Properly writing down your inventory is crucial, helping ensure its value is accurately reflected in your books while reducing taxable income.
When an inventory’s value decreases below the cost of purchasing or producing it, you need to record it on the books as an expense. To do so, you make an inventory write-down.
You’re probably already familiar with some of the ways your inventory can take a hit. (For instance, spoilage, vermin and transportation losses may reduce the value of feed.) But the economy takes its toll, too. Changing commodities prices and other market conditions can reduce the sale value of crops or livestock in your inventory.
An inventory write-down ensures the value of inventory is accurately reflected in your books. Importantly, it also reduces your taxable income. Here’s what you need to know about inventory write-downs—how they work, how they affect your financial statements and how to record them on the books.
What is an inventory write-down?
An inventory write-down is triggered when an inventory’s market value (the price you can sell it for) drops below its historical cost (the price you paid for it or the cost of producing it).
When you make an inventory write-down, you:
Decrease the value of an asset on the books and; and
Record that loss of value as an expense.
After you make an inventory write-down, the asset’s value on your balance sheet decreases, and your income statement shows an expense—either:
An increase on cost of goods sold (COGS), if the write-down is small, or
A new expense under Non-Operating Items.
As an expense (either COGS or Non-Operating Item), an inventory write-down reduces your net income. This also reduces your taxable income. As a decrease in the value of an asset, it reduces your owner’s equity in the business.
Why do you need to make inventory write-downs?
An inventory write-down anticipates the reduction in income you will realize with the sale of inventory due to its value being less than its cost.
If you are using the inventory as input for your ag operation—e.g. feed for livestock or fertilizer for crops—then the write-down anticipates the reduced usefulness of the inventory and the impact that will have on your bottom line.
How does an inventory write-down work?
Generally accepted accounting principles (GAAP) follow the philosophy of conservatism in accounting. Part of that means that you try to avoid overvaluing inventory—that is, overestimating the amount it’s worth. Following GAAP, your inventory is valued using either the lower of cost or market (LCM) method (a more conservative valuation) or the farm-price method (a less conservative valuation).
With the LCM method, the value of inventory is the lesser of either its average sale price in the market where you plan to sell it or the cost of purchasing or producing the inventory (its historical cost).
With the farm-price method, you value farm inventory at its market price less the cost of disposition, which may include brokers’ fees or transportation costs.
In either case, an inventory write-down changes the valuation. For instance, if 20% of your silage spoils due to a leaky silo, then its market value also decreases 20%. If that means the value of the silage is now less than its historical cost, and if you follow the LCM method, you now use the market value—rather than the historical cost—to value the silage.
On the other hand, if you use the farm-price method, then the value of the silage decreases differently. The market value—one part of the silage’s farm-sale value—goes down 20%. But the disposition cost may change according to a different rate. Because you are selling 20% less silage does not necessarily mean your broker’s fees go down 20%, and because you are transporting 20% silage does not necessarily mean transport fees go down 20%. It will depend on your specific situation.
Whichever method you use, an inventory write-down should accurately reflect the inventory’s reduced value to your operation—either as a product to be sold directly or an input used to produce other products for sale.
Inventory write-down vs. inventory write-off
When we talk about inventory write-downs, it’s important that we distinguish them from inventory write-offs.
An inventory write-down decreases the value of an inventory, while a write-off completely eliminates it.
For instance, if you lost 20% of your silage to spoilage, you would write down its value by 20%. If, on the other hand, 100% of your silage was wiped out by a tornado, you would write off 100% of its value.
It’s the difference between inventory being worth less and inventory being worthless. In the first case, the inventory has a lower value, so you make sure it’s valued for less on the books, and record the value lost as an expense. In the second case, the inventory has no value, so you reduce its value on your balance sheet to $0, and record 100% of its value as an expense.
Are inventory write-downs tax deductible?
In order to be deductible from your taxes, an inventory write-down must:
Be acceptable under the valuation method you follow (write-downs are acceptable under the LCM, farm-price and unit-livestock-price methods)
After the write-down, the inventory is clearly worth less than its historical cost
You have records clearly demonstrating the reduction in value (damage reports, commodities price changes, etc.)
If a write-down doesn’t meet this criteria, it’s considered a “book write-down”—meaning, you can record it on the books for your own use, but you can’t deduct it on your tax return.
