Inventory Loss Accounting: Write-Downs, Entries, and Deductions

Inventory loss accounting comes down to one rule with a few branches: when inventory is damaged, stolen, spoiled, or no longer sellable at its recorded cost, you write it down to what it can actually recover, record the reduction as an expense in the same period, and then decide whether the tax deduction flows through cost of goods sold or through a separate casualty and theft loss on Form 4684. The specifics depend on why the inventory lost value, how material the loss is, and whether insurance is in play.

The Three Kinds of Loss You’re Recording

Before picking a method, identify which category the loss falls into, because the accounting and tax paths diverge from there.

Shrinkage is the gap between recorded quantities and what a physical count reveals. It captures unrecorded breakage, data-entry errors, and theft, and it is usually discovered through the annual count or through cycle counts run against the perpetual system.

Obsolescence is a value decline rather than a physical disappearance. Products sit on the shelf past their season, styles shift, technology moves on, and the goods can no longer be sold at their recorded cost. Damage and spoilage cover physical deterioration: perishables past their date, chemicals past shelf life, fragile stock harmed by mishandling or environmental exposure.

Casualty and theft sit in their own bucket for tax purposes. A warehouse fire, flood, or break-in is treated differently from routine shrinkage on the return, even though the book entry may look similar.

How Much to Write Down

Under US GAAP, most inventory is measured at the lower of cost and net realizable value (LCNRV). An entity that does not use LIFO or the retail inventory method must measure inventory at the lower of its recorded cost and its NRV.¹

NRV is the estimated selling price in the ordinary course of business, minus reasonably predictable costs of completion, disposal, and transportation. If an item recorded at $90 can now only be sold for $85 net of disposal costs, the write-down is $5 per unit. Multiply by the affected units and you have the period’s write-down.

Companies using LIFO or the retail inventory method still follow the older lower of cost or market (LCM) rule.¹ “Market” is generally replacement cost, capped at NRV on the high end and NRV minus a normal profit margin on the low end. The result usually lands close to LCNRV, but the calculation adds a bounding step.

One boundary worth knowing if you also report under IFRS: IAS 2 uses the same lower-of-cost-and-NRV measurement, but it requires reversal of a prior write-down up to original cost when value recovers.² US GAAP prohibits any reversal. Once written down, the reduced amount is the new cost basis for all future periods.³

Reserve or Direct Write-Down

Two mechanics accomplish the balance sheet reduction, and most companies use both.

A direct write-down credits inventory for the impaired amount, permanently reducing its carrying value. It fits when specific items have been identified as damaged, expired, or otherwise unsaleable.

An inventory reserve, sometimes called an allowance for obsolescence, is a contra-asset account that sits alongside gross inventory and reduces net inventory on the balance sheet. Management estimates a percentage of inventory unlikely to sell and credits the reserve accordingly. The reserve gets re-evaluated each period, while a direct write-off targets specific items and is permanent. Reserves handle estimated losses across the population; direct write-offs handle the ones you can point to.

The Journal Entry and Where the Debit Goes

The mechanics are the same either way: debit an expense, credit inventory or the contra-asset reserve. The judgment call is which expense account.

For routine shrinkage and minor obsolescence, the debit goes to cost of goods sold. These are treated as normal, recurring costs of carrying inventory. Material or unusual losses (a warehouse fire, a one-time product recall, a technology shift that wipes out a product line) go to a separate income statement line such as “Loss on Inventory Write-Down.” Presenting them separately keeps COGS from being distorted by one-off events, so gross margin still reflects recurring operations.

Perpetual vs. Periodic Systems

The system in use changes when the loss hits the books. Under a perpetual system, the shrinkage adjustment is recorded when the physical count is reconciled against the records. The inventory asset account stays current throughout the year.

Under a periodic system, there is no dedicated shrinkage account during the period. The end-of-period COGS formula (beginning inventory plus purchases minus ending physical inventory) absorbs the loss automatically. Missing units simply are not in the ending count, so the calculation captures them inside COGS. The tradeoff is that shrinkage is invisible until the period closes and cannot be isolated without additional analysis.

