Proper inventory management is one of the most important jobs for an ecommerce business owner.
While ecommerce inventory items are reported as an asset on a business’s financial statements, most notably your balance sheet, until it is eventually sold to customers, what happens if ‘eventually’ never comes?
Whether products are stolen or spoiled, become damaged or too outdated, there are several scenarios in which the anticipated financial value of inventory cannot be fully realized. These excess inventory situations may require an inventory write-off in order to get any sort of tax benefits or breaks.
Here’s how to write off inventory on your ecommerce business taxes along with some guidance on tax rules and helpful inventory strategies.
- What is an inventory write-off?
- What’s the difference between an inventory write-off and an inventory write-down?
- What does the IRS consider inventory?
- How to write-off inventory on your taxes
- How to write-off damaged inventory?
- Understanding the risks of inventory write-offs
- How to reduce inventory write-offs
What is an inventory write-off?
An inventory write-off is the inventory accounting process for recognizing a portion of ecommerce inventory that no longer has financial value to the business and removing it from the company’s income statement.
Accounting for inventory is defined as an asset under generally accepted accounting principles (GAAP), the default accounting standard used by organizations in the United States as well as most tax preparers for ecommerce businesses. Inventory is defined as an asset because it represents future cash value.
However, there are instances where your inventory reserve can lose value from the original cost, invalidating it as an asset. Common causes of inventory write offs include everything from inventory shrinkage to obsolete inventory.
For example, imagine if an ecommerce business purchased $10,000 worth of t-shirts, which were listed as $10,000 worth of assets. The t-shirts were damaged in a warehouse fire before they were sold. The “assets” no longer have any financial value, so the business would write off the $10,000.
What’s the difference between an inventory write-off and an inventory write-down?
Inventory is recorded with a book value, a number in the company’s ledger that reflects the potential financial value of an asset based on its purchase price. When inventory retains some fair market value, but less than its recorded book value, it should be written down instead of written off.
In other words, a write-off has no financial value, whereas a write-down simply has less value.
Consider an ecommerce business that purchased 5,000 printed coffee mugs for $2,500. When the mugs arrived, the print was slightly off-centered but still completely visible. Rather than lose out on the full $2,500, the business can sell the mugs at a discounted rate and list them as a write-down.
On the other hand, consider an ecommerce business that purchased 5,000 coffee mugs for $2,500. When the mugs arrived, they were damaged in a warehouse fire two days later. Because these mugs will not sell at all, they lose all value as assets and must be written off.
What does the IRS consider inventory?
If all inventory is considered an asset to the Internal Revenue Service (IRS), then what classifies items as inventory? According to the IRS Tax Guide for Small Business, there are five categories:
- Supplies that physically become a part of sold items
- Work in process (actively being manufactured)
- Raw materials used in manufacturing
- Merchandise or stock in trades
- Finished products
In other words, all of the goods that are available for sale or will eventually become eligible for sale as part of an ecommerce company’s primary business are included as inventory. However, the IRS also specifies several items that may not be included in inventory, specifically for tax purposes.
Items that the IRS does not consider inventory and cannot be listed on your business taxes include equipment and real estate used in the business and items that you’ve ordered but not yet received.
How to write-off inventory on your taxes
From raw materials to imported products, there are several items you can choose to write-off on your taxes if they’ve lost financial value. Follow these steps to write off inventory on your taxable income.
1. Determine the value loss
If you’re going to write-off inventory on your taxes, you’ll need to complete a valuation first. You can opt for the cost method, which involves calculating all the direct and indirect costs associated with the inventory you plan to write-off (purchase price, associated costs of transporting the items, etc.).
Alternatively, you can compare the above all-in costs to the current market value of the inventory. However, the IRS will require you to use whichever figure is lower when filing your taxes. Multiply the cost-per-unit by the number of units to be written off, then continue to step two.
