Inventory Write-Off

How Does an Inventory Write-Off Work?

In financial accounting, an inventory write-off is recognized if the fair market value (FMV) of the adjusted inventories has fallen to zero from the perspective of the company.

The inventory write-off adjustment removes the value of inventory determined to have become obsolete or unsellable.

The most common causes that precede the an inventory write-off include the following examples:

• Irreparable Damage to Inventory (e.g., Flood, Hurricane)
• Spoilage of Perishable Inventory
• Loss of Inventory (e.g., Theft, Misplacement in Transit)
• Product Obsolescence (e.g. Technological Disruption)
• Unfavorable Market Trends and Secular Shifts

The conservatism principle, one of the core concepts underpinning the reporting standards under accrual accounting, mandates companies to record the carrying value of certain assets at their fair value.

However, the aforementioned fair value adjustment is unidirectional because the reported balance must be the lesser value between the historical cost and the market value at present.

The carrying value of inventories on the balance sheet is expected to promptly be adjusted downward soon after management recognizes the conditions are met.

In practice, an inventory write-off is a normal part of conducting business and an inevitable occurrence, particularly for industries where inventories are subject to the risk of technological disruption and becoming obsolete due to their perishable nature.

However, the reverse scenario, wherein the fair value has increased relative to the original cost, is not permitted, which illustrates the underlying intent of the conservatism principle (or “prudence concept”).

Why Write-Off Inventory?

Financial Accounting Standards Board (FASB) — the governing organization that established and oversees the Generally Accepted Accounting Principles (GAAP), the set rules that dictate the reporting guidelines that publicly traded companies must adhere to — requires financial statements to be prepared with caution to mitigate the risk of misleading investors.

The recorded values on the core financial statements (e.g., the income statement, balance sheet, and cash flow statement), including the supporting footnotes in SEC filings, are used by investors and other market participants to guide their decisions.

FASB must ensure the reporting guidelines are set in place to ensure the financial reports are audited and presented with near full transparency to protect investors from incurring monetary losses due to misleading statements (or financial data) and unreported material risks.

The central component of the conservatism concept is the belief that understating the value of assets on the balance sheet is preferable to overstating the values (i.e., downward bias).

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

Inventory write-down and write-off are two common accounting adjustments made to the inventory value, reducing its carrying value on the balance sheet.

Despite the conceptual similarities, there is a notable difference between the two adjustments:

Therefore, an inventory write-down is a partial reduction in the carrying value of inventory recorded on the balance sheet to reflect a decline in market value, whereas an inventory write-off is the complete removal of the inventory value for bookkeeping purposes.

If the salvage value of the inventory exceeds zero, the proper accounting term to use for the adjustment would be “write-down” rather than “write-off,” as the severity of the surrounding circumstances is the differentiating factor.

How to Write Off Inventory?

By writing off obsolete or unsellable inventory, the financial statements are presented with a higher degree of transparency, causing them to be more reliable.

Since the recorded values on the balance sheet reflect the conservative, fair value of their inventories, the profits of companies that abide by U.S. GAAP reporting standards are far less likely to be overstated.

In fact, the intrinsic value derived by analyzing the financial statements by investors and market participants alike is more likely to be understated.

The process of writing off inventory comprises the following steps.

1. Identify the Obsolete Inventory Items with No Value
2. Appraise the Value Attributed to the Inventory Accounts (i.e., Removal of Recorded Value)
3. Record Journal Entry Adjustments in Accounting Ledger (Debit to Inventory Account; Credit to Cost of Goods Sold Account)
4. Record Write-Off on Financial Statements (with Commentary on Justification)

Note that the steps outlined above provide a high-level, generalized overview of a rather complicated matter.

In actuality, the write-off can be time-consuming with several third parties involved, like independent appraisers and legal advisors.

Other steps include obtaining formal approval from the board of directors and preparing substantial documentation to ensure full compliance with the regulatory procedures.

What is the Journal Entry for an Inventory Write-Off?

The journal entry for an inventory write-off must “wipe out” the value of the inventory in need of adjustment with a coinciding entry to an expense account.

If the write-off amount is immaterial and not a recurring event for the company, the cost of goods sold (COGS) account can be the expense account debited.

• Debit Entry → Cost of Goods Sold (COGS) Account
• Credit Entry → Inventory Account

Therefore, the reduction in the inventory account is offset by the charge to the cost of goods sold (COGS) account on the ledger.

