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Inventory Write-Off

Inventory Write-Off
BusinessCorporate Finance and AccountingAccounting

What Is an Inventory Write-Off?

An inventory write-off is an accounting term for the proper recognition of a portion of a company's inventory that no longer has value. An inventory write-off might be recorded in one of two ways. It could be expensed directly to the cost of goods sold (COGS) account, or it might offset the inventory asset account in a contra asset account, usually alluded to as the allowance for obsolete inventory or inventory reserve.

Understanding Inventory Write-Off

Inventory alludes to assets owned by a business to be sold for revenue or changed over into goods to be sold for revenue. Generally accepted accounting principles (GAAP) expect that any thing that addresses a future economic value to a company be defined as an asset. Since inventory meets the requirements of an asset, it is reported at cost on a company's balance sheet under the section for current assets.

At times, inventory might become obsolete, ruin, become harmed, or be taken or lost. At the point when these circumstances happen, a company must write off the inventory.

Accounting for Inventory Write-Off

An inventory write-off is a course of eliminating from the general ledger any inventory that has no value. There are two methods companies can use to write off inventory: the direct write-off, and the allowance method.

Direct Write-Off Method versus Allowance Method

Utilizing the direct write-off method, a business will record a credit to the inventory asset account and a debit to the expense account. For instance, say a company with $100,000 worth of inventory chooses to write off $10,000 in inventory toward the year's end. In the first place, the firm will credit the inventory account with the value of the write-off to reduce the balance. The value of the gross inventory will be reduced thusly: $100,000 - $10,000 = $90,000. Next, the inventory write-off expense account will be increased with a debit to mirror the loss.

The expense account is reflected in the income statement, diminishing the firm's net income and hence its retained earnings. A decline in retained earnings converts into a relating decline in the shareholders' equity section of the balance sheet.

In the event that the inventory write-off is irrelevant, a business will frequently charge the inventory write-off to the cost of goods sold (COGS) account. The problem with charging the amount to the COGS account is that it twists the gross margin of the business, as there is no relating revenue placed for the sale of the product. Most inventory write-offs are small, annual expenses. A large inventory write-off, (for example, one brought about by a warehouse fire) might be classified as a non-recurring loss.

The other method for discounting inventory, known as the allowance method, might be more fitting when inventory can be sensibly estimated to have lost value, however the inventory has not yet been discarded. Utilizing the allowance method, a business will record a journal entry with a credit to a contra asset account, for example, inventory reserve or the allowance for obsolete inventory. An offsetting debit will be made to an expense account.

At the point when the asset is really discarded, the inventory account will be credited and the inventory reserve account will be debited to reduce both. This is valuable in saving the historical cost in the original inventory account.

Special Consideration

Large, recurring inventory write-offs can demonstrate that a company has poor inventory management. The company might be purchasing unnecessary or copy inventory since it has lost track of certain things, or it is utilizing existing inventory wastefully. Companies that would rather not own up to such problems might resort to unscrupulous methods to reduce the apparent size of the obsolete or unusable inventory. These strategies might comprise inventory fraud.

Inventory Write-Off versus Write-Down

In the event that the inventory actually has some fair market value, however its fair market value is found to be not exactly its book value, it will be written down rather than written off. At the point when the market price of the inventory falls below its cost, accounting rules expect that a company write down or reduce the reported value of the inventory on the financial statement to the market value.

The amount to be written down is the difference between the book value of the inventory and the amount of cash that the business can acquire by discarding the inventory in the most optimal way. Write-downs are reported similarly as write-offs, however rather than debiting an inventory write-off expense account, an inventory write-down expense account is debited.

An inventory write-off (or write-down) ought to be recognized without a moment's delay. The loss or reduction in value can't be spread and recognized over different periods, as this would suggest that there is some future benefit associated with the inventory thing.

Features

  • An inventory write-off is the proper recognition of a portion of a company's inventory that no longer has value.
  • On the off chance that inventory just declines in value, rather than losing it totally, it will be written down rather than written off.
  • Write-offs normally happen when inventory becomes obsolete, ruins, becomes harmed, or is taken or lost.
  • The two methods of discounting inventory incorporate the direct write off method and the allowance method.