Insurance Recoveries

When lost or destroyed inventory is insured, the accounting has its own timing. Under GAAP, the loss is recognized when it occurs; you cannot net expected proceeds against it up front. An asset for the insurance recovery is recognized only when receipt is probable and the amount is reasonably estimable. That recovery asset cannot exceed the loss recognized; any excess is a gain contingency and stays off the books until cash is received.

The practical effect is that a large loss can hit one period and the recovery show up in a later one, even when full reimbursement is expected. If the recovery is probable and estimable before the statements are issued, both can be booked in the same period, but they are presented separately rather than netted.

Tax Deduction: Routine Losses Through COGS

Normal shrinkage, spoilage, and obsolescence written down under the lower of cost or market method flow through the COGS calculation on the return and reduce taxable income as an ordinary business expense. The IRS lets you value damaged, shopworn, or otherwise unsaleable goods at their bona fide selling price minus direct disposal costs, regardless of the method used for the rest of the inventory. Raw materials and partially finished goods must be valued on a reasonable basis considering usability, but never below scrap value.⁴

The IRS also accepts shrinkage estimates confirmed by a post-year-end physical count, provided the business normally counts inventory at each location on a regular schedule and adjusts its estimates when they differ from actuals. Small businesses meeting the gross receipts test under IRC 448(c) may be exempt from the general inventory rules altogether and can treat inventory as non-incidental materials and supplies.⁵

Tax Deduction: Casualty and Theft

Inventory destroyed in a fire, flood, or other casualty, or taken in a break-in, gets different treatment. The IRS gives businesses two options for claiming the loss, and you cannot use both for the same loss.⁶

The first option is to let the loss flow through COGS by reporting the reduced ending inventory. If you go this route, any insurance reimbursement must be included in gross income.

The second is to deduct the loss separately. You remove the affected items from the COGS calculation by reducing opening inventory or purchases, then report the loss on its own. Insurance proceeds reduce the deductible loss rather than being included in income.⁴

For business inventory completely destroyed or stolen, the loss is the adjusted basis minus salvage value and any insurance reimbursement received or expected.⁶ The $100-per-casualty and 10-percent-of-AGI thresholds that limit personal casualty losses do not apply to business property; those limits are restricted to personal-use assets under IRC 165(h).⁷ If the loss results from a federally declared disaster, the business can elect to deduct it on the prior year’s return, though opening inventory for the loss year must be reduced to avoid double-counting.⁴

For theft losses, the IRS expects documentation showing that you owned the property, that it was actually stolen, when you discovered the loss, and whether a reimbursement claim exists with a reasonable expectation of recovery.⁶ When the loss is claimed separately rather than through COGS, it is reported in Section B of Form 4684.⁸

Donating Obsolete Inventory

For inventory that still has functional value but is heading toward a write-off, donation to a qualifying charity can produce a better tax outcome than scrapping it. A C corporation that donates inventory to a 501(c)(3) organization for use in caring for the ill, needy, or infants can claim an enhanced deduction. For food inventory donations specifically, the aggregate deduction can reach up to 15 percent of taxable income, with any excess carrying forward for five years.⁹ This route is common for food manufacturers and retailers facing spoilage, where donation to a food bank produces a tax benefit and avoids disposal costs.

Disclosure

Significant write-downs belong in the notes to the financial statements. IAS 2 requires disclosure of the amount recognized as expense, the amount of any write-down, and any reversal along with the circumstances that led to it.² US GAAP has no equally prescriptive checklist in ASC 330, but material write-downs that would influence an investor’s view are expected to be disclosed under general materiality principles, and most public companies describe the nature, amount, and circumstances of large write-downs in the inventory footnote.

1
FASB. Accounting Standards Update 2015-11, Inventory (Topic 330)
2
IFRS Foundation. IAS 2 Inventories
3
KPMG. Inventory Accounting: IFRS Standards vs US GAAP
4
Internal Revenue Service. Publication 538 – Accounting Periods and Methods
5
Office of the Law Revision Counsel. 26 U.S. Code 471 – General Rule for Inventories
6
Internal Revenue Service. Publication 547 – Casualties, Disasters, and Thefts
7
Office of the Law Revision Counsel. 26 U.S. Code 165 – Losses
8
Internal Revenue Service. Instructions for Form 4684 (2025)
9
Office of the Law Revision Counsel. 26 U.S. Code 170 – Charitable, Etc., Contributions and Gifts