2. Update your balance sheet
Many ecommerce businesses establish an inventory write-off expense account to record the value of items that have been written off from the company’s current assets and keep them separate from the cost of goods sold (COGS). While you must reduce your inventory, depending on the size of the loss, you can either credit the loss on the inventory write-off account or credit the COGS account.
On your balance sheet, credit the inventory write-off expense account and reduce the amount of inventory to reflect the inventory loss for substantial losses. If you’re writing off a small amount of inventory, you can choose to credit your COGS account and reduce the amount of inventory instead.
Bear in mind, you must write-off all inventory simultaneously and update your balance sheet immediately. As per GAAP, inventory cannot be written off at a later date nor spread out over several accounting periods. Rather, the entire inventory write-off must be recognized and recorded at once.
3. Document the appropriate disposal
While you must document the write-off immediately, you can take a bit more time to dispose of written off items properly. You can choose to destroy, donate, or liquidate written off inventory; however, it’s wise to take photos and retain receipts to provide proof to the IRS if necessary.
4. File the correct line items
When writing off inventory on your taxes, the majority of the heavy lifting is contained in the initial valuation and bookkeeping processes. By the time tax season rolls around, you’ll simply need to file the correct line items. For most businesses, this means filling out lines 35 to 42 of Schedule C.
- 35: Inventory at the beginning of the year
- 36: Purchases less cost of items withdrawn for personal use
- 37: Cost of labor
- 38: Materials and supplies
- 39: Other costs (such as overhead expenses)
- 40: Total of lines 35 through 39 (cost of the goods available for sale)
- 41: Inventory at the end of the year
- 42: Cost of goods sold
How to write-off damaged inventory?
There are two methods to write-off damaged inventory depending on how the products in question were damaged. If stock arrived at the warehouse damaged from transit, you would issue a damage report, calculate the value lost, credit the appropriate account, and adjust the inventory amount.
The IRS presents an alternative method to write-off damaged inventory if it was vandalized, stolen, or damaged by a natural disaster. In this instance, you would enter the details of the loss — including the value of the damaged items — on Section B of Form 4684 for a tax deduction.
Understanding the risks of inventory write-offs
The most obvious risk of inventory write-offs is a reduction in your business’ net income, and with it, your retained earnings. You are essentially eliminating assets you previously owned. Likewise, a reduction in retained earnings will decrease shareholders’ equity in the balance sheet in return.
Depending on the size of the write-off, your business can begin to lose money on products that had previously anticipated value, putting significant financial strain on your ecommerce operation. Not to mention, substantial write-offs due to damaged items can indicate issues with your suppliers.
Combined, these factors can be major red flags to potential investors or business partners. If your ecommerce business routinely has to write-off damaged products, obsolete items, or worse, is frequently vandalized or burglarized, regular inventory write-offs can tarnish your brand image.
How to reduce inventory write-offs
Inventory write-offs can stem from a number of directions, whether it’s stolen products, items damaged in transport, stock that has expired or soiled, or even inventory considered too obsolete to sell. While you can’t completely prevent these things, you can strive to reduce inventory write-offs.
- Avoid purchasing excess stock. Buying too large a volume of inventory creates an inherent risk that only a fraction will sell, leaving the rest vulnerable to spoiling, becoming outdated, or becoming damaged in storage. Instead, use historical market demand, current market trends and market conditions and your previous sales cycles to do proper inventory forecasting.
- Establish replenishment intervals for your inventory to replace sold inventory in smaller batches, rather than large purchase orders. It’s wise to revise your order cycle quarterly, calculating the amount of inventory necessary to fulfill customer orders without short-stocking.
- Use inventory management software. The right software platform can monitor elements like your order frequency to gauge the proper quantity of stock to purchase. It can also help quantify written off inventory as well as maintain proper GAAP inventory compliance.
Consult with your ecommerce accounting firm. An ecommerce accounting firm, like Bean Ninjas, can help you not only with bookkeeping and tax compliance, but can also help you set up proper inventory forecasts.