Inventory Write-Down: GAAP Rules, IRS Limits, and Methods

An inventory write-down reduces the recorded value of goods on your balance sheet when their worth drops below what you paid, and under U.S. GAAP (FASB ASC 330) you have to book one as soon as the evidence shows a decline. The IRS treats the deduction separately, with tighter rules, so the amount you write down on the books and the amount you can deduct on the return are often different numbers.

When You Have to Write Inventory Down

The trigger is simple. If the value your inventory can generate in the normal course of business falls below its cost, you recognize the difference as a loss in the current period. The cause does not matter: physical damage, obsolescence, a general drop in market prices, or a shift in consumer demand all qualify.¹

Which valuation rule you apply depends on your costing method:

FIFO, average cost, and other non-LIFO methods: lower of cost or net realizable value.
LIFO and the retail inventory method: lower of cost or market.

The two approaches compute the comparison figure differently, and mixing them up is a common audit finding.¹

How to Measure the Write-Down

Net Realizable Value (Non-LIFO)

Net realizable value is the estimated selling price in the ordinary course of business, minus reasonably predictable costs of completion, disposal, and transportation.¹ If a table would sell for $500 but needs $80 in finishing and $20 in shipping, NRV is $400. If that table cost you $450 to produce, you write it down by $50.

Calculating NRV means pulling recent sales data for comparable goods, outstanding purchase orders, and a breakdown of remaining completion and disposal costs. Document the figures in a formal valuation memo. That memo is your primary defense during an audit; without it, examiners have little reason to accept your number at face value.

Lower of Cost or Market (LIFO and Retail)

For LIFO and retail method users, “market” generally means current replacement cost, bounded by a ceiling and a floor. The ceiling is NRV, so market cannot exceed what you would actually get for the goods. The floor is NRV minus a normal profit margin. That range prevents wild period-to-period swings in reported inventory values.

For tax purposes, the IRS defines market for normal goods as the aggregate of current bid prices at the inventory date, and the figure must include all direct and indirect costs required under the applicable rules, including any uniform capitalization costs for businesses subject to Section 263A.²

Recording the Adjustment

Once you know the amount, you have two ways to book it.

The direct method reduces the inventory account and increases cost of goods sold by the same amount in one entry. It is the simpler approach and what most businesses use. Gross profit for the period drops accordingly.

The allowance method leaves the original inventory cost alone and creates a contra-asset account (often called “allowance for inventory obsolescence”) that offsets the inventory balance on the balance sheet. The corresponding expense hits a separate loss account rather than cost of goods sold. You get better visibility into how much of the inventory decline is valuation adjustment versus actual sales activity, at the cost of more complex reconciliation.

Both methods are acceptable under GAAP. Pick based on how much internal detail you want.

Write-Downs Are Permanent Under GAAP

Once you write inventory down, the reduced amount becomes its new cost basis. If the market recovers next quarter, you cannot reverse the write-down and mark the inventory back up. The loss is locked in for any inventory still on hand at period end.¹

This is one of the sharpest differences between U.S. GAAP and IFRS. Under IFRS, a business can reverse a previous write-down up to the amount of the original reduction when the conditions that caused it no longer exist. A U.S. company following GAAP has no such option, which pushes management to be careful about the timing and size of the reduction because there is no later correction available.

What the IRS Actually Lets You Deduct

The financial-statement write-down and the tax deduction are not the same thing. The IRS framework is more restrictive in several ways.

Sub-Normal Goods and the 30-Day Rule

Treasury Regulation Section 1.471-2 covers goods that are unsalable at normal prices or unusable in the normal way because of damage, imperfections, style changes, odd lots, or similar causes. These items are valued at bona fide selling price minus direct costs of disposition. Raw materials or partially finished goods are valued on a reasonable basis considering their condition, but never below scrap value.³

The catch is “bona fide selling price.” You have to actually offer the goods for sale during a window ending no later than 30 days after your inventory date. A theoretical markdown on a spreadsheet does not count. The goods must be offered to buyers at a price reflecting their condition, and the burden of proof is on you. Keep records of when and how you offered them, and what happened.³

LIFO Taxpayers Cannot Write Down to Market

If you use LIFO for tax, Section 472 requires you to value inventory at cost.⁴ You may still use lower-of-LIFO-cost-or-market for financial reporting without violating the LIFO conformity requirement, but the return has to reflect actual LIFO cost.⁵ LIFO businesses cannot deduct market-value declines the way FIFO or average-cost businesses can. It is one of the most significant trade-offs of the LIFO election.

