Inventory isn’t a static asset. Factors like changing market conditions, obsolescence,damage, theft and other circumstances can cause its value to depreciate—which must benotedfor accounting purposes.
An inventory write-down is the required process used to reflect when an inventory loses valueand its market value drops below its book value. The write-down impacts the balance andincome statement of a company—and ultimately affects the business’s net incomeand retainedearnings. Considering its implications, it’s valuable for companies to understand whatitis, how to do it and inventory management techniques to reduce the need for write-downs.
What Is an Inventory Write-Down?
Let’s answer the burning question here: what exactly is an inventory write-down? Thetermrefers to a required accounting process that must be conducted when inventory decreases invalue—but does not lose its value completely. When an inventory’s fair marketvalue dropsbelow its book value, a journal entry is made in the inventory write-down expense account orcost of goods sold (COGS) account depending on the significance of the write-down. Theadjustment must be made as soon as possible. This ensures accounting accuracy and lessenstax liability. Ultimately, an inventory write-down reduces the value of the ending inventoryfor the period, which has implications on both the income statement and balance sheet of abusiness.
Inventory Write-Down Journal Entry Example
As an example, online retailer Case City sells phone cases and a new version of the mostpopular cell phone brand has come out. Case City’s current inventory of phone caseswill notfit the new device. Because the cases in the inventory are becoming obsolete, they drop invalue from $25 each to $10, a difference of $15 each.
Now, let’s say the amount of the write-down is not significant. The company only had afew ofthat particular model left. The journal entry on the income statement would appear as such:
| Debit entry | Credit entry | |
|---|---|---|
| Cost of goods sold | $45 | |
| Inventory | $45 |
However, let’s say the inventory write-down is significant—the company had 100cases left.The journal entry on the income statement would instead appear:
| Debit entry | Credit entry | |
|---|---|---|
| Inventory write-down | $1,500 | |
| Inventory | $1,500 |
Key Takeaways
- If inventory loses value, an accounting process called an inventory write-down isrequired to show on the financial statements that the net realizable value is less thananticipated.
- An inventory write-down differs from an inventory write-off because it deals withinventory losing some of its value, not all of its value.
- Inventory often loses value because of obsolescence, theft, decrease in consumer demand,damage, spoilage, misplacement and shifts in the market.
- An inventory write-down impacts both the income statement and the balancesheet—reducingnet income, retained earnings and shareholder equity.
- Companies can reduce incidents of inventory write-downs through effective inventorymanagement strategies like avoiding excessive inventory, reviewing order frequency,tracking trends in demand and implementing precautionary measures to avoid theft ordamage.
What Items are Eligible for a Write-Down?
Inventory can be written down if the value is reduced. This includes the raw materials,in-progress products and finished merchandise. Items affected by a range of differentscenarios—like damage, theft and shifting market trends—are all subject to aninventorywrite-down if their actual worth drops below the book value. It should be noted though thatif a piece of inventory loses all its value as opposed to just some, it would notbe eligible for a write-down. Instead, it would be treated as an inventory write-off.
Why Do Write-Downs Happen?
Inventory write-downs occur when the value of an inventory is diminished—which canhappen fora multitude of reasons. Obsolescence tends to be a common reason why inventory might bewritten down. If a new model of a product comes out, consumer demand decreases, or markettrends shift, and companies may be left holding inventory that is a fraction of its originalvalue. This is especially frequent in industries like technology and retail where there areshort life cycles for products.
However, inventory might also be written down for more physical reasons, like misplacement,damage, spoilage or theft. In these cases, an effective inventory management strategy andsecurity measures become imperative to prevent inventory shrinkage and devaluation.
What Is the Effect of an Inventory Write-Down?
An inventory write-down impacts both the income statement and the balance sheet. A write-downis treated as an expense, which means net income and tax liability is reduced. A reductionin net income thereby decreases a business’s retained earnings, which would thendecreasethe shareholder’ equity on the balance sheet. The inventory’s asset value on thebalancesheet must be reduced as well to its accurate netrealizable value (NRV). Small business accounting software can help you keep trackof expenses and accurately record inventory write-downs.
An inventory write-down also impacts several financial ratios:
| Financial Ratio | Effect |
|---|---|
| Current ratio | Lower |
| Inventory turnover | Higher |
| Days of inventory on hand | Lower |
| Net profit margin | Lower |
| Gross profit margin | Higher |
How Does a Write-Down Affect the Income Statement?
The specific effects depend on where you list the write-down. If it’s not significant,itwill be listed as a part of the COGS. In this case, the company would debit the general COGSaccount on the income statement and credit the inventory the difference between the originalvalue and its current value. This approach will increase the COGS.
However, if the inventory write-down is significant, record the expense in a separateimpairment loss line item (inventory write-down) so the aggregate size can be tracked. As ageneral guideline, writing down 5% or more of the inventory is considered significant.
