Inventory Write Off: Reasons, Recording, and Tax Rules

An inventory write-off is an accounting process that recognizes a loss when a portion of a company’s inventory can no longer be sold at its normal price or has become worthless. This adjustment is necessary for maintaining accurate financial statements because it ensures that the company’s assets are not overstated. The process provides a clearer picture of the business’s financial health by reflecting the true economic condition of the inventory.

Common Reasons for an Inventory Write-Off

A primary trigger for writing off inventory is obsolescence. This occurs when products become outdated or are superseded by newer versions, leaving the older stock with little to no demand. For example, a retailer holding a large stock of last year’s smartphone model would likely need to write-off that inventory as consumers gravitate toward the latest release.

Damage is another frequent cause for an inventory write-off. Goods can be harmed during shipping, handling in a warehouse, or due to unforeseen events like floods or fires. For instance, a pallet of glass vases cracked during transit cannot be sold at full price, necessitating a write-off to account for the loss.

For businesses dealing with perishable items, spoilage is an expected reason for write-offs. Food products, flowers, and certain pharmaceuticals have a limited shelf life and must be sold before their expiration dates. A grocery store that overestimates demand for fresh berries will have to dispose of any unsold, expired stock. This predictable loss is a regular part of business for such industries and is managed through write-offs.

Theft and other forms of loss, often referred to as inventory shrinkage, also lead to write-offs. This can range from customer shoplifting to employee theft or administrative errors where inventory is misplaced. When a physical count of inventory reveals fewer items than are listed in the accounting records, the value of the missing goods must be removed from the books.

A decline in market value forces a write-off when the cost to acquire or produce inventory is higher than what it can be sold for. If a company purchased a raw material for $50 per unit, but a global oversupply causes the market price to drop to $30, it must write down the value of its existing stock to reflect the new market reality.

Determining the Write-Off Amount

The calculation of an inventory write-off is guided by valuing inventory at the lower of its cost or market value. The specific rule depends on the inventory accounting method a company uses. Businesses using First-In, First-Out (FIFO) or average cost apply the “Lower of Cost or Net Realizable Value” (LCNRV) rule, while companies using Last-In, First-Out (LIFO) or the retail inventory method follow the “Lower of Cost or Market” (LCM) rule. These principles prevent companies from overstating the value of their assets.

“Cost” is the original purchase price of the inventory, including costs incurred to bring the goods to their existing condition, such as shipping fees. “Net Realizable Value” (NRV) is the estimated selling price in the ordinary course of business, less any predictable costs of completion, disposal, and transportation.

The process involves an item-by-item comparison. For each product, the historical cost is compared against its calculated NRV. If the cost is lower than the NRV, no adjustment is needed. If the NRV is lower than the cost, the difference between the two figures is the required write-off amount.

For example, a company holds tablets purchased for $100 each. Due to a new model release, the company estimates it can only sell the tablets for $70 each and will incur $5 per tablet in shipping costs.

In this scenario, the Net Realizable Value is $65 ($70 selling price – $5 shipping costs). Comparing the $100 cost to the $65 NRV, the NRV is lower. The company must therefore write down the value of each tablet by $35 ($100 Cost – $65 NRV), which is the per-unit write-off amount.

Recording the Inventory Write-Off

Once the write-off amount is determined, it is recorded with a journal entry. This entry affects both the balance sheet and the income statement, ensuring financial reports reflect the reduction in inventory value. The entry decreases the company’s reported assets and its net income for the period.

The standard journal entry for an inventory write-off involves a debit to an expense account and a credit to the inventory account. The debit increases an expense, which reduces profitability, while the credit decreases the inventory asset on the balance sheet.

There are two common accounts for the debit. For smaller, recurring write-offs, such as minor spoilage, the amount is often debited directly to the Cost of Goods Sold (COGS) account. For larger or unusual write-offs, such as those from a major flood, a separate expense account titled “Inventory Write-Off Expense” is often used. This provides greater transparency on the income statement.

The credit portion of the entry is a direct credit to the Inventory asset account, which reduces the book value of the inventory on the balance sheet. Using the previous example where the write-off was determined to be $35 per tablet for 100 tablets, the total write-off is $3,500. The journal entry would be a debit of $3,500 to Inventory Write-Off Expense (or COGS) and a credit of $3,500 to Inventory, which reduces total assets and lowers pre-tax income by $3,500.

Tax Treatment and Documentation

The tax rules for deducting an inventory write-off are more stringent than financial accounting requirements. While Generally Accepted Accounting Principles (GAAP) require a write-off as soon as a loss in value is identified, the Internal Revenue Service (IRS) requires more definitive proof for a tax deduction.

To claim a deduction for worthless inventory, a business must demonstrate that the goods have no value and have been physically disposed of. This is often accomplished by destroying the inventory or selling it for scrap. The IRS requires evidence that the business has abandoned the goods, meaning they cannot be retained for future sale or use.

When inventory has declined in value but is not worthless, tax rules allow for a deduction before the item is sold under specific conditions. If a business offers the devalued inventory for sale at a price lower than its cost, it can value that inventory at the lower price for tax purposes at the end of the year. This is permitted as long as the offer for sale was made within 30 days of the inventory valuation date.

Thorough documentation is necessary to substantiate an inventory write-off deduction with the IRS, as businesses must maintain records that serve as proof of the loss. This documentation can include:

• Detailed inventory count sheets showing the items in question
• Photographs of damaged or obsolete goods
• Records of disposal, such as a certificate of destruction or a receipt from a scrap yard
• A receipt from a qualified charitable organization for donated inventory

Without this evidence, the IRS may disallow the deduction.