Explain the two methods of accounting for inventory write-down

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2. How To Do an Inventory Write-Down (With Examples)

By Indeed Editorial Team

Published October 8, 2021

If the value of a firm's inventory reduces, revising the listed book value to its current net realizable value (NRV) can reflect the change. The write-down affects the company's balance sheet, income statement and net income.

The accountants compare the cost of acquiring the inventory with its current value and writes down the difference. In this article, we discuss what an inventory write-down is, evaluate items that are eligible for write-downs and assess the steps and effects of the process.

What is an inventory write-down?

An inventory write-down is an accounting process that records the loss of an inventory's value. It captures the drop of the inventory's market value below its value on the balance sheet. Market or economic conditions can cause a drop in value. The write-down differs from a write-off. You use a write-down when the value drops below its book value, but a write-off shows the inventory's value is zero.

Which items are eligible for an inventory devaluation?

Inventory items eligible for a write-down include finished merchandise, in-progress products and raw materials. Items affected by scenarios, such as theft, damage and shifting market trends, qualify for an inventory write-down if their value drops below their book value. If these items lose all their value, they aren't eligible for inventory write-downs. You treat them as inventory write-offs.

Why do inventory write-downs happen?

Inventory management techniques and security measures are necessary to prevent inventory devaluation and shrinkage in these instances. Inventory write-offs happen when inventory's value drops. Some things that can cause this include:

• Obsolescence

• Damage

• Misplacement

• Theft

• Spoilage

Related: Inventory: Definition and Methods for Management

What is the effect of an inventory write-off?

An inventory write-off affects the balance sheet and the income statement. Organizations treat it as an expense, so the tax liability and net income are reduced. The reduction in net income decreases the company's retained earnings, which reduces the shareholders' equity on the balance sheet. You can reduce the inventory's value on the balance sheet to its accurate NRV. An inventory write-off also affects various financial ratios. These ratios include:

Financial ratio EffectCurrent ratioLowerInventory turnoverHigherDays of inventory on handLowerNet profit marginLowerGross profit marginHigher## How does an inventory devaluation affect the income statement?

The effect the inventory write-down has on an income statement depends on where you list the inventory depreciation. You can list the inventory devaluation as part of the cost of goods sold (COGS), if it isn't significant. The company debits the general COGS account and credits the difference in value between the inventory cost and its current value. This move increases the COGS.

Capture the expense in a different impairment loss line item, if the inventory write-off is significant to track the aggregate size. An inventory write-off of 5% or more on the inventory is significant. Treating the inventory devaluation as an expense means the firm's taxable income and net income reduce.

Related: What To Know About Income Statements

How to record an inventory write-off

Follow these steps to record the inventory depreciation:

1. Assess the value difference

Determine what the firm has listed in its accounting books as the value of the inventory items and their current value. Calculate the difference and check if it's significant or not. This move helps you know how to treat inventory depreciation.

2. Determine where to record the journal entry

Choose a place to record the journal entry. The difference in the inventory's value is significant or small. Record the amount in the COGS part if it's small or on a separate line if it's significant. Different companies can consider different amounts significant or small, but any occurrence that leads to at least a 5% loss is significant.

3. Report the inventory depreciation

Credit the inventory account and debit the COGS account of the value difference if the inventory depreciation value is significant. Picking the right place to note the difference is vital to make the books accurate. Stakeholders can track the loss quickly.

4. Review circumstances

Review the occurrences to understand why the inventory depreciation happened. Implement measures to prevent more losses. The move can reduce the losses your business incurs and increase your net income.

Inventory write-off journal entry example

Here is an example of inventory write-offs in a company's books:

Phone Lab sells phone cases. Manufacturers have released a new version of the most popular phone brand. Phone Lab's current inventory of phone cases doesn't fit the new gadgets. Their prices fall from $25 each to $10 because the phone cases are becoming obsolete. The decrease in value of the inventory is $15 each.

If the company had a few models of phone cases, the inventory depreciation is small. The journal entry on their income statement would look like:

The inventory devaluation is significant if the amount involved is at least 5% of the inventory value. Its report on the accounting books looks like this if the remaining phone cases are $100:*

Reversal of inventory depreciation

A company can reverse its inventory depreciation. This approach can happen if the inventory's value increases after the inventory devaluation. For example, the inventory's market value can rise, or the initial inventory write-off was too aggressive.

The United States Generally Accepted Accounting Principles (GAAPs) prohibits the reversal of inventory write-offs, but the process is allowed under the International Financial Reporting Standards (IFRS). Identify the value difference in the period it happens and limit the reversal to the amount of the original inventory write-off.

For example, if the new phones above were recalled because of a faulty design or changes in the law, Phone Lab can sell their phone cases at their original prices as people use the older phone model. The company can reverse the inventory write-off if the cases' value equals or is close to their initial price. The reversal is always equal to or less than the original inventory depreciation.

If Phone Lab had few inventory items, the company's income statement reversal would look like:

If Phone Lab had reduced the value of 100 phone cases, their income statement could look like:

Strategies to reduce inventory devaluation

A company can reduce its inventory devaluation through these strategies:

Avoid excess inventory

The company should hold a reasonable amount of stock. Use tools, such as EOQ, LIFO and FIFO, to determine the correct inventory amount to hold. Holding large amounts can expose the firm to increased risks of damage, obsolescence and spoiling.

Related: How To Calculate Days in Inventory (With Examples)

Review order frequency

Revise the order frequency to be more frequent and in smaller amounts. These approaches can ensure you have the right inventory size. You may also keep your inventory items current if you order them regularly.

Track trends in sales and demand

Track trends in sales and demand to forecast the quantity of inventory to hold. Follow market news to know improvements or replacements that can render your inventory obsolete. Store fewer items if people may not need them in the future to avoid wasting them. You may also store your commodities in quantities that suit seasonal demand changes.

Protect the inventory

Theft or damage are common causes of inventory depreciation. Install locks, video surveillance, security alarms, security cages, smoke detectors and motion sensors to protect your inventory. Implement inventory control policies and regular audits to monitor and prevent theft and fraud.

Use inventory management software

Inventory management software can help your firm implement various inventory management strategies. Use it to track inventory in various locations, cycle count and plan for demand. The program offers a user-friendly platform that offers helpful information.

Related: How To Track Inventory

Inventory write-off FAQs

Here are some frequently asked questions about inventory depreciation:

When is an inventory devaluation considered significant?

You can consider an inventory devaluation significant, if the difference is at least 5% of the inventory value. The specific amount can vary, depending on the firm. Record a significant inventory devaluation on its line in an income statement.

Why does an inventory devaluation increase the COGS?

The COGS increase when the value of the ending inventory decreases. A reverse inventory depreciation increases the value of the ending inventory and decreases the COGS. The COGS equation is:

Cogs = beginning inventory + purchases - ending inventory

Why put a significant inventory depreciation on its line?

Putting significant inventory devaluations with the COGS expense account can cause a significant decline in your gross profit ratio. This occurrence makes an explanation necessary. Putting it on its line helps stakeholders identify it.