Section 263A

Businesses subject to uniform capitalization keep two points in mind. Costs remaining on hand at year-end for Section 471 purposes exclude goods already written down below cost, so no additional capitalization layers get applied to inventory you have already marked down.⁶ When you compute market for normal goods, however, the replacement cost figure has to include all direct and indirect costs required by Section 263A.²

Small Business Exception

Not every business has to follow these rules. Section 471(c) exempts taxpayers who meet the gross receipts test under Section 448(c) from the general inventory requirement.⁷ The base threshold is $25 million in average annual gross receipts over the prior three tax years, adjusted for inflation. For tax years beginning in 2025, the adjusted figure is $31 million.⁸

Qualifying businesses can either treat inventory as non-incidental materials and supplies (deducting cost when the goods are used or sold rather than carrying them as an asset) or conform their tax inventory method to whatever they use on their financial statements or internal books.⁷ Below the threshold, the entire valuation framework above is optional for tax purposes. Tax shelters are excluded from the exception regardless of gross receipts.

Changing Your Inventory Method

Switching how you value inventory for tax, whether between permissible methods or from a non-compliant method to a compliant one, requires IRS Form 3115. Many inventory changes qualify for automatic consent: you attach Form 3115 to a timely filed return and send a copy to the IRS National Office, with no user fee.⁹

Non-automatic changes need advance IRS approval and a user fee, and must be filed during the tax year you want the change to take effect. Common automatic categories relevant to inventory include moving from an impermissible valuation method to a permissible one, switching between permissible methods, and adopting or leaving the Section 471(c) small business exception.⁹

A method change almost always requires a Section 481(a) adjustment so income is neither duplicated nor skipped in the transition. An adjustment that increases income spreads over four years; one that decreases income hits fully in year one. Skipping the Form 3115 filing does not excuse you from using the correct method. It just means you made an unauthorized change.

Penalties for Getting It Wrong

A disallowed write-down increases taxable income, and if the resulting understatement is substantial you face a 20 percent accuracy-related penalty on the underpayment.¹⁰ “Substantial” generally means the understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000. Reasonable cause and good faith can defeat the penalty, but that defense requires showing a genuine effort to comply, not just that you relied on a spreadsheet someone else prepared.

Three patterns cause most of the trouble: failing to actually offer sub-normal goods for sale within the 30-day window, writing LIFO inventory down to market on the return, and claiming write-downs without documentation of the market decline. Inventory is one of the easiest places to manipulate reported income, and examiners know it.

Financial Statement Disclosures

A write-down does not end with the journal entry. Footnotes have to disclose the basis for stating inventory (FIFO, LIFO, average cost, and so on) and the nature of any material impairment charges. A substantial or unusual write-down gets called out separately rather than buried in cost of goods sold. Any significant change in valuation method, along with its effect on income, also requires disclosure.

LIFO users carry additional obligations. If a LIFO liquidation generates income because older, lower-cost layers are sold, the income effect must be disclosed. If the difference between replacement cost and reported LIFO value is material, that gap must be stated parenthetically or in a note.

Effects on Loan Covenants

This is where businesses get surprised. A significant write-down cuts reported profits and shrinks the collateral backing any asset-based loan at the same time. If inventory secures a revolving credit line, the write-down can push the outstanding balance past the borrowing base and leave the loan over-advanced.¹¹

Loan agreements commonly include covenants requiring minimum working capital, income coverage ratios, or maximum leverage. A large write-down can breach these by reducing current assets and net income simultaneously. When a borrower trips a covenant, the lender is expected to analyze the root cause and may require corrective action, adjust advance rates, or reclassify the loan to a higher risk rating.¹¹

If you see a material write-down coming, call your lender before the statements are finalized. A conversation about why it happened and what you are doing about it lands better than a covenant violation discovered in a routine compliance review.

1
Financial Accounting Standards Board. Accounting Standards Update 2015-11 – Inventory (Topic 330): Simplifying the Measurement of Inventory
2
eCFR. 26 CFR Part 1 – Inventories
3
eCFR. 26 CFR 1.471-2 – Valuation of Inventories
4
Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories
5
Internal Revenue Service. LIFO Conformity
6
Internal Revenue Service. Examining a Resellers IRC 263A Computation
7
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
8
Internal Revenue Service. Revenue Procedure 2024-40
9
Internal Revenue Service. Instructions for Form 3115
10
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
11
Office of the Comptroller of the Currency. Accounts Receivable and Inventory Financing – Comptrollers Handbook