Businesses that create or merchandise products count on selling their inventories at a profit -- that is, at a price that exceeds the cost of acquisition. Sometimes, things don’t work out as planned and you have to write off inventory that is damaged, spoiled or obsolete. The extent to which you disclose losses from inventory write-offs depends on the size of the loss compared to net income for the period.
In the direct method, you write off obsolete or otherwise impaired inventory as soon as you become aware of the loss. If the loss is not substantial, you debit cost of goods sold and credit inventory for the loss amount. However, if the loss is significant, you should create an expense account such as “loss on obsolete inventory” that you include on the income statement. Debit this expense account instead of COGS. The problem with the direct method is that you might record the write-off after the period in which the loss actually occurs, which violates the matching principles of accrual accounting.
To observe the matching principle, you create inventory reserve accounts and estimate your inventory losses up front. Inventory reserves are contra-asset accounts with credit balances that reduce the net value of inventory. For example, if you estimate that you’ll have to write off $10,000 of inventory in the period because of obsolescence, credit the reserve account “allowance for obsolete inventory” and debit either COGS or an inventory expense account for $10,000. In this way, you recognize the loss in the current period. When you actually must write off inventory, debit the reserve account and credit inventory for the loss amount.
The Internal Revenue Service allows you to value ending inventory using the lower of cost or market method. Under LCM, you can write down inventory when the selling price falls below the acquisition cost. The new value is based on net realizable value, which is the money you’ll get for disposing of the inventory minus the cost to complete and sell the inventory. Under U.S. GAAP, the marked-down value can't exceed net realizable value and can't fall below net realizable value minus your normal gross margin. International standards require the use of net realizable value without adjusting for your gross margin. You can set up a reserve account for LCM losses and report the loss in an expense account such as “loss from LCM adjustment.”
The use of reserve accounts elevates the visibility of inventory losses, because the reserve amount appears on the balance sheet. Under the direct method, the loss is buried in the inventory balance sheet account. You also can hide write-downs by debiting the loss to COGS rather than to a bespoke expense account. International financial reporting standards require you to disclose any inventory write-offs on the income statement. GAAP standards are less demanding but do require you to disclose losses due to LCM on the income statement.