No company wants to deal with damaged inventory, but errors and accidents are unavoidable. Workers drop boxes, trucks leak in the rain, and manufacturers make mistakes during production. The good news is that there are ways to financially account for ruined inventory and make the loss easier to bear.
When damage happens and items are no longer fit to sell, you can write them off. Inventory write-offs help your financial records reflect your inventory’s actual value and minimize the impacts of damage and loss.
Here’s a guide to writing off damaged inventory, accounting for write-offs, and understanding their benefits. Jump to the end if you’re here to discover how Fishbowl streamlines all your inventory management needs.
Understanding inventory write-offs
Inventory write-offs are a company’s chance to remove the value of dead stock — inventory that has become unsellable — from its financial records. This is necessary when inventory becomes damaged, obsolete, lost, stolen, or otherwise unusable.
Write-offs ensure the inventory value in your books matches its actual value. An item you’d sell for $50 is worth $0 when it’s damaged beyond repair. Since generally accepted accounting principles (GAAP) require you to record all assets, including inventory, write-offs help you comply with these standards.
Inventory write-offs are commonly confused with inventory write-downs, but these are two different processes. While a write-off removes the entire value of damaged inventory, a write-down records inventory you can still sell but that has declined in value.
Suppose a clothing retailer discovers that a shipment of sweaters got wet during shipping and can’t be fixed. In that case, the retailer would write off the entire value of those sweaters from their inventory. But if the sweaters aren’t damaged — just out of season and thus can be sold at a 50% discount — the retailer would write down the value of that inventory to reflect the reduced price.
How to write off inventory in 5 steps
If you have damaged inventory, write it off by following these five steps.
1. Evaluate inventory
Start by conducting a thorough inventory inspection to identify damaged items. Depending on your inventory management system, you might be tracking inventory periodically (like once a year) or perpetually (with ongoing, real-time updates). Both options offer insight into item quantity and quality and facilitate opportunities to notice damaged goods, like inventory audits. Then, determine the extent of the damage and identify any items that are unsellable or unusable.
2. Estimate losses
Next, determine the financial impact of the damaged inventory by calculating the total cost. This is the amount of money you paid for them, not the price you would have sold them for.
Choose an inventory valuation method to estimate these losses accurately. For example, with the first-in, first-out (FIFO) method, you’d apply the cost of the oldest inventory items to the damaged goods. This method assumes that the earliest purchased or produced items would have been sold first, so the cost of these older items is most accurate.
3. Adjust financial records
After estimating the damaged goods’ financial impact, update your financial statements to reflect this loss accurately. Here are the two most popular damaged inventory accounting methods.
Direct write-off method
This reduces the value of the inventory account by the write-off amount. Make a journal entry that credits the inventory asset account with the value of the write-off. Then, debit the inventory write-off expense account the same value. The change to the expense account reduces your company’s net income on its income statement and decreases shareholder equity in the balance sheet.
If the loss of inventory is immaterial, which means it only accounts for a small percentage of inventory, charge it to the cost of goods sold (COGS) account instead of a separate one. This simplifies the accounting process by combining smaller losses with overall COGS, but it could also make the gross margin less accurate. If the inventory write-off is significant — for example, if a fire or flood destroys a significant portion of inventory — you’d list it as a non-recurring loss.
Allowance method
Create a journal entry that credits the write-off to a contra-asset account (like “allowance for obsolete inventory” or “inventory reserve”). Then, debit the same value to an expense account. This method is best when the value of the inventory items is reduced, but they haven’t been disposed of — for example, if a toy is returned with a broken component.
If you’ve already disposed of the items, credit the inventory account and debit the inventory reserve account. This records the historical cost of the original inventory account.
4. Decide on an inventory removal option
Damaged inventory takes up valuable warehouse space better used for sellable goods. To get rid of the damaged stock, you have a variety of options to choose from, including disposal, donation, and recycling. Disposal is often the most viable option because it’s the fastest and cheapest, though it’s best to create as little warehousing and manufacturing waste as possible.
5. Document inventory accurately
In case of a tax audit or financial review, you may be asked to provide proof of write-offs. Before disposing of damaged inventory, gather evidence of the losses. For example, take photos of damaged goods to show the extent of the damage and support the claims.
3 benefits of inventory write-offs
Inventory write-offs aren’t just a practical way to handle damaged stock — they also offer several strategic benefits. Here are three key advantages:
- Reduced tax liability: Inventory write-offs record losses as expenses and reduce net profits. This lowers your taxable income for the period, potentially reducing tax liability and softening the impact of the inventory loss on cash flow.
- Enhanced inventory management: Formally noting inventory loss keeps stock records as accurate as possible. Taking this step prevents inventory shrinkage or a mismatch between the amount you have recorded and what’s actually in stock, creating a safeguard against discrepancies that could impact your bottom line.
- Improved loss prevention: Regularly writing off damaged inventory can highlight recurring issues or inefficiencies in your accrual and storage practices. Identifying patterns gives you the necessary information to implement better loss prevention strategies. For example, improve delivery processes, adjust the warehouse setup, or store easily damaged items in safer areas.
Take control of inventory with Fishbowl
Don’t worry about finding new ways to track damage to your inventory. Instead, try Fishbowl.
Fishbowl’s inventory management software makes it easy to optimize operational efficiency and spot patterns of loss. Plus, with Fishbowl’s seamless QuickBooks integration, you don’t have to add information to both platforms — they’ll share information back and forth to help you focus on more important tasks. Experience the benefits of precise inventory management and reliable financial reporting by booking a demo with Fishbowl today.