How to Write-Off Damaged Inventory for Your Business

Writing off damaged inventory is important for financial management. It ensures accurate financial records and profitability. Understanding this process is important for financial integrity and tax compliance.

Defining and Valuing Damaged Inventory

Damaged inventory refers to goods that have lost their original value, making them unsellable at their intended price. Common causes include physical damage, spoilage, obsolescence, theft, or misplacement. Unlike slow-moving or out-of-season items, damaged inventory typically has little to no recoverable value and is subject to a “write-off” rather than a “write-down.”

Valuing damaged inventory for write-off purposes involves determining its reduced worth. The primary method for valuing inventory under Generally Accepted Accounting Principles (GAAP) is the “lower of cost or net realizable value” (LCNRV). LCNRV dictates inventory be recorded at the lower of its historical cost or its net realizable value (NRV). NRV is the estimated selling price, less any estimated costs of completion and sale.

For example, if an item cost $100 but is now damaged and can only be sold for $20 after incurring $5 in disposal costs, its NRV is $15 ($20 – $5). When inventory is damaged beyond repair and has no selling value, its NRV becomes zero. This ensures assets are not overstated, providing accurate financial health representation.

Scrap value is another valuation consideration for damaged goods, representing the minimal amount obtained from selling components or materials no longer useful for their intended purpose. This value is determined by market prices for raw materials or recyclable components. It applies to damaged inventory that can be broken down and sold for its material components. Businesses must assess whether a damaged item has any remaining scrap value or if its value is truly zero, requiring a complete write-off.

Documentation and Timing for Write-Off

Proper documentation is essential when writing off damaged inventory to substantiate the loss for accounting and tax purposes. Comprehensive records provide clear evidence during audits and ensure compliance with financial reporting standards. Businesses should maintain detailed inventory count sheets, damage reports describing the damage and date, and photographs for visual proof.

Records of how the damaged inventory was disposed of are also important. This includes disposition records, such as receipts from salvage sales, donation acknowledgments, or certificates of destruction. Insurance correspondence and settlement documents must be retained if a claim is filed. Valuation assessments, detailing how the reduced or zero value was determined, should be part of the documentation.

The timing of an inventory write-off impacts financial statements and tax reporting. Generally, the write-off should occur in the accounting period when the damage was incurred or discovered, and the inventory is determined to have lost its value. This adheres to the matching principle, recognizing expenses when the loss becomes evident.

Inventory must be physically removed from saleable stock. This segregation reinforces that the inventory no longer holds value and prevents accidental sale. Businesses should not delay the write-off, as postponing recognition distorts financial statements by overstating assets and understating expenses. Timely identification and documentation ensures current and accurate financial records.

Recording the Write-Off in Your Books

Recording an inventory write-off involves journal entries to adjust financial records for asset loss. The goal is to remove damaged inventory from the balance sheet and recognize the expense on the income statement. When inventory has no market value, a direct write-off method is employed, recognizing the loss as an expense in that period.

A direct write-off debits an expense account (e.g., “Inventory Write-Off Expense”) and credits the “Inventory” asset account. For instance, writing off $5,000 in damaged inventory debits $5,000 to “Inventory Write-Off Expense” and credits $5,000 to “Inventory.” This reduces the inventory asset on the balance sheet and increases expenses on the income statement, reducing net income.

For immaterial losses, businesses might debit “Cost of Goods Sold” (COGS) instead of a separate expense account. This simplifies accounting by incorporating the loss into the overall cost of products sold. However, substantial write-offs are preferably recorded to a distinct “Inventory Write-Off Expense” account. This provides greater transparency and prevents gross margin distortion, allowing clearer financial analysis.

Larger businesses with recurring losses might use an “allowance method” for inventory obsolescence or damage. This involves creating a contra-asset account, like “Allowance for Obsolete Inventory,” credited with an estimated amount for future losses. When actual losses occur, this allowance account is debited, and the inventory account is credited. This approach spreads the impact of losses and aligns with GAAP by matching expenses with revenues. Accurate and timely adjustment of financial records ensures the balance sheet and income statement reflect the business’s true economic reality.

Tax Reporting of Damaged Inventory

Reporting damaged inventory for tax purposes involves understanding how write-offs impact taxable income and which forms reflect these adjustments. An inventory write-off is a deductible business expense, representing a loss of asset value. This deduction reduces a business’s net profit, lowering its overall tax liability.

An inventory write-off primarily affects a business’s tax return by increasing its Cost of Goods Sold (COGS). COGS is calculated as Beginning Inventory + Purchases – Ending Inventory. Writing off damaged inventory reduces ending inventory, which increases calculated COGS. Higher COGS leads to lower gross profit and taxable income. This adjustment ensures businesses are not taxed on worthless inventory.

Sole proprietors report this adjustment on Schedule C (Form 1040). Corporations report this on Form 1120, with inventory values and COGS detailed on Form 1125-A. Accrual method businesses can deduct the cost basis of unsellable inventory due to damage, spoilage, or obsolescence. The deduction must be taken in the year the loss occurred.

Inventory write-offs are generally tax-deductible, but proper documentation is important for IRS compliance. Detailed records, including damage reports, valuation assessments, and proof of disposal, support the deduction in case of an audit. Donated damaged inventory may qualify for a charitable contribution deduction, subject to IRS rules. If sold for salvage, the recovered amount reduces the deductible loss.