Inventory Write-Off: All That You Need to Know
Inventory write-off refers to the accounting process of reducing the value of the inventory that has lost all of its value. The inventory may lose its value due to damage, deterioration, loss from theft, damage in transit, changes in market demands, misplacement etc.
Inventory write-offs are done to support accounting accuracy objectives while also reducing the tax liability for business owners. It’s done by charging it to the cost of goods sold or by balancing the obsolete inventory allowance in the books.
What this article covers:
- How to Write-Off Inventory
- When Should Inventory Be Written Off?
- How to Write-Off Damaged Inventory?
- How Does a Write-Off Affect the Income Statement?
How to Write-Off Inventory
When the inventory loses its value, the loss impacts the balance sheet and income statement of the business. The amount to be written off is the cost of the inventory and the amount of cash that can be obtained by selling off or disposing of the inventory in the most optimal manner.
If specific inventory items have not been identified, businesses can set up a reserve for inventory write-offs. To write-off inventory, you must credit the inventory account and record a debit to the inventory.
If you decide to write-off $20,000 worth of inventory from the $80,000 worth of inventory that your business has at the end of the year, you must first credit the inventory account with the value of the write-off to reduce the balance.
The value of inventory to be written off is:
$80,000 – $20,000 = $60,000.
Next, credit the inventory shrinkage expense account in the income statement to reflect the inventory loss. The expense item, in any case, appears as an operating expense.
The impact of this is:
- A reduction of the business’ net income and therefore, its retained earnings.
- The reduction in retained earnings, in turn, decreases the shareholders’ equity in the balance sheet.
If the inventory write-off is inconsequential, the inventory write-off is charged to the cost of goods sold account. The problem with this is that it distorts the gross margin of the business, as there is no matching revenue entered for the sale of the product.
When Should Inventory Be Written Off?
The accurate value of inventory is crucial in calculating gross profit or loss. This is why it’s important for businesses to account for inventory write-off when the value of inventory changes significantly.
This could happen due to the following reasons:
- Inventory is stolen by shippers, shoplifters or employees
- Inventory, such as fruits and flowers, maybe spoilt due to their short shelf life
- Damage due to inadequate storage and handling
- Items such as technology products with high market value can become obsolete after a few months
While most businesses do an inventory write-off at the end of each year, if you have a large inventory, you should account for significant changes once every month.
How to Write-Off Damaged Inventory?
- Examine the stock when it arrives to identify goods that might have been damaged and place it in a designated area. Prepare a damage report for each damaged inventory item.
- Calculate the value of the damaged inventory at the end of the accounting cycle to write-off the loss.
- The damaged stock is valued at fair market value, which is the current purchase price for the same inventory items. This amount may be lower than the original purchase price.
- Set up an inventory write-off expense account to record the value of the damaged inventory. Every time you make an entry in the inventory write-off expense account, you reduce the amount of inventory carried on the books.
- Debit the cost of goods sold (COGS) account and credit the inventory write-off expense account. If you don’t have frequently damaged inventory, you can choose to debit the cost of goods sold account and credit the inventory account to write off the loss.
How Does a Write-Off Affect the Income Statement?
If you’re writing off small amounts of inventory, you don’t require separate disclosure on the income statement. Instead, the loss is included in with the COGS amount.
However, if you’re writing off large dollar amounts of inventory, it has to be disclosed on your income statement. A separate account such as inventory write-off expense account is included with the other inventory accounts. The loss this account should appear on the income statement each time inventory is written off.
It’s vital to remember that the loss or reduction in value of inventory cannot be spread and recognized over multiple periods, as this would imply that there is some future benefit associated with the inventory item. This is why inventory write-off must be recognized at once.