Inventory Write-Offs: A How-To Guide with Example Entry

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 them 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 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 of 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 COGS is an accounting of all the indirect and direct costs that go into making a product.

Key Takeaways

• Inventory items can lose all of their value due to damage, theft, obsolescence, spoilage, or changes in demand.
• When this happens, a company accounts for it in its financial records as an inventory write-off.
• There are two primary approaches to take: the direct-write off method and the allowance method.
• Understanding when and how to write off inventory—and what the impact is—is essential to effective execution.
• Monitoring inventory write-offs can illuminate areas where better inventory management could stem losses.

Inventory Write-Offs Explained

When a company has inventory on its hands that has lost all of its value or has become unsellable, it needs a way to address that in its books. An inventory write-off is how the accounting team formally accounts for the fact that these items are no longer considered financial assets. In this way, the company ensures that the true value of its inventory is represented in its financial statements (specifically, its balance sheet and income statement).

Write-offs can become necessary for any number of reasons. Inventory may have been damaged, say from a leak or flood in a warehouse or a natural disaster. Negative shifts in market demand for the goods may occur, meaning that customers are no longer willing to buy them. Alternatively, the items may have been stolen or lost, perishable goods may have spoiled, or the products may have become obsolete.

Whatever the reason, the company then must address the issue from an accounting standpoint. There are two main approaches its accounting team can take: the direct write-off method and the allowance method.

Direct Write-Off Method

Under the direct write-off method, the cost of the inventory is written off directly as an expense once the items are identified as no longer having value. The company records the expense at the time the inventory is deemed unsellable rather than when it was initially produced or purchased.

The direct write-off method is the more straightforward way of writing off inventory. Here’s how it works: The inventory write-off expense is debited and the inventory account is credited by the same amount. For example, if a sneaker manufacturer has to write off $10,000 worth of shoes that are water-damaged, there would be a journal entry noting an inventory write-off expense of $10,000 and an inventory credit of $10,000.

The direct write-off method has a number of advantages. It’s easy to understand and implement, involves the recording of actual losses (rather than estimates), and works well for companies that only occasionally have to write off inventory. That said, it’s not the best approach for every company or situation. Large write-offs can result in significant swings in reported expenses and an inaccurate sense of true inventory value over time. It’s typically not a good option for large companies with frequent inventory write-offs, and it won’t work for those that must follow Generally Accepted Accounting Principles (GAAP) guidelines, unless the amount is considered immaterial.

Allowance Method

While the direct write-off method is simple and appropriate for smaller businesses, many larger companies opt for the allowance method for inventory write-offs. The allowance method involves estimating and recording potential inventory losses in advance of their actual occurrence. Here’s how it works: At the end of each accounting period, the company estimates potential inventory obsolescence or value losses in an allowance account. Then when specific items are identified as unsellable, the company writes them off against that allowance account.

Let’s consider that sneaker maker again. It estimates that $10,000 worth of shoes may become unsellable in the coming year. At the end of the year it would create journal entries of $10,000 as an inventory write-off expense as well as a $10,000 credit to the allowance for obsolete inventory account. If only $3,000 worth of sneakers actually become unsellable, the company would then record a $3,000 debit to the allowance for obsolete inventory account and a $3,000 credit to the inventory account.

This more conservative approach to inventory valuation results in more stable patterns of expense recognition, smoothing out the impact of inventory write-offs on the company’s income statement and providing a more accurate representation of inventory value. It also adheres more closely to both GAAP accounting principles and the matching principle (because estimated expenses are recognized in the same period as related revenue). On the downside, the allowance method requires some estimation, which may not always be accurate. It can be more complex to implement than the direct write-off method, requiring more complex inventory tracking and inventory aging analytics.

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 of their worth due to a multitude of circumstances, including:

• Changes in market demand: Changes in consumers’ desires or other unfavorable market shifts can result in inventory items that will no longer sell.
• Internal or external theft: When items are stolen in transit or in storage—by those outside or inside the company—the accounting team will need to write off the purloined inventory.
• Damage: Products can be irreparably damaged in myriad ways—fire, flood, natural disaster, heat, cold—rendering them unsellable.
• Obsolescence: From tech products to fast fashion, many types of products can become outdated, outmoded, or otherwise obsolete over time.
• Spoilage: This is a problem that companies dealing with perishable goods face when items are not well-managed or selling as quickly as expected. These spoiled or expired items, such as fruit and pharmaceuticals, lose all of their value.
• Misplacement: Sometimes inventory is simply lost or misplaced, whether in transit or in a warehouse. In these cases, the company must financially record the loss in value.

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.

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.

How to Write Off Inventory in 5 Steps

1. 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.
2. 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.
3. 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.
4. 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.
5. Document disposal: Whether a company liquidates, donates, or destroys its written-off inventory, it should ensure proper documentation (i.e., receipts, pictures, etc.) to provide as proof to the IRS if needed.

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:

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.

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 putaway to picking and order fulfillment, to find inefficiencies and problem areas that can reduce the amount of damaged inventory. 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, such as 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, such as 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, such as 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.

What happens when you write off inventory?

An inventory write-off is how a company formally accounts for inventory items that no longer have value. Here is what happens—both positive and negative—as a result of writing off inventory:

• The company debits the loss and credits the inventory account for the value of the valueless inventory (per the direct write-off method).
• The firm’s financial records then reflect the real value of its assets, which helps the company maintain compliance with accounting standards and provides a more accurate picture of its financial position.
• This results in more precise reporting that leads to better decision-making in the future, such as liquidating excess inventory before it has to be entirely written off or making changes to production plans.
• The write-off reduces the value of assets on a company’s balance sheet, potentially impacting working capital and the ability to obtain financing.
• The write-off is reported as an expense on the company’s income statement, reducing net income for the reporting period, which can negatively impact financial performance.
• Since the company can claim the lost value of inventory as a tax deduction, the write-off can yield certain tax benefits, such as a reduction in taxable income and tax liability.

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.

How do you record inventory loss?

Recording inventory losses is important to maintain accurate financial records that reflect the precise value of a company’s inventory. There are a couple of common approaches to recording inventory loss (also referred to as an inventory write-off). One is the direct write-off method, whereby the cost of the inventory is written off directly as an expense once the items are identified as having lost their value. It’s the more straightforward approach and can work well for smaller businesses. The other approach is called the allowance method, whereby a company estimates potential inventory losses in an allowance account ahead of time and then writes off the actual inventory losses as they occur against that allowance account. This approach works better for larger companies and those that must adhere to certain accounting principles.