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 may be recorded in one of two ways. It may be expensed directly to the cost of goods sold (COGS) account, or it may offset the inventory asset account in a contra asset account, commonly referred to as the allowance for obsolete inventory or inventory reserve.
Key Takeaways
- An inventory write-off is the formal recognition of a portion of a company's inventory that no longer has value.
- Write-offs typically happen when inventory becomes obsolete, spoils, becomes damaged,or is stolen or lost.
- The two methods of writing off inventory include the direct write off method and the allowance method.
- If inventory only decreases in value, instead of losing it completely, it will be written down instead of written off.
Understanding Inventory Write-Off
Inventory refers to assets owned by a business to be sold for revenue or converted into goods to be sold for revenue. Generally accepted accounting principles (GAAP) require that any item that represents 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.
In some cases, inventory may become obsolete, spoil, become damaged,or be stolen or lost. When these situations occur, a company must write off the inventory.
Accounting for Inventory Write-Off
An inventory write-off is a process of removing from the general ledger anyinventory 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 vs. Allowance Method
Using the direct write-off method, a business will record a credit to the inventory asset account and a debit to the expense account. For example, say a company with $100,000 worth of inventory decides towrite off$10,000 in inventory at the end of the year. First, 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 as such:$100,000 - $10,000 = $90,000. Next, the inventory write-off expense account will be increased with a debit to reflect the loss.
The expense account is reflected in the income statement, reducing the firm’s net income and thus its retained earnings. A decrease in retained earnings translates into a corresponding decrease in the shareholders’ equity section 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 charging the amount to the COGS account is that it distorts the gross margin of the business, as there is no corresponding revenue entered for the sale of the product. Most inventory write-offs are small, annual expenses. A large inventory write-off (such as one caused by a warehouse fire) may be categorized as a non-recurring loss.
The other method for writing off inventory, known as the allowance method, may be more appropriate when inventory can be reasonably 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 a contra asset account, such as inventory reserve or the allowance for obsolete inventory. An offsetting debit 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 in preserving the historical cost in the original inventory account.
Special Consideration
Large, recurring inventory write-offs can indicate that a company has poor inventory management. The company may be purchasing excessive or duplicate inventory because it has lost track of certain items, or it is using existing inventory inefficiently. Companies that don't want to admit to such problems may resort to dishonest techniques to reduce the apparent size of the obsolete or unusable inventory. These tactics may constitute inventory fraud.
Inventory Write-Off vs. Write-Down
If the inventory still has some fair market value, but its fair market value is found to be less than its book value, it will be written down instead of written off. When the market price of the inventory falls below its cost, accounting rules require 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 obtain by disposing of the inventory in the most optimal manner. Write-downs are reported in the same way as write-offs, but instead of debiting an inventory write-off expense account, an inventory write-down expense account is debited.
An inventory write-off (or write-down) should be recognized at once. The loss or reduction in value cannot be spread and recognized over multiple periods, as this would imply that there is some future benefit associated with the inventory item.
