How do I account for inventory that was damaged, spoiled, stolen, or that I can no longer sell?

What happened to the goods, and what does that decide?

One symptom, goods worth less than the books say, covers six situations, each with its own treatment and period:

Where that period is already closed or reported, follow the closed-period practice in the timing section below.

The label also decides the evidence. IRS Publication 547 defines a casualty as the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual. It describes an unusual event as one that isn't a day-to-day occurrence and isn't typical of the activity in which you were engaged; record routine breakage in handling or storage as ordinary damage, not a casualty. The publication defines a theft as the taking and removing of money or property with the intent to deprive the owner of it, and says the taking must be illegal under the law of the state where it occurred and done with criminal intent. The same publication says the simple disappearance of money or property is not a theft, although an accidental loss or disappearance can qualify as a casualty if it results from an identifiable event that is sudden, unexpected, or unusual. It also sets progressive deterioration apart from casualties, because that damage results from a steadily operating cause or a normal process rather than from a sudden event. Ordinary spoilage of ageing stock fits that description.

How do you measure goods that leave inventory, and goods that stay at a lower value?

Goods that are gone leave at the cost carried in the item records, under the costing method the business already uses; choosing that method is a separate question.

Goods still on hand are written down, not written off. FASB's Accounting Standards Update 2015-11 requires inventory measured using any method other than LIFO or the retail inventory method to be measured at the lower of cost and net realizable value, which it defines as the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. When evidence exists that net realizable value is below cost, the Update says the difference is recognized as a loss in earnings in the period in which it occurs, and it names damage, physical deterioration, obsolescence, changes in price levels, or other causes. Under LIFO or the retail inventory method, the Update leaves the earlier lower of cost or market measurement unchanged. Under that rule, the Update says, market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin; confirm which applies with your accountant.

For example, 20 jackets are carried at 60.00 each, 1,200.00 in all. They are out of style and will now sell for 35.00 each, with 3.00 of selling cost per jacket, so net realizable value is 32.00 each, 640.00 in all. The item record keeps all 20 jackets, now valued at 640.00, and the write-down is 560.00. Unless your software posts it from an item adjustment (see item quantities below), the journal entry is:

For the tax return, the IRS inventory regulation values such goods at bona fide selling prices less direct cost of disposition, which require an actual offering, and lists deducting an estimated depreciation in value among methods not in accord with its rules; see the evidence below. Book and tax values can therefore differ, and the return preparer decides which figure the return uses.

Which account takes the charge, and when is it shown apart from cost of goods sold?

The Codification's cost-of-sales guidance, as amended by ASU 2015-11, refers to the inventory measurement paragraphs for adjustments affecting cost of sales, so a write-down ordinarily sits within cost of goods sold. The same Update says substantial and unusual losses from the subsequent measurement of inventory, that is from write-downs, should be disclosed in the financial statements.

As a matter of practice, post each kind of loss to its own ledger account, such as inventory write-downs, spoilage and shrinkage (including ordinary breakage), or casualty and theft losses, rather than straight into purchases or cost of goods sold. Those accounts support either of two presentations:

• Absorbed into cost of goods sold. Routine losses are grouped under cost of goods sold on the income statement, so gross margin includes them while each amount stays visible in the ledger.
• Shown separately. A large or unusual loss may be reported on its own line, straight from its account.

Either way, a substantial and unusual write-down should still be disclosed. How a fire or theft loss is classified in statements prepared for others is a question for your accountant.

A separate account also keeps open both IRS routes for casualty and theft losses of inventory, described under recoveries below.

Which period does the loss go in?

ASU 2015-11's write-down rule, quoted above, recognizes the loss in the period in which it occurs. By extension to goods that are gone, the loss belongs to the period in which the damage, spoilage or theft occurs, not the later period when the goods are hauled away or sold off. As a practical rule, an unexplained shortage goes in the period it is discovered, because no earlier date can be shown; a theft with a known date follows the same rule as any other loss.

Never post into a period that is already closed or reported. As a practical course, when a loss belongs to such a period, record it in the current period, note when it happened, and raise it with whoever prepared the earlier statements before changing them.

What evidence must each write-off rest on, and who approves it?

The IRS records regulation, 26 CFR 1.6001-1, says that, except as its paragraph (b) provides, anyone subject to federal income tax must keep books or records, including inventories, sufficient to establish the amounts the return must show. For casualty and theft losses, IRS Publication 547 says that to deduct the loss you must be able to show there was a casualty or theft, and be able to support the amount. Build each write-off file to that standard, whichever way the loss is later reported:

For goods kept at a reduced value, the IRS inventory regulation, 26 CFR 1.471-2(c), says goods unsalable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes, including second-hand goods taken in exchange, should be valued at bona fide selling prices less direct cost of disposition, whether the business otherwise values inventory at cost or at cost or market, whichever is lower. The regulation defines a bona fide selling price as an actual offering of goods during a period ending not later than 30 days after the inventory date, puts the burden of proof on the taxpayer to show the goods fall within those classes, and requires records of the goods' disposition that allow the inventory to be verified. Keep the price list, listing or advertisement showing the offer, and the later sales records.

