There are many ways products can become unsaleable: Water damage, expiration, theft, and obsoletion to name but a few. And every time this happens, an inventory write-off must follow.
Link Reporting Co-founder and all-round accounting expert, Will McTavish, explains what inventory write-offs are, why they matter, and how to conduct one.
What is an inventory write-off?
An inventory write-off is the process of removing inventory items from your stock on hand list. This is done when items are no longer saleable due to being damaged, spoiled, stolen or becoming otherwise obsolete.
Inventory write-offs vs inventory write-downs – what’s the difference?
An inventory write-off is where the item is removed from stock-on-hand, which means the full cost of the item is removed from the balance sheet. Effectively the stock no longer exists.
An inventory write-down, however, is where the value of the stock is reduced, but the item is still available for sale.
Inventory write-downs can occur for a number of reasons:
- The stock has aged and no longer has the same sell value due to a newer version of the stock being available. Under these circumstances, we may want to recognise a loss of the value of the stock we are holding so would conduct an inventory write-down.
- The market value for the stock has changed due to an oversupply. In this situation, we may want to record a loss of the value of the stock we are holding to represent what the new market cost would be.
- We have receipted the stock value incorrectly and want to update the value of the stock to reconcile what it should have been, had the mistake not been made.
It’s important to note inventory write-ups are also possible. These can happen if the inverse of the above three situations were to occur.
- Learn more: The Unleashed Inventory Accounting Guide
What’s the purpose of an inventory write-off?
The purpose of an inventory write-off is to ensure the stock on hand available in our inventory system is a true representation of the actual stock on hand we have available for sale.
If we had 100 coffee mugs for sale, and we broke 5 of them, we would need to write off this stock, so we only show 95 available for sale. Without an inventory write-off, we could end up in a situation where we sell 100 but are only able to deliver 95.
Inventory write-offs help guarantee the accuracy of your stock on hand values.
Consequences & legal implications of an inventory write-off
Because an inventory write-off can reduce a company’s tax liability they need to be processed with the proper care and consideration.
However, there are generally no legal implications of an inventory write-off, unless the business is operating in a sector which is highly regulated. Examples include sectors such as the cannabis industry, where stock-write offs need to be carefully documented and disclosed to third parties.
The main implication of a stock write-off is how we account for it.
When $100 of stock is written off, the following journal entry would be processed:
Dr Cost of Goods Sold $100
Cr Stock on Hand $100
This entry means we are increasing our cost of goods sold by $100 and reducing our stock on hand by $100.
There are three main implications to this journal entry:
- We have reduced the company’s current assets on the balance sheet by $100. Stock on hand is recognised on the balance sheet as a current asset, so when inventory is written off, the value of our current assets is reduced by the value of the inventory write-off.
- We have increased the expenses on the profit and loss by $100. In a perpetual inventory system, we recognise the cost of the stock when we sell it (not when we buy it). As we are not able to sell it, and are instead writing it off, this is the time to recognise the cost.
- We have reduced our tax liability. As we have recognised a $100 expense, this reduced our profit by $100, and therefore the tax we need to pay on it. Assuming a 30% company tax rate, we have reduced our tax liability by $30.
Reducing our tax liability is the real-life impact of a stock write-off and the reason they should be processed with diligence.
When should you consider an inventory write off?
Inventory write-offs can be processed at any time, but generally, the earlier the better. As soon as the business becomes aware of stock that needs to be written-off, it should be processed.
There are a number of reasons this is a good idea:
- The business will have more up-to-date information regarding true stock on hand values. This creates trust among the team that the values are correct and are more likely to be relied on.
- It reduces the chance of a customer ordering an item that is no longer available. This can create a lot of work for the team as they would need to contact the customer for a refund or explain the delays on shipping the item.
- It allows the procurement team to see if stock is getting low and needs to be ordered.
Writing off stock as soon as possible allows the business to function better without creating delays for customers and creating additional work for the team within the business. There are, however, times the team may not know about stock that needs to be written off, which is why monthly, or annual stock takes are conducted.
Learn more: What is Inventory Replenishment & Why Does it Matter?
Stocktakes and inventory writes-offs
A stocktake is the process of counting the quantity of units on hand for a business and reconciling these against what is in the inventory system.
The more often this is done, the more reliable the business' stock on hand values are.
Stocktakes are time-consuming and therefore an expensive exercise. But they must be done at least once a year to ensure accurate accounting records.
A business' annual stocktake is generally done at the end of the financial year. This is because the values counted are then used to write-off any stock that is lost, broken or stolen, and therefore the tax liability is updated to reflect this.
How do you conduct an inventory write-off?
To write-off inventory follow these steps:
- Identify the stock items that need to be written off. This could be from a stock take, or an event such as a breakage, theft, or where you have identified items as lost.
- Log into your inventory system.
- Create a stock adjustment.
- Select the warehouse in which you wish to write the stock off.