Common inventory write-downs for ag operations
Some of the most common reasons ag operations write down crops, livestock, inputs, and products manufactured on-farm include:
Crops
Market decline due to seasonality, oversupply, or transportation bottlenecks
Quality degradation due to moisture or heat damage, shrink loss, aflatoxin or mycotoxin contamination, foreign material, or test-weight issues
Spoilage due to insect damage, improper aeration, or gradual loss of value (eg. hay losing feed value)
Livestock
Market decline due to lower market prices for certain classes of livestock or a drop in futures values
Health or condition decline due to weight loss, grade-reducing injuries, or animals no longer qualifying for premium programs (eg. organic)
Quality-class changes due to cows being moved to cull status or bulls being downgraded because of fertility problems
Inputs
Obsolescence due to seed varieties becoming no longer viable or aging past their germination warranties, chemicals expiring, or fertilizer blends degrading
Damage or deterioration due to feed spoiling, mineral blocks dissolving due to precipitation, or bagged seeds and supplements being spoiled by rodents
Price declines, eg. fertilizer market prices dropping below their historical cost
Manufactured products
Fermentation issues or spoilage
Packaging defects
Contamination
Quality test failures
Market decline
Inventory items may also be written down due to damage or partial loss during transportation and handling.
Calculating inventory write-downs
This is the formula for calculating an inventory write-down:
Write-Down Amount = Historical Cost – Market Value
To use this formula:
Determine the historical cost of the inventory. the amount you paid for it (in the case of inputs like fertilizer) or the amount you spent producing it (in the case of crops or livestock).
Determine the market price of the inventory, the amount you can reasonably expect to sell it for on the local market based on commodities prices, offers you’ve received, or sales other producers have made.
Subtract the market price from the historical cost to find the total amount you will write down the inventory (this will be a negative number)
Once you’ve worked through this formula, you can record the write-down on the books as a journal entry.
The inventory write-down journal entry
Heads up: If you use Ambrook, an inventory write-down is called a Balance Adjustment.
The steps for entering an inventory write-down differ according to whether the write-down is small (immaterial) or large (material).
For an immaterial write-down
Debit the amount of the write-down to a Loss on Inventory Write-Down account
Credit the amount to COGS
Credit the amount to Inventory
Example: Stored silage with a market value of $10,000 degrades 2%, or $200. Even though it’s a small decrease (immaterial), it happens to bring the market value below its historic cost. Here are the journal entries:
| Account | Debit | Credit |
|---|---|---|
| Loss on Inventory Write-Down | $200 | — |
| COGS | — | $200 |
Once COGS is credited, Inventory is also credited:
| Account | Debit | Credit |
|---|---|---|
| Loss on Inventory Write-Down | $200 | — |
| Inventory | — | $200 |
For a material write-down
Debit the amount of the write-down to a Loss on Inventory Write-Down account
Credit the amount to an account called Allowance for Inventory Losses
Credit the amount to Inventory
Allowance for Inventory Losses is a contra account. Every contra account is paired to another account and works contrary to it. Allowance for Inventory Losses is paired to your Inventory account (an asset). Because it’s a contra account, a credit to Allowance for Inventory reduces the amount in the Inventory account.
Example: Stored silage with a market value of $10,000 degrades 20%, or $2,000. This brings the market value below its historic cost. Here are the journal entries:
| Account | Debit | Credit |
|---|---|---|
| Loss on Inventory Write-Down | $2,000 | — |
| Allowance for Inventory Losses | — | $2,000 |
Once Allowance for Inventory Losses is credited, Inventory is also credited:
| Account | Debit | Credit |
|---|---|---|
| Loss on Inventory Write-Down | $2,000 | — |
| Inventory | — | $2,000 |
Inventory write-downs on financial statements
A journal entry you make recording an inventory write-down carries forward to your ag operation’s financial statements. It appears differently on each statement:
Income Statement: An immaterial write-down appears as an increase in COGS, while a material write-down appears separately under Non-Operating Items. In either case, both your earnings before taxes (EBT) and net income are reduced.
Balance Sheet: The carrying value of Inventory is reduced on the Assets side of your balance sheet. Because of the reduction in earnings recorded on the Income Statement, Retained Earnings also decreases.
Cash Flow Statement: Under Cash Flow Operations (CFO), an inventory write-down is added back into net income, because cash did not change hands. However, Free Cash Flow (FCF) may be impacted.
Ambrook helps you take stock of your ag operation
Ambrook is a complete financial platform for your agricultural operation. With Ambrook, you get a complete set of books and detailed financial insights. Entries like inventory write-downs are easy to make through Ambrook’s intuitive dashboard.
With time-saving bookkeeping automation features, automatically-generated financial reports, streamlined bill pay and invoicing, and other powerful accounting and financial management tools, Ambrook takes the guesswork out of running your business. Want to learn more? Schedule a demo today.
Want to learn more about Ambrook?
This resource is provided for general informational purposes only. It does not constitute professional tax, legal, or accounting advice. The information may not apply to your specific situation. Please consult with a qualified tax professional regarding your individual circumstances before making any tax-related decisions.