COSO's Internal Control — Integrated Framework names authorizations and approvals, verifications and reconciliations among control activities, and says segregation of duties is typically built into them. So the person who approves a write-off should not be the person who looks after the goods or keeps the item records, where staffing allows. The approval record shows the item, quantity, recorded cost, what happened and when it was found, the evidence attached, who found it, who approved it and when, and the journal reference. COSO also says that where segregation of duties is not practical, management selects and develops alternative control activities. Where the approver cannot be separate from whoever keeps the goods or the item records, the owner reviews and signs each write-off record, and any outside accountant reviews the period's write-offs.

When goods are missing and nothing was disposed of, the amount is inferred rather than observed: the shortfall between the item records and a count, at recorded cost. Record it as shrinkage unless there is evidence the goods were taken. Whether an employee or bookkeeper is taking goods, and how to run the count, are separate questions. Never post a write-off whose only support is the adjusting entry itself.

How long must the write-off evidence be kept?

The IRS records regulation requires the records it covers to be kept available for inspection by authorized IRS officers or employees, and retained so long as their contents may become material in the administration of any internal revenue law. The IRS page How long should I keep records? says that, generally, records supporting an item of income, deduction or credit shown on a return must be kept until the period of limitations for that return runs out: the period in which you can amend the return to claim a credit or refund, or the IRS can assess additional tax. Applying those rules, keep the write-off file, including approvals and disposal records, while it may become material: at least until the period of limitations runs out for the return reporting the loss, and for any later return whose inventory figures it supports, such as goods still held at a reduced value. How many years that is in a given case is a separate record-retention question.

How do you correct item quantities along with the value?

For book inventories kept in a sound accounting system, the IRS inventory regulation says the balances should be verified by physical inventories at reasonable intervals and adjusted to conform. A write-off therefore has to reach both the item records and the ledger's inventory account, with inventory credited only once. If your inventory software keeps the item records and posts ledger entries for item adjustments, make the write-off as an item adjustment coded to the loss account and do not also post the journal entries shown for the jackets or olive oil. Otherwise, post the journal entry and change the item record, with the same date and reference, without a second ledger posting. Changing only the quantity, or only the value, leaves the item records and the ledger disagreeing, and the gap resurfaces at the next count.

For example, a shelf collapses and breaks 8 cases of olive oil carried at 36.00 a case, and the cases are thrown away the same day. The goods leave inventory at 288.00:

The ledger, the item record and the loss account, before and after:

After posting, check that the item's quantity, its value and the ledger balance all moved by the amounts in the approval record.

How do you record a recovery from an insurer, vendor or carrier?

Record the loss in full in its own period, and the recovery as a separate entry; do not write off only the uninsured part. FASB Interpretation No. 30 is a 1979 interpretation, not the current Codification text. It gave the total or partial destruction or theft of insured assets as examples of involuntary conversions, and where an asset was destroyed or damaged in one accounting period but the amount to be received was not determinable until a later one, it left recognition of the gain or loss to FASB Statement No. 5 on contingencies. As a practical course, record a recovery once its amount is determined, for example when the insurer settles, the vendor issues a credit memo or the carrier approves the claim. If you prepare statements for lenders or investors, have your accountant confirm the current rule, including whether a probable recovery is recognized earlier. If the insurer later settles the olive oil claim at 250.00, on the accrual basis:

The receivable clears when the money arrives; a vendor's credit memo instead reduces the amount owed to that vendor. On cash-basis books there is no receivable, and the recovery is recorded when it is received. The item records do not change, because the goods left when they were written off. If a recovery exceeded the goods' recorded cost, Interpretation No. 30 required the gain to be recognized even if the money was reinvested in replacement goods, except for certain involuntary conversions of LIFO inventories; the same check with your accountant applies.

IRS Publication 547 gives two ways to deduct a casualty or theft loss of inventory, through cost of goods sold or separately, and they treat a reimbursement differently. Separate loss and recovery accounts let the return preparer take either route; choosing between them and computing the deduction are return questions. Netting the recovery into the loss account instead hides both the exposure and the recovery, and can put each in the wrong period.

How do you handle routine small losses of perishable goods?

Where spoilage is a normal daily event, an entry per item is unworkable. Keep a waste log where goods are discarded, recording date, item, quantity, reason and the initials of the person discarding them, with a second person's initials where staffing allows. Total the log weekly or monthly, value it at recorded cost, and make one write-off to the spoilage account that reduces the item quantities and credits inventory once, approved like any other write-off. Whatever the interval, total and post the log at every period end so each period's spoilage falls in that period. The periodic count, which the IRS inventory regulation expects to verify book inventories, catches what the log missed, and that difference goes to the same account. The log, the count sheets and the signed approvals are the realistic evidence for many small losses. How to run the count is a separate question.