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 be noted for accounting purposes.
An inventory write-down is the