sold at a reduced price? Or is the value totally lost? Take the steps to record the loss in your COGS or your general ledger.
Look for trends in damaged inventory. Are there specific areas or products with frequent issues you could address? Examine each step of the process from receiving and put away to picking and order fulfillment to find inefficiencies and problem areas that can reduce the amount of damaged inventory. And inventory management software can help with each step of this process, along with the needed analysis to find and fix problem areas.
How Does a Write-Off Affect the Income Statement?
With an inventory write-off, the specific effects depend on where the write-off is listed. If the write-off is not significant, it will be listed as a part of the COGS. In this case, the company would debit the general COGS account on the income statement and credit the inventory. This approach will increase the COGS.
However, if the inventory write-off is significant, the company would record the expense in a separate impairment loss line item (inventory write-off) so the aggregate size can be tracked, and the gross margins aren’t distorted.
The treatment of the write-down as an expense means that both the net income and taxable income will be reduced.
How to Reduce Inventory Write-Offs
- Avoid excess inventory: Items are more susceptible to spoilage, obsolescence and damage when ordered and stored in large amounts for a long time.
- Protect inventory items: The need for an inventory write-off can be prevented by instituting measures to deter theft, damage and misplacement of goods. Implement protective actions like installing locks, security cages, video surveillance, smoke detectors, security alarms, tracking, etc. Additionally, put in place intensive inventory control policies and audits to help monitor and prevent fraud and theft.
- Consider a write-down first: There is still a chance the inventory has some value, even if it’s not the original book value. Check for opportunities to sell at a discount, remarket or bundle items. In cases where some of the value can be preserved, companies can pursue a write-down as opposed to a write-off.
- Revisit order cycles and sizes: Intermittently reevaluate the size and frequency of inventory orders to gauge whether the amount is appropriate for demand. Many companies find that smaller, more frequent orders help reduce inventory value loss in comparison to larger, less frequent orders.
- Track market demand and trends: Some companies find themselves needing to write-off inventory because the product has become obsolete in the market. Tracking previous sales and keeping an eye on trends in the product’s marketplace can help companies take proactive measures like adjusting order size and frequency to avoid being stuck with excess, obsolete and unsellable goods.
- Track inventory levels: Inventory management software shows real-time inventory levels, which helps you make better purchasing and management decisions.
- Implement an inventory management system: Investing in inventory management software can help companies avoid inventory write-offs through features like cycle counting, tracking inventory in multiple locations and demand planning.
Managing the accounting processes behind lost or damaged goods helps you maintain compliance while reducing your overall taxable income. There are steps you can take to try and reduce the amount of inventory that must be written down or written off, like monitoring inventory levels and order cycles. And inventory management software can help you every step of the way. From tracking historical trends and predicting needed inventory to correctly recording inventory losses, inventory management software can reduce costs while improving efficiency.
Inventory Write-Off FAQs
Can I write off expired inventory?
Expired inventory can be written off as if it were lost or damaged because it has lost its market value and can no longer be used for its normal intended purposes.
Is an inventory write-off tax deductible?
An inventory write-off can be considered tax deductible if certain criteria are met. In order to prove to the IRS that the inventory wasn’t in fact sold, companies must provide proof of the following:
- Bona fide sale: Written-off inventory can be sold to a salvage yard or liquidator and still be eligible for a tax deduction from the IRS. A company would then subtract the profit recovered from the inventory’s original fair market value and could claim any remaining cost as a tax benefit.
- Example: A company has $10,000 worth of devalued inventory and sells it to a liquidator for $1,000. The company could then write off $9,000.
- Donation: Another option is to donate the written-off inventory to a charity, which would make it eligible for a tax deduction. Additional tax deductions may be available if donated inventory directly helps impoverished, ill or infant populations. If you make a donation, be sure to get a receipt in case you’re audited.
- Destroy: When all else fails, inventory that has lost its value can be destroyed. This should be a last resort, as it doesn’t provide as much of a deduction as other options. Take pictures before and after the inventory is destroyed in case you need to show the IRS that no profit was made off the products.
Is an inventory write-off an expense?
Inventory initially is considered an asset to a company because it has economic value and the potential for future benefit. When inventory is written off, that process is acknowledging that the item no longer has economic value and will not provide future value to the company, thus rendering it an expense.