- Enter the code for the item you wish to write off.
- Enter the quantity you would like to adjust by. Most inventory systems will use a negative value to denote a reduction in quantity, and a positive to value to denote an increase.
- The inventory system should automatically generate the value of this write-off. This will be based on the costing method the inventory system uses. This may either be Average Landed Cost or FIFO. Leave the pre-populated cost of the write-off unless you have a reason for (and understanding of) why this should be changed.
- Select your adjustment reason. Your inventory system may allow you to set up and customise you adjustment reasons. This can be helpful in identifying and reducing the reasons for writing off stock.
- Select your write-off expense account. This will be explained further in the next section.
- Complete the stock adjustment.
An inventory write-off can be conducted in 10 easy steps – just be sure to make a note of the reason for each write-off to refer back to later.
How does an inventory write-off affect COGS?
When processing an inventory write-off, the following journal entry is processed:
Dr Cost of Goods Sold $100
Cr Stock on Hand $100
This entry assumes the value of the stock we wrote off was $100.
To understand this, we first need to look at what happens when we purchased the stock.
In a perpetual inventory management system, when we purchase stock, it is recognised on the balance sheet but not on the profit and loss as an expense.
Here is the journal entry for purchasing stock:
Dr Stock on Hand $100
Cr Cash on Hand $100
Here we have purchased $100 of inventory using the funds in our cash on hand. This is represented by a debit to our stock on hand for $100 (which is an increase), and a credit to our cash on hand for $100 (which is a decrease).
Our net assets have not changed. We have simply traded one current asset (cash) for another current asset (stock on hand).
You’ll note that in this journal there is no recognition of the cost of the inventory. One asset has been exchanged for another, but there has been no entry made to our profit and loss to recognise the expense.
When we sell the inventory (for $300), we would recognise the sale as follows:
Dr Cash on Hand $300
Cr Sales Revenue $300
Dr Stock on Hand $100
Cr Cost of Goods Sold $100
There are two entries here.
The first entry is to recognise the sale and the cash coming in. We have a debit to our Cash on hand for $300 (an increase to our assets), and a credit to our Sales Revenue for $300 (an increase to our revenue).
The second entry is to recognise the inventory that has left our business. We have a debit to our Stock on hand for $100 (which decreases our assets), and a credit to Cost of Goods Sold (which increases our expenses).
Overall, we have $300 of sales revenue and $100 of cost of goods sold, giving us a $200 profit.
Now let’s look at the situation where we have to write the inventory off, rather than sell it.
So far, we have this entry from earlier when we purchased the inventory:
Dr Stock on Hand $100
Cr Cash on Hand $100
So we have $100 of Stock on Hand, but nowhere have we recognised the cost of the inventory on the profit and loss. When we write it off, we need to recognise its cost, and that our stock on hand has decreased.
Here is the journal:
Dr Cost of Goods Sold $100
Cr Stock on Hand $100
We have a debit to increase our Cost of Goods Sold for $100 (an increase to our expenses), and a credit to our Stock on Hand for $100 (a decrease to our assets).
We may want to use a different account when we write stock off for our Cost of Goods sold, such as "Stock Write-offs” or “Damaged/Lost Stock”. This allows us to separate out our true cost of goods sold verses the stock we have to write off.
If you do choose to use a separate expense account, it’s important it is located in the same section as your cost of goods sold expense account. That way your Gross Profit will not be affected by this approach.
Here is what the alternative journal would look like:
Dr Stock Write-offs $100
Cr Stock on Hand $100
This journal achieves the exact same as the one above, but it is more clear what happened to the inventory by looking at this journal.
By separating the COGS from the stock that needs to be written off, your gross profit will be unaffected by inventory write-offs.
Tax implications of an inventory write off
Businesses pay income tax on their profit. Profit is calculated by taking the total revenue, less the total expenses in a business. One of these expenses is cost of goods sold.
This means any increase to our cost of goods sold reduces our profit, and therefore the amount of tax we need to pay.
When a business writes inventory off, it creates an entry to cost of goods sold, which reduces its profit, and therefore the amount of tax it needs to pay.
For this reason, it’s important to be diligent when processing inventory write-offs because it has a real impact on your tax implications.
3 ways to avoid inventory write-offs
- Ensure your business has a clear Standard Operating Procedure (SOP). An SOP is a written set of instructions that outlines the steps taken in a specific process or activity. An SOP will help team members follow process which will help avoid stock being stolen, lost or damaged.
- Complete stock takes more regularly. This will allow you to identify issues and correct them faster, rather than waiting till the end of financial year each time. Keep in mind stock takes are time consuming and therefore expensive, so doing mini stock takes on sections of the business while staff have downtime is a good way to mitigate this cost – they are being paid anyway!
- Use a good inventory management system like Unleashed. A good inventory system will reduce the time required to fulfill all the functions within the business, while providing deeper visibility into the numbers, allowing better decisions to be made.
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