However, certain industries are far more prone to recognizing inventory write-offs, such as the retail and consumer goods (e.g., perishable food) industries.

Therefore, management can decide to record the loss by debiting a reserve account for inventory write-offs.

• Debit Entry → Inventory Write-Off Expense Account
• Credit Entry → Inventory Account

The debit entry to the expense account reflects the cost attributable to the inventory acknowledged as unsellable with no economic utility to the company (i.e., no value).

On the other hand, the corresponding credit entry is applied to the inventory account to reduce the recorded carrying value on the balance sheet.

What is the Inventory Write-Off Reserve Account?

The benefit of recording the loss in a reserve account (i.e., allowance) is that the company’s financial statements will fluctuate less, and establishing a reserve account reflects that management anticipates and is prepared in advance for such situations.

By anticipating the losses from inventory write-offs, there is less of a “surprise” to investors in the event of a write-off, stabilizing the stock price of the company’s shares in the open markets.

The inventory write-off expense is a contra account paired with the inventory account on the ledger. The reserve (or allowance) account size is estimated based on historical data and internal projections.

Once the anticipated write-off occurs and the process of removing the inventory value from the books (and disposal) is complete, the loss is charged against the reserve account.

But irrespective of the expense account debited, the adjustment flows into the cost of goods sold (COGS) line item of the income statement.

On that note, the implication of an inventory write-off on the financial statements is identical under either approach.

The debit and credit entries in the accounting ledger must be equivalent for the fundamental accounting equation to remain true.

If a company operates in an industry where write-offs in inventory are a frequent occurrence, charging the loss to the COGS account can distort the granular analysis of the company’s periodic gross profit for internal planning and budgeting purposes — albeit, the internal data is not required to be reported in SEC filings.

Inventory Write-Off Journal Entry Example (Debit and Credit)

Suppose a clothing retailer determines a portion of its inventory is no longer sellable because of unfavorable market trends in consumer shopping behavior.

The historical cost of the inventory, or original value, was $100k, and we’ll assume the entirety of the inventory value will be wiped out.

The journal entry to record the inventory write-off would be a debit entry of $100k to the “Inventory Write-Off Expense” account and a $100k credit entry to the “Inventory” account.

Once the journal entry is recorded in the retailer’s accounting ledger and the loss is recognized on its financial statements, the value of the unsellable inventory is effectively removed from the books.

How Does an Inventory Write-Off Affect the Financial Statements?

As the prior sections have discussed the journal entry process (debit, credit) in the event of an inventory write-off, this final section will focus on the impact on the three financial statements.

The inventory write-off affects the three financial statements by reducing the reported value of a company’s inventory in the current assets section of the balance sheet.

The reduction in the inventory balance must be offset by recognizing an inventory impairment expense of equivalent value on the income statement. The impairment expense will be recorded in the non-operating items section of the income statement because write-downs are non-recurring events that are not part of the core operations of a business.

Recognizing the impairment expense reduces the income statement’s net income (the “bottom line”).

However, the expense causes the company’s pre-tax income (EBT), or taxable income, to decrease. The income tax provision is reduced from the lower taxable income.

Considering the retained earnings line item is the prior period balance plus the current period net income, subtracted by dividend issuances to shareholders, the reduction in net income flows into the retained earnings line item in the shareholders’ equity section.

Since the cash flow statement (CFS) reconciles the accrual accounting-based income statement, the inventory impairment is treated as a non-cash add-back in the cash from operations (CFO) section.

In conclusion, the impact of the $100k inventory write-down on the three financial statements, assuming a 30% tax rate, would be as follows.

• Income Statement (I/S) → The $100k inventory impairment expense is recognized in the non-operating items section of the income statement. Given the 30% tax rate, the expense reduces the pre-tax income (EBT), resulting in tax savings of $30k (30% × $100k). The impact on net income is a reduction of $70k.
• Cash Flow Statement (CFS) → The net income decreased by $70k. However, the impairment charge is treated as a non-cash add-back. The $100k inventory write-down is added back on the cash flow from operations (CFO) section to reconcile the ending cash balance, which is up by $30k.
• Balance Sheet (B/S) → The inventory balance decreased by $100k, but the ending cash balance increased by $30k from the tax savings. The net impact on the assets side is a loss of $70k. The retained earnings line item is down by $70k on the liabilities and equity side, causing the accounting equation to remain true.