Can You Write Off Inventory? How to Handle Unsalable Stock

Managing inventory effectively is crucial for businesses, but not all stock can be sold. Some items lose value due to damage, obsolescence, or expiration and must be written off, affecting financial statements and tax filings. Accurate handling ensures compliance with accounting rules and minimizes losses.

Evaluating Inventory for Write-Off

Determining whether inventory should be removed from the books requires careful assessment. Businesses must identify stock that no longer holds value to maintain accurate financial records. Damaged, outdated, and perishable goods are common categories for write-offs.

Damaged Goods

Products that become unsellable due to mishandling, transportation issues, or environmental factors may qualify for a write-off. If an item cannot be repaired or repurposed, accounting standards such as GAAP and IFRS allow inventory adjustments.

For tax purposes, the IRS permits deductions for inventory losses, but businesses must provide evidence that the damage is permanent and the products have no recoverable value. Some companies attempt to recover losses by selling damaged items at a discount, but if disposal is the only option, the cost must be removed from financial records. Proper valuation prevents overstating assets and misrepresenting a company’s financial position.

Obsolete Items

Stock that becomes outdated due to technological advancements, shifts in consumer preferences, or industry changes is considered obsolete. Electronics, fashion, and seasonal goods businesses often encounter this issue. If an item cannot be sold at its original price or repurposed, it may be written off.

Accounting standards require companies to evaluate inventory regularly and apply lower-of-cost-or-market (LCM) rules, meaning an item must be recorded at whichever is lower: its original cost or its current market value. If an item has no resale potential, it should be removed from the books. Tax regulations allow deductions for obsolete goods, but businesses must prove that efforts to sell the items have failed. Donating outdated stock to charities can provide a tax benefit while reducing storage costs, though donation deductions require compliance with IRS rules.

Perishable Stock

Businesses in food, pharmaceuticals, and other industries with expiration-dated goods must closely monitor inventory turnover. Products reaching the end of their shelf life may no longer be legally sellable, requiring disposal.

Regulatory agencies such as the FDA and USDA impose strict guidelines on the disposal of expired goods. From an accounting standpoint, perishable inventory is often assessed using a first-in, first-out (FIFO) method to track depreciation. If unsold items must be discarded, the associated costs should be adjusted in financial records. Tax deductions for expired goods may apply, but businesses must prove that the inventory was unsellable and disposed of appropriately. Failure to account for perishables correctly can distort profit calculations and affect financial planning.

Effects on Financial Health

Writing off inventory affects a company’s financial statements, particularly the balance sheet and income statement. When inventory is removed from the books, total assets decrease, which can lower net worth. This reduction may impact financial ratios such as the current ratio and inventory turnover, both monitored by investors and lenders. A sudden drop in these metrics might indicate inefficiencies in inventory management or changes in market conditions, raising concerns about stability.

Inventory write-offs also influence reported earnings. Since inventory is considered a cost of goods sold (COGS) only when sold, unsalable stock that is written off instead must be recorded as an expense. This reduces net income, affecting profitability for the reporting period. Frequent or substantial write-offs may signal poor purchasing decisions, inadequate demand forecasting, or supply chain disruptions. Investors and stakeholders often scrutinize these trends, as excessive write-offs could indicate deeper financial or operational issues.

Tax implications play a role as well. While inventory losses can be deductible, tax authorities require businesses to follow strict guidelines to justify reductions in taxable income. If a company misclassifies write-offs or fails to substantiate the loss, it could face penalties or audits. The IRS may disallow deductions if there is insufficient proof that the inventory had no recoverable value, leading to unexpected tax liabilities and cash flow strain.

Required Documentation

Maintaining thorough records is necessary when writing off inventory, as tax authorities and auditors require clear evidence to support adjustments. Businesses must document original purchase details, including invoices, receipts, and supplier agreements, to establish the cost basis of the inventory being removed. Without these records, determining the financial impact of the write-off becomes difficult, and tax deductions may be challenged. Proper documentation also ensures compliance with GAAP and IFRS, which require accurate records of asset reductions.

A detailed inventory log should include item descriptions, quantities, and the reason for removal. This log should be consistently updated and supported by physical inventory counts or system-generated reports from enterprise resource planning (ERP) software. Businesses using perpetual inventory systems must ensure that write-offs are recorded in real-time to prevent discrepancies between book values and actual stock levels. Internal controls, such as requiring managerial approval for significant write-offs, help mitigate risks associated with fraud or mismanagement.

Photographic evidence is often valuable, particularly when dealing with regulatory compliance or insurance claims. If inventory is destroyed due to contamination or environmental factors, pictures can substantiate the loss. Third-party verification, such as reports from independent auditors or disposal service providers, can further strengthen a company’s position in case of an IRS audit or financial review. When donating unsalable inventory, businesses should obtain written acknowledgment from the recipient organization, as tax deductions for charitable contributions require proof of donation.

Consequences of Mistakes

Incorrectly writing off inventory can create financial and legal risks, particularly if misstatements lead to regulatory scrutiny. Overstating write-offs to reduce taxable income may violate IRS regulations, triggering audits, penalties, and interest charges on underpaid taxes. Under Internal Revenue Code 6662, substantial understatements of tax liability can result in a 20% accuracy-related penalty, and if fraud is suspected under Internal Revenue Code 6663, penalties may reach 75% of the underpayment. Businesses attempting to manipulate financial results through excessive write-offs risk further consequences, including SEC investigations for publicly traded companies, as inaccurate reporting can mislead investors.

Errors in financial statements due to improper write-offs can also breach debt covenants tied to liquidity ratios or net income thresholds. Loan agreements often require businesses to maintain specific financial metrics, such as a minimum current ratio or a debt-to-equity ceiling. A miscalculated inventory reduction could push these figures out of compliance, potentially leading to loan defaults, higher interest rates, or forced renegotiations with creditors. For companies relying on external financing, this can disrupt cash flow and limit access to future capital.