Explaining Inventory Loss Due to Damage
No matter how carefully your employees handle your inventory, sooner or later you will incur a loss from items being damaged. Under generally accepted accounting principles, you must write off the value of the damaged inventory shortly after the loss occurs. The way you disclose the amount depends on how frequently your business experiences a loss from damaged inventory. Since you can write off the loss on your financial statements and take a deduction on your business income tax return, you must keep accurate records on the value of the items written off.
Inspect inventory when it arrives at your business to identify goods that might have been damaged in transit. At this point you can contact the supplier and return the damaged inventory for a full credit or refund. Once the inventory is in your warehouse, it can be damaged while in storage, incur damage on the production line or experience damage from your store customers. Employees should identify and remove damaged inventory whenever it is discovered and place it in a designated bin or area. A loss/damage report should be prepared for each damaged inventory item.
At the end of your accounting cycle, you should calculate the value of the damaged inventory so you can write off the loss. However, you do not value the inventory at its purchase price. Rather, the damaged inventory is valued at the lower of the fair market value or the purchase price. The fair market value is the current purchase price for the same inventory items. This amount may be lower than the inventory’s original purchase price. In this case, you must value the damaged inventory at the lower market cost instead of the higher purchase price.
If large amounts of inventory flow through your business, you can set up an inventory contra account to record the value of the damaged inventory. You reduce the amount of inventory carried on the books each time you make an entry into the inventory contra account. At the end of the month, you write off the damaged inventory by debiting the cost of goods sold account and crediting the inventory contra account. However, if you infrequently have damaged inventory, you can debit the cost of goods sold account and credit the inventory account to write off the loss.
If you occasionally write off small amounts of damaged inventory, you do not have to make a separate disclosure on the income statement. The loss is included in with the cost-of-goods-sold amount. However, large dollar amounts of inventory that are written off should be disclosed on your income statement. A separate account such as loss from write-off of Inventory is included with the other inventory accounts. The loss from write-off of Inventory account should appear on the income statement each time inventory is written off.