Inventory Write-Down

How Does an Inventory Write-Down Work?

An inventory write-down adjusts the book value recorded on the balance sheet for given inventory to match its current market value.

In financial accounting, an inventory write-down becomes necessary if the market value of a company’s inventory drops below the recorded carrying value on the balance sheet.

Often referred to as “inventory impairment”, an inventory write-down is an accounting term describing the reduction in the inventory balance in the event that the market value of inventory falls below its book value, yet remains sellable.

Under the reporting guidelines established by U.S. GAAP, the reduction in the inventory balance is intended to improve the transparency of a company’s financial health, namely for the sake of not misleading investors.

How to Write-Down Inventory?

Compliance with U.S. GAAP reporting standards mandates that companies write off inventory as an expense right after the determination that the inventories lost a significant percentage of their original value.

Inventory is reported on the balance sheet at its historical cost, however, reductions are often necessary based on the lower-of-cost-or-market (LCM) rule.

The recorded cost can vary based on the inventory valuation method abided by the company. In practice, the three most common inventory accounting methods are the FIFO, LIFO and average cost methods.

However, irrespective of the inventory costing method used, the conservatism principle of accrual accounting is what dictates the preparation of financial statements.

What Causes Inventory Write-Down to Occur?

An inventory write-down reduces the book value of inventory by the incremental loss in market value. Hence, the post-adjustment balance will be of lesser value than its prior book value.

In most scenarios, write-downs are caused by external, unanticipated factors such as accidental damage, obsolescence, or material changes in market conditions (e.g. shifts in consumer preferences and behavioral patterns).

The reason for the necessity of an inventory write-down can stem from numerous factors, such as the following:

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Inventory Write-Down Formula

Under U.S. GAAP accounting standards (FASB), the lower of cost or market (LCM) rule is used to value inventories. The LCM rule states that the inventory carrying balance recorded must reflect the lesser value of the original cost or current market value.

The current market price is the expected replacement cost of inventory, or the cost of acquiring the asset on the reporting date.

Under IFRS accounting standards, on the other hand, the write-down equals the difference between the historical value and net realizable value (NRV).

The market value must be less than the net realizable value (NRV), including the NRV reduced by the normal profit margin. If not, the inventory is not impaired and a write-down is not necessary.

The formula for calculating the net realizable value (NRV) is the difference between the expected sale price from the ordinary course of business and the costs related to selling the inventory, such as repairing the inventory to improve its condition and marketability.

• Expected Sale Price → The estimated price at which the inventory could be sold in the open markets, i.e. the replacement cost as of the present date.
• Total Sale Costs → The total costs expected to be incurred in the process of marketing and selling the asset to potential buyers.

The current market value of the inventory, or replacement cost, cannot exceed the net realizable value (NRV), nor the NRV adjusted by a normal profit margin.

How Does an Inventory Write-Down Impact the 3 Financial Statements?

• Income Statement (P&L) → The loss attributable to the inventory write-down is recognized as either cost of goods sold (COGS) or separately in the non-operating items section. The write-down is a non-recurring item not part of the core operations of the business, however, and reduces pre-tax income (EBT). In effect, net income in the current period and earnings per share (EPS) figures are reduced from the write-down.
• Cash Flow Statement (CFS) → In the cash flow from operations (CFO) section of the statement of cash flows, the inventory write-down is added back to net income since the reduction is a non-cash item. In other words, there was no real movement in cash. However, the free cash flow (FCF) of the company can be influenced by the change in the inventory line item.
• Balance Sheet (B/S) → On the assets side of the balance sheet, the carrying value of inventory is reduced by the write-down. On the other hand, the corresponding impact on the liabilities and shareholders’ equity side is via the reduction in net income, which flows into retained earnings.

What is the Journal Entry for Inventory Write-Down?

If a company recognizes an inventory write-down in a given period, the coinciding journal entry comprises recording a debit entry for “Loss on Inventory Write-Down”, while a credit entry is applied to the “Inventory” account.

Suppose a manufacturing company purchased inventory at an original cost of $120k but now its market value has decreased to $100k from reduced customer demand.

The journal entry to reflect the $20k decline in inventory value would be as follows:

• Debit Entry → Loss on Inventory Write-Down
• Credit Entry → Allowance for Inventory Losses (or Cost of Goods Sold)

Inventory Write-Down Journal Entry Example

The credit entry to the “Allowance for Obsolete Inventory” account — which functions as a contra-account — offsets the inventory line item to calculate the ending net value of inventory for the reporting period.

In our hypothetical example, the “Inventory” account is adjusted by the debit entry of $20k, while the “Allowance for Obsolete Inventory” account reflects a credit balance of $20k.

Therefore, the ending net inventory balance is $100k, the value recognized on the current period balance sheet.

• Ending Net Inventory = $120k — $20k = $100k

Inventory Write-Down Journal Entry Example

Note: If the write-down amount is immaterial, the debit is applied to the cost of goods sold (COGS) account.

Inventory Write-Down vs. Write-Off: What is the Difference?

An inventory write-down and write-off are two common accounting adjustments to inventory that reduce the carrying value of inventory on the balance sheet. But while the circumstances for both share commonalities, one particular distinction must be understood.

• Inventory Write-Down → In an inventory write-down, the adjustment to the recorded inventory value occurs after the market value of the company’s inventory falls below its book value. However, the written-down inventory still retains some residual market value and thus could be sold.
• Inventory Write-Off → An inventory write-off is conceptually the same as an inventory write-down. The distinction pertains to the severity of the loss in market value. For instance, the value of a company’s inventory could be entirely wiped out by a fire or theft.

Therefore, an inventory write-down is a partial reduction in market value, whereas an inventory write-off is the complete removal of the corresponding value from the company’s books.