Inventory Write-Offs the Right Way (2024)

When it comes to inventory, events like spoilage, damage or obsolescence, along with theftand loss of market value can reduce or even eliminate its value. When businesses experiencethese losses, writing it off correctly for accounting purposes can reduce their overall taxliability 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 beeligible for a tax deduction to alleviate the loss.

What Is an Inventory Write-Off?

First, what is inventory? Inventory is acompany’s raw materials, component parts or finished product. If inventory loses allitsvalue because it’s spoiled, damaged, obsolete or stolen, the accounting processrequired toreflect that loss is known as a write-off.

When inventory value is totally eliminated, that loss is recorded in the contra account orcost of goods sold (COGS) accounting, depending on the significance of the write-off. Acontra account is an entry on your general ledger that shows the original value and the newreduced value. Rather than simply change the original entry, it’s a cleaner way ofshowingthe reduction in value and can be useful for tracking historical costs. It’sespeciallyuseful when calculating your taxable income. And the COGS is an accounting of all theindirect 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 freezerbreaks down and the meat spoils, rendering it unsellable and unsalvageable. Because the meathas 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 freezerbroke andit didn’t have much meat in it—the large majority of the inventory wasunaffected. Theinventory write-down process will debit the COGS and credit inventory. Usually a loss isconsidered immaterial if it amounts to less than 5% of total inventory on hand. The journalentry would appear as such:

To calculate COGS, follow this formula:

COGS = Beginning inventory + purchases – endinginventory

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 multiplefreezers with the most expensive cuts of meat. The damage is $5,000. In that case, a largeinventory write-off will debit a loss on a separate inventory write-off account and creditinventory. This approach is taken because a large charge to COGS would distort the grossmargin of the business.

Inventory Write-Off vs. Write-Down

An inventory write-off is nearly identical to an inventorywrite-down—itonly differs in the severity of the loss. When inventory decreases in value butdoesn’t loseall it’s worth, it’s written down. It could still be sold—just not at ashigh of a price. Awrite-off occurs when inventory has lost all of its value. While the degree of lossdiffers, the actual circ*mstances that cause the loss and the accounting process that mustoccur remain the same.

When Should Inventory Be Written Off?

Inventory items might lose all their worth due to a multitude of circ*mstances, including:

• Changes in market demand
• Internal or external theft
• Damage
• Obsolescence
• Spoilage
• Misplacement

Many of these situations constitute inventory shrinkage, which meansloss 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 theaccounting records to reflect the loss.

Generally Accepted Accounting Principles (GAAP) requires that inventory be written off as anexpense as soon as it is determined to have lost all value. Companies are not allowed towait until it might be more advantageous to address it or spread it out over multipleperiods, like they might treat a depreciating asset.

5 Steps to Write-Off Inventory

1. Assess value loss: Determine if the inventory has any remaining marketvalue. If it does, it can be treated as a write-down. If all value has been lost,proceed with the inventory write-off process.
2. Determine significance of loss: If an inventory write-off is consideredimmaterial to the company, it will be recorded in COGS. If it is significant, it will bedocumented in a separate account for tracking purposes and to avoid distorting grossmargins.
3. Create journal entry: Depending on the significance of the lossdetermined in the previous step, a business will either debit the COGS and creditinventory or debit the loss on a separate inventory write-off accountand 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. Theentire write-off must be recognized and documented as an expense at once. Inventorymanagement software can help you correctly write-off lost goods and maintain GAAP compliance.
4. Determine best method of disposal: Businesses do not have to get rid ofwritten-off inventory right away. But it’s important to follow IRS-methods ofdisposal.
5. Document disposal: Whether a company liquidates, donates or destroysits 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 catchit asearly as possible and take appropriate steps right away.

Carefully examine inventory as it arrives and while it’s stored in a warehouse. If youfinddamaged inventory, start by setting it aside so it doesn’t get mistaken for unbrokengoods.Inspect the damaged inventory and prepare a damage report for each item that’s broken.Couldit be sold at a reduced price? Or is the value totally lost? Take the steps to record theloss in your COGS or your general ledger.

Look for trends in damaged inventory. Are there specific areas or products with frequentissues you could address? Examine each step of the process from receiving and put away topicking and order fulfillment to find inefficiencies and problem areas that can reduce theamount of damaged inventory. And inventory managementsoftware can help with each step of this process, along with the needed analysis tofind 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. Ifthe write-off is not significant, it will be listed as a part of the COGS. In this case, thecompany would debit the general COGS account on the income statement and credit theinventory. This approach will increase the COGS.

However, if the inventory write-off is significant, the company would record the expense in aseparate impairment loss line item (inventory write-off) so the aggregate size can betracked, and the gross margins aren’t distorted.

The treatment of the write-down as an expense means that both the net income and taxableincome 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 beprevented 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 intensiveinventory control policies and audits to help monitor and prevent fraud and theft.
• Consider a write-down first: There is still a chance the inventory hassome value, even if it’s not the original book value. Check for opportunities tosell ata 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 andfrequency of inventory orders to gauge whether the amount is appropriate for demand.Many companies find that smaller, more frequent orders help reduce inventory value lossin comparison to larger, less frequent orders.
• Track market demand and trends: Some companies find themselves needingto write-off inventory because the product has become obsolete in the market. Trackingprevious sales and keeping an eye on trends in the product’s marketplace can helpcompanies take proactive measures like adjusting order size and frequency to avoid beingstuck with excess, obsolete and unsellable goods.
• Track inventory levels: Inventory managementsoftware shows real-time inventory levels, which helps you make betterpurchasing and management decisions.
• Implement an inventory management system: Investing in inventorymanagement software can help companies avoid inventory write-offs through features likecycle counting,tracking inventory in multiple locations and demand planning.

Managing the accounting processes behind lost or damaged goods helps you maintain compliancewhile reducing your overall taxable income. There are steps you can take to try and reducethe amount of inventory that must be written down or written off, like monitoring inventorylevels and order cycles. And inventorymanagement software can help you every step of the way. From tracking historicaltrends and predicting needed inventory to correctly recording inventory losses, inventorymanagement 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 itsmarket 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. Inorder to prove to the IRS that the inventory wasn’t in fact sold, companies mustprovideproof of the following:

• Bona fide sale: Written-off inventory can be sold to a salvage yard orliquidator and still be eligible for a tax deduction from the IRS. A company would thensubtract the profit recovered from the inventory’s original fair market value andcouldclaim any remaining cost as a tax benefit.
  • Example: A company has $10,000 worth of devalued inventory and sells it to aliquidator for $1,000. The company could then write off $9,000.
• Donation: Another option is to donate the written-off inventory to acharity, which would make it eligible for a tax deduction. Additional tax deductions maybe available if donated inventory directly helps impoverished, ill or infantpopulations. If you make a donation, be sure to get a receipt in case you’reaudited.
• Destroy: When all else fails, inventory that has lost its value can bedestroyed. This should be a last resort, as it doesn’t provide as much of adeduction asother options. Take pictures before and after the inventory is destroyed in case youneed 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 andthe potential for future benefit. When inventory is written off, that process isacknowledging that the item no longer has economic value and will not provide future valueto the company, thus rendering it an expense.