What is an inventory write-off?
An inventory write-off is an accounting term for the formal recognition of a portion of a company’s inventory that no longer has value. An inventory write-off can be recorded in two ways. It can be attributed directly to cost of goods sold (COGS) or it can offset the inventory asset account in a contra asset account, commonly referred to as the provision for obsolete inventory or reserve inventory.
Key points to remember
- A write-off of inventory is the formal recognition of a portion of a company’s inventory that no longer has value.
- Write-offs typically occur when inventory becomes obsolete, spoils, damaged, stolen, or lost.
- The two inventory write-off methods include the direct write-off method and the provision method.
- If the inventory only decreases in value, instead of losing it completely, it will be depreciated instead of written off.
Understanding inventory write-off
Inventory refers to assets held by a business to be sold for profit or converted into goods to be sold for profit. Generally Accepted Accounting Principles (GAAP) require that anything that represents future economic value to a business be defined as an asset. Because inventory meets the requirements of an asset, it is reported at cost on a company’s balance sheet in the current assets section.
In some cases, inventory may become obsolete, spoil, damaged, stolen or lost. When these situations occur, a business must write off inventory.
Accounting for inventory write-off
A write-off of inventory is a process of removing big general book any inventory that has no value. There are two methods businesses can use to write off inventory: the direct write-off method and the deduction method.
Direct Cancellation Method vs Allocation Method
Using the direct write-off method, a business will record a credit to the inventory account and a debit to the expense account. For example, let’s say a company with $100,000 of inventory decides to write off $10,000 of inventory at the end of the year. First, the company 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 as such: $100,000 – $10,000 = $90,000. Then the inventory write-off expense account will be increased by a debit to reflect the loss.
The expense account is reflected in the income statement, reducing the company’s net income and therefore its retained earnings. A decrease in retained earnings results in a corresponding decrease in equity part of the balance sheet.
If the inventory write-off is immaterial, a business will often charge the inventory write-off to the cost of goods sold (COGS) account. The problem with posting the amount to the COGS account is that it skews the Gross margin of the business, as no corresponding revenue is captured for the sale of the product. Most inventory write-offs are small annual expenses. A large write-off of inventory (such as that caused by a fire in a warehouse) can be classified as a non-recurring loss.
The other inventory write-off method, known as the write-off method, may be more appropriate when the inventory can reasonably be estimated to have lost value, but the inventory has not yet been disposed of. Using the allowance method, a business will record a journal entry with a credit to an offsetting asset account, such as inventory reserve or obsolete inventory allowance. A chargeback will be made to an expense account.
When the asset is actually disposed of, the inventory account will be credited and the inventory reserve account will be debited to reduce both. This is useful to preserve the historical cost in the original inventory account.
Large and recurring inventory write-offs can indicate that a company has poor inventory management. The company may purchase excessive or duplicate inventory because it has lost track of certain items or is using existing inventory inefficiently. Companies unwilling to admit such problems may resort to dishonest techniques to reduce the apparent size of obsolete or unusable inventory. These tactics may constitute inventory fraud.
Inventory write-off vs depreciation
If the inventory still has some fair market value, but its fair market value is less than its book value, it will be writing instead of being removed. When the market price of inventory falls below its cost, accounting rules require a business to depreciate or reduce the reported value of inventory in the financial statements to market value.
The amount to be depreciated is the difference between the book value of the inventory and the amount of cash the company can obtain by disposing of the inventory in the most optimal way. Depreciations are reported in the same way as write-offs, but instead of debiting an inventory depreciation expense account, an inventory depreciation expense account is debited.
A write-off (or write-down) of inventory must be recognized immediately. The loss or write-down cannot be allocated and accounted for over multiple periods, as this would imply that there is a future benefit associated with the item of inventory.