An inventory write-off is an accounting term for the formal recognition of a portion of a company’s inventory that no longer has value. An inventory write-off can be recorded in two ways. It can be expensed directly to the cost of goods sold (COGS) account or it can offset the inventory asset account in a contra asset account. This is commonly referred to as the allowance for obsolete inventory or inventory reserve.
What Is An Inventory Write-Off?
An inventory write-off is a business process where one removes or reduces the costs of the items in their inventory that no longer is of significant value. This is important, especially when the inventory items get damaged, misplaced, stolen or changes occur in a market at a specific point. Items that a company usually writes off are the supplies they use to conduct their business or the products they sell. There are two main types which are:
- Direct method: In the direct method of writing off an inventory, a business can remove an item from its accounting records immediately after pointing out its loss of value. They do this by introducing a debit line item in their expense account and a credit line item in the asset section of their balance sheet.
- Allowance method: With the allowance method of writing off an inventory, a business can remove some value or amount from an item that is damaged or has experienced a loss in value but is something they have not yet removed from their stock. In this method, a company might create a credit line item for a contra asset account and a debit line item in the category of expenses.
Writing-off inventories vary from inventory write-downs. For example, when the value of an item in your inventory goes below its price, you can record it as an inventory write-down. In such cases, you can either write down the product or reduce the reported value of the inventory on the financial statement to the market value. This amount is the difference between the item’s value and the amount the company can earn by either getting rid of it or selling it. Companies report write-offs and write-downs in the same manner.
When To Conduct Write-Off Inventory
Stolen inventory
Businesses can face the issue of stolen inventory at any stage in the supply chain. It is not uncommon for a company to experience this even before the stock reaches them. When a business learns that its inventory counts do not match, it points to the case of stolen inventory.
Damaged inventory
All items in the inventory may not reach a business in pristine condition. It might get damaged if there is an issue with the supply chain, because of which it can stop functioning properly, leading to damaged products. This makes the item unsellable, causing a company to write it off.
Irrelevant inventory
An item that is popular in the present might not remain popular or relevant months later. With new market trends emerging, the demands also continue to change. Because of this, when a product is irrelevant, you may write it off or perform the recommended actions by the company for which you work.
Perishable inventory
Perishable inventory is an issue mainly for the businesses that sell food, beverages and anything else that is perishable. You may avoid this if you do not overbuy or take a careful look at the dates, but if something reaches its expiration date, writing it off is often the viable option. This makes it essential that you keep monitoring the items that can perish quickly.
Benefits Of Writing Off Inventory
- Reduces tax liability: When you do write-offs, you also reduce the tax you owe, as there is a decrease in your assets account.
- Updates products: A company may sometimes write things off, as they are no longer relevant. This helps you determine the expenses related to low-value inventory, aiding you in identifying whether your items are current.
- Improves inventory management: Writing-off inventories can help manage the inventory efficiently to minimise related expenses. You can review the company’s products, check their value and see if something is removable.
- Identifies risks: If you frequently come across items destroyed because of theft or natural disasters, write-offs help you prepare better for such situations to prevent future losses.
- Increases the accuracy of financial documents: Recording the values of the assets is much simpler when companies involve their written-off inventories. This helps you monitor and identify the products that have decreased in their value and assess their costs.
How To Conduct Inventory Write-Offs
1. Keep an updated record of the finances
Different types of transactions require different write-offs when recording them. First, maintain the sections in your balance sheets, such as an inventory reserve, cost of goods sold (COGS) account and contra asset section. Then, for each transaction, the business can record the cost under the expenses section and remove the asset’s value through crediting.You can record immaterial losses in the COGS section of your income statement. With damaged inventory, the company may register a debit item in the category of expenses while recording a credit in a contra asset account. Recording the nonrecurring losses as footnotes can be helpful, as it becomes convenient to exclude while calculating costs.
2. Assess your inventory
As you evaluate and assess the inventory, you might identify which method is best suited to write off the required items. For instance, if the goods get damaged because of natural calamities such as floods or cyclones in such a way that you cannot fix them, you may use the direct method and get rid of them immediately. Recording different types of write-offs become more manageable when you identify the inventory affected and how you might go ahead with them.
3. Evaluate the impact
After determining the inventory that got affected, you can then evaluate its impact on the accounting records and the business. If the inventory that you write-off does not have substantial value or is not likely to affect the company significantly, you might charge the write-off to the COGS expense account. In the instance of material write-offs, record them in accounts that do not ultimately impact the gross margin calculation. For the more significant write-offs, you might choose to categorise them as nonrecurring losses.
4. Analyse removal options
Businesses might wish to get rid of their written-off inventories from their stock. Before doing so, go through the various options based on your situation. For instance, in the scenario of stolen items, there may not be anything which can require disposal. With damaged merchandise, a company can consider donating them. You might also keep a written-off item, such as something that has lost its market value, if it gains its value back in the future.
5. Record your inventory
When documenting the write-offs, it is imperative that you record the inventory before getting rid of it. This is important so that it matches the financial records if you ever wish to review them in the future. It includes keeping receipts of the items you donate or taking pictures of the things that got destroyed because of natural disasters such as floods. Such evidence can also serve as proof for any taxation purpose.
FAQs
What Is Obsolete Inventory?
Obsolete inventory is an item or items that a business can no longer sell. They may have been replaced in the marketplace by an improved or less expensive product or model. Businesses are consequently forced to write off or write down their value or cost in their accounting records.
What Is GAAP?
Generally Accepted Accounting Principles or “GAAP” is a set of accounting standards established by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). These standards govern how financial statements are prepared by organizations, companies, governments, and nonprofits.
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