Inventory Disposal: Accounting and Tax Treatment

Inventory disposal is the process of removing unsalable, obsolete, or damaged goods from a company’s stock. This process arises when products can no longer be sold at their intended price or at all. Proper disposal is a component of maintaining accurate financial records, and handling these goods correctly ensures that a company’s financial statements reflect the true value of its assets, preventing an overstatement of inventory.

Effective management of unsalable stock also frees up physical space, reducing storage costs and allowing for more profitable items to be housed. The methods chosen for disposal have direct financial consequences, influencing tax liabilities and reported profits.

Identifying Inventory for Disposal

A business must first determine when its inventory has lost value to the point that it requires disposal or a write-down. Common triggers include physical damage from accidents, spoilage of perishable goods, and technological obsolescence that renders products outdated. Changes in consumer demand or the introduction of newer models can also leave a company with excess stock that is difficult to sell at its original price.

To formalize this evaluation, Generally Accepted Accounting Principles (GAAP) provide the Lower of Cost or Net Realizable Value (LCNRV) rule. This principle requires companies to value their inventory at either its original historical cost or its net realizable value, whichever is lower. Net Realizable Value (NRV) is the estimated selling price of the inventory in the normal course of business, minus any reasonably predictable costs of completion, disposal, and transportation.

The LCNRV calculation is a direct comparison. For instance, if a company paid $50 for an item (cost) but can now only sell it for $40 due to market changes, the NRV is $40. Since the NRV is lower than the cost, the company must write down the inventory’s value by $10, recognizing a loss. If there were an additional $2 cost to package and ship the item, the NRV would be $38, and the required write-down would be $12.

This evaluation is performed regularly, often at the end of each reporting period. When evidence exists that the NRV of inventory is lower than its cost, the difference must be recognized as a loss in that period. This process of identifying and valuing impaired inventory is the foundational step that precedes any physical disposal action.

Common Methods of Inventory Disposal

Once inventory has been identified as obsolete or impaired, a business has several practical methods for its removal. One common approach is liquidation, where the goods are sold at a significant discount to specialized liquidation companies or directly to consumers through clearance sales. This method allows a business to recover a portion of the inventory’s cost quickly, converting unsalable goods into cash. The primary goal is loss mitigation rather than profit generation.

Another method is donating the inventory to a qualified charitable organization. For this to be a valid option with tax benefits, the recipient must be a registered 501(c)(3) organization. Businesses may choose this route to support community causes while clearing out stock. It can also generate goodwill and positive brand association, but the business must receive proper documentation of the donation for its records.

A final option is the physical destruction or scrapping of the inventory. This method is sometimes necessary for defective or recalled products to prevent potential liability or harm to consumers. Businesses also use destruction to protect brand integrity, ensuring that deeply discounted or substandard goods do not flood the market and devalue the brand’s image. When choosing this path, it is important to meticulously document the destruction process to create a clear audit trail for financial and tax reporting.

Accounting and Tax Treatment

The financial recording of inventory disposal begins with a write-down, which adjusts the inventory’s value on the balance sheet. When inventory is identified as impaired, its value is reduced, and a loss is recognized on the income statement. This loss is recorded as an increase in the Cost of Goods Sold (COGS) or in a separate expense account for inventory losses. For example, if inventory costing $1,000 is written down to an NRV of $200, the journal entry would be a debit to COGS for $800 and a credit to Inventory for $800.

Each disposal method carries distinct tax consequences. When inventory is liquidated by selling it for less than its cost, the transaction generates a business loss. This loss directly reduces the company’s taxable income. The loss is calculated as the difference between the inventory’s carrying amount and the cash received from the sale.

Donating inventory to a qualified charity can create a tax deduction. A business can deduct the fair market value of the donated goods, but this is often limited to the cost basis. For C corporations, an enhanced deduction may be available under Internal Revenue Code Section 170. This allows a deduction equal to the inventory’s cost plus half the difference between its fair market value and cost, capped at twice the cost.

Filing requirements for these donations depend on the business structure. Individuals, partnerships, and S corporations must file IRS Form 8283 for noncash contributions over $500. C corporations are only required to file the form if the deduction exceeds $5,000.

If inventory is destroyed or scrapped, its cost can be deducted as a loss from business income, often treated as an abandonment loss. To substantiate the deduction, the business must maintain thorough records proving the inventory was physically destroyed and cannot be sold or used in the future. This includes documentation detailing the items destroyed, their cost, the date of destruction, and the reason for the disposal.