How to Account for Damaged Finished Goods

For many companies, inventory can be one of the largest assets on the balance sheet. For this reason, the valuation of inventory is crucial for accounting. For tax purposes, the valuation of inventory directly affects taxable income. Properly accounting for damaged goods affects both cost of goods sold and income. Different methods are used depending on whether the damage occurred during or after production.

Damage During Production: No Finished Product

The standard rule for valuing inventory is the lower of cost or market value. If the manufacturing process is disrupted and results in a smaller batch of finished goods, the resulting inventory is valued at cost, but your income when selling the undamaged products will be lower, allowing you to recoup the loss.

For example, your factory starts production of a new item, expecting to manufacture 1,000 plastic widgets per month. However, the first batch of 200 widgets melted and are not salable. The cost of raw materials and manufacturing was $1,000, but the ending inventory was only 800 widgets, rather than 1,000 widgets. Market value is $5 per widget. Thus, the month-end value of 800 widgets is $1,000 under the rule of lower of cost or market value.

If the sale price of widgets is $5, your income after selling the month's production of 800 widgets is $4,000. Profit is $3,000 ($4,000 sales - $1,000 cost). This is lower than if you had produced and sold the expected 1,000 widgets, which would have produced $5,000 in income, resulting in profit of $4,000 ($5,000 sales - $1,000 cost). You have taken the loss on damaged widgets by a reduction in income. At tax time, you pay tax on lower profits, which helps to offset the loss.

Damage During Production: Irregular Product

If errors during manufacturing result in products that must be sold at a discount, you still value the inventory at the lower of cost or market even if the market price of the irregular items is less than the cost of production. This lower value is also called net realizable value, reports Corporate Finance Institute. When you sell the items, you will still have income, and your profit will depend on the actual cost of producing the finished goods. You may incur a loss if you cannot sell all the goods or you sell below cost.

For example, your factory produces knitted sweaters with blue and white stripes. A malfunction caused the stripes to be unevenly spaced and your regular customers will not accept the merchandise. The cost of producing one sweater is $5, and the market value of perfect goods is $10, but the irregular sweaters are worth only $4. If there are 1,000 irregular sweaters, the value of the inventory is $4,000, which is the lower of cost ($5,000) or market ($4,000.).

You also will report a loss of $1,000 on the sale of the irregular goods. If you are completely unable to sell the irregular items, you may end up having to scrap or destroy the lot. You can write off an additional amount for the cost of removal or destruction.

Inventory Loss Example: Casualty Loss

Goods damaged in the warehouse is a common occurrence for both manufacturers and retailers. If the damage is a result of an unexpected event not normal for your business – such as a storm, earthquake, fire or vandalism – the damage is considered a casualty loss.

The Internal Revenue Service allows two different methods of accounting for an inventory loss in these circumstances. Use Form 4684 to claim a casualty loss. Part B is for business losses. You can choose to remove the damaged items from inventory without adjusting the cost of goods sold; the unit cost rises, but the reduction in income balances out the higher cost.

The second option is to report the loss separately. Under this method, you adjust out the damaged goods from both cost of goods sold and inventory. Then you will file a separate claim against the cost of goods.

Insurance Reimbursement for Casualty Loss

Whichever method you elect to account for a casualty loss, you must reduce the amount of loss claimed or adjusted by any insurance payment received. The adjustment will be taken in cost of goods sold when you remove the damaged goods from inventory. In the case of a separate loss adjustment, subtract the insurance reimbursement from the amount of loss you claim.

For example, if a flood damaged goods which cost $10,000 to produce or acquire and you chose the first option, you will reduce inventory for the damaged items. Insurance covered $5,000 of the loss, so you must reduce the cost of goods sold by $5,000 to account for the reimbursement. Given the same casualty event, if you choose to make a separate loss claim, subtract $10,000 from cost of goods sold, removed the damaged items from inventory and claim only a $5,000 loss.