What Is an Inventory Write-Off?
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 may be handled in the company's books by charging it to the cost of goods sold or by offsetting the obsolete inventory allowance.
Understanding Inventory Write-Off
Inventory refers to assets owned by a business to be sold for revenue or converted into goods to be sold for revenue. The Generally Accepted Accounting Principles (GAAP) require that any item that represents future economic value to a company be defined as an asset. Since inventory meets the requirements of an asset, it is reported at cost on a company’s balance sheet statement under the current assets account. In some cases, the stock that a business holds in its inventory may become obsolete, spoil, become damaged or be stolen or lost. When these situations occur, a company must write the inventory off.
- An inventory write-off is the formal recognition of a portion of a company's inventory that no longer has value.
- Inventory write-offs typically happen when stock become obsolete, spoils, becomes damaged or is stolen or lost.
- If inventory only decreases in value, instead of losing it completely, it will be written down instead of written off.
Accounting for Inventory Write-Off
An inventory write-off is the process of removing from the accounting books any inventory that has no value. Items that companies commonly write off include uncollectable accounts receivable and obsolete fixed assets.
To write-off inventory, a business will record in its journal entry a credit to the inventory account and a debit to the inventory write-off expense account. For example, say a company with $100,000 worth of inventory decides to write-off $10,000 in inventory at the end of the year. First, the firm will credit the inventory account with the value of the write-off to reduce the balance. The value of the gross inventory will be reduced as such: $100,000 - $10,000 = $90,000. Next, the inventory write-off expense account will be credited to reflect the loss.
The expense account is reflected in the income statement, reducing the firm’s net income and, thus, its retained earnings. A decrease in retained earnings translates into a corresponding decrease in the shareholders’ equity section of the balance sheet.
If the inventory write-off is immaterial, a business will often charge the inventory write-off to the cost of goods sold (COGS) account. The problem with charging the amount to the cost of goods sold account is that it distorts the gross margin of the business, as there is no corresponding revenue entered for the sale of the product. Most inventory write-offs are small, annual expenses; a large inventory write-off (such as one caused by a warehouse fire) may be categorized as a non-recurring loss.
Large, recurring inventory write-offs can indicate that a company has poor inventory management. The company may be purchasing excessive or duplicative inventory because it has lost track of certain items or it is using existing inventory inefficiently. Companies that don't want to admit to such problems may resort to dishonest techniques to reduce the apparent size of the obsolete or unusable inventory. These tactics may constitute inventory fraud.
Inventory Write-Off vs. Write-Down
If inventory still has some value, it will be written down instead of written off. When the market price of inventory falls below its cost, accounting rules require that a company write down or reduce the reported value of the inventory on the financial statement to the market value. The amount to be written down is the difference between the book value of the inventory and the amount of cash that the business can obtain by disposing of the inventory in the most optimal manner. Write-downs are reported in the same way as write-offs, but instead of debiting an inventory write-off loss account, an inventory write-down loss account is debited.
An inventory write-off (or write-down) should be recognized at once. The loss or reduction in value cannot be spread and recognized over multiple periods, as this would imply that there is some future benefit associated with the inventory item.