It’s inevitable for some inventory to become obsolete, damaged, spoiled, stolen, lost, or returned. Damaged inventory, which may include things like holiday returns and damaged goods, needs to be recognized on a cost basis in cost of goods sold (COGS) under the assumption that a certain level of damage is expected during normal business operations.
Accounting for inventory of damaged goods will entail a journal entry that involves debiting the cost of the goods sold and crediting the inventory. Also called an “inventory write-off,” or just a “write-off,” damaged inventory is formally recognized as a portion of a company’s inventory that no longer holds value.
Inventory refers to all the assets that a business owns to be sold for revenue or to be converted as goods that also must be sold. The Generally Accepted Accounting Principles (GAAP) stipulate that items representing a future economic value to a company must be defined as an asset, and inventory meets the requirements of an asset.
As such, it is reported at cost on a company’s balance sheet under current assets.
Accounting for inventory write-off
Accounting for damaged inventory is the process of removing any inventory with no value from the general ledger. This can be done in two ways:
With the direct write-off method, businesses will record a debit to the expense account and a credit to the inventory asset account. For instance, a company with $500,000 worth of inventory writes off $50,000 by the end of the year.
The company will first have to credit its inventory account with the write-off value to reduce the balance. This will reduce the value of their gross inventory to $450,000. The inventory write-off expense account will then be increased with a debit reflecting the loss.
The expense account, which is likewise reflected in the income statement, will reduce the company’s net income and retained earnings. The decrease in retained earnings will then translate to a corresponding decrease in shareholder equity in the balance sheet.
Immaterial inventory write-offs will often be charged to the COGS account. One issue with this, though, is that charging the amount to the COGS account may distort the company’s gross margin. This is because no corresponding revenue will be entered for the product’s sale. Larger inventory write-offs, however, like those caused by a fire or flood, will be categorized as non-recurring losses.
The allowance method is ideal when inventory can be appropriately estimated to have lost value but has not yet been disposed of (such as returns). Through the allowance method, a company will record a journal entry with a credit to a contra-asset account (i.e., allowance for obsolete inventory or inventory reserve). Then, an offsetting debit will also be made to an expense account.
If the asset has been disposed of, then the inventory account will need to be credited. The inventory reserve account will also be debited to reduce both. This method is ideal for preserving the historical cost of the original inventory account.