The treatment of the write-down as an expense means that both the business’ net incomeandtaxable income will be reduced.
Inventory Write-Down vs. Write-Off
The difference between an inventory write-down and an inventory write-off essentially comesdown to a matter of degree. Whereas write-downs deal with a reduction in value, write-offsdeal with an elimination of value. While it tends to occur for similarreasons—obsolescence,market changes and damage, as well as lost, stolen or spoiled—an inventory write offremovesinventory items of no value from the general ledger.
Understanding Inventory Write-Down
An inventory write-down might seem complex, but it boils down to a simple concept: If acompany’s products are no longer worth as much, the business’s financials needto reflectthat by revising the listed book value to its accurate NRV. While any company can be forcedto write-down the value of inventory due to unforeseen circumstances, many write-downs couldbe reflective of poor inventory management, which constitutes having the right stock, at theright levels, in the right place, at the right time and at the right cost.
4 Steps to Write-Down Inventory
- Assess the value difference: What does the company have listed in thebooks as the value of the inventory and what is its actual value now?
- Determine where to record journal entry: Depending on the materialityof the value change, an inventory write-down can either be recorded in the COGSor as aseparate line item on the income statement.
- Report the write-down: If the write-down is determined to be relativelysmall, debit the COGS account and credit the inventory account of the value difference.If the write-down is deemed significant, debit the inventory write-down line item andcredit the inventory account of the value difference.
- Review circumstances: Understand why the inventory write-down occurredand what measures could be implemented in the future for preventive means.
Reversal of an Inventory Write-Down
Now, if a company writes down inventory but then the value goes up later, the business mayneed to do an inventory reversal. For instance, there might be an increase in theinventory’s market value or perhaps the initial write-down was too aggressive. Itshould benoted that the reversal of write-downs is prohibited by the U.S. Generally AcceptedAccounting Principles (GAAP). However, under the International Financial Reporting Standards(IFRS), a reversal is permitted. A value difference must be identified in the period inwhich it occurs, and the reversal is limited to the amount of the original write-down.
Using the example from above, let’s say the new phone released was recalled because offaultybatteries. The company’s phone cases can be sold at the original price with thepreviousphones being the mainstay. Case City would reverse the write-down if the cases reached thesame or more than their previous value. Remember, a reversal cannot be more than theoriginal write-down.
If Case City had only written down a few phone cases, the income statement reversal wouldlook like this.
| Debit entry | Credit entry | |
|---|---|---|
| Cost of goods sold | $45 | |
| Inventory | $45 |
If Case City had written down 100 cases, if might look like this.
| Debit entry | Credit entry | |
|---|---|---|
| Debit entry | Credit entry | |
| Inventory write-down | $1,500 | |
| Inventory | $1,500 |
If the value increases, but not back to its full amount, then the entries would be the newvalue difference.
How to Reduce Inventory Write-Downs
Considering the effects of inventory write-downs, it’s in a company’s bestinterest to avoidthem whenever possible. Strategies to reduce write-downs include:
Avoiding excessive inventory:
It’s easy to get excited about a product. However, ordering a large amount could exposethecompany to increased risks of obsolescence damage andspoiling in the case of perishable inventory.
Reviewing order frequency:
Revising order frequency to be smaller amounts and more frequent intervals can right-sizeinventory and help keep it current.
Track trends in demand and sales:
Revisiting the example above, the company would probably know ahead of time that a new phonewith different dimensions was coming out and that demand was likely to drop. They couldadjust their inventory ahead of time.
Protecting the inventory:
Damage or theft are common causes of write-downs. Implement protective measures likeinstalling locks, security cages, video surveillance, smoke detectors, security alarms, etc.Additionally, implement intensive inventory control policiesand audits to help monitor and prevent fraud and theft.
Consider the LIFO inventory valuation method:
Companies that use the last in, first out (LIFO) warehouse management method that assumes themost recently-produced items are sold first tend to have less write-downs than companiesthat use the first in, first out (FIFO) method. Under LIFO, the remaining balance sheetvalue for inventory reflects the older, and lowest, prices.
Implementing inventory management software:
Investing in inventory managementsoftware can help companies enact the strategies above through features like cyclecounting, tracking inventory in multiple locations and demand planning.
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Inventory Write-Down FAQs
When is an inventory write-down considered significant enough to be recorded as its own lineitem?
As a general guideline, writing-down 5% or more of the inventory is a material adjustment andshould be recognized separately.
Why does an inventory write-down increase the COGS?
This is best explained by looking at the COGS equation:
COGS = Beginninginventory + purchases – ending inventory
If the value of the ending inventory has decreased, as it does with a write-down, the COGSwill increase.
Why should a large inventory write-down not be included in COGS?
If you were to bury a large write-down within the COGS expense account, it would cause alarge decline in the gross profit ratio, which would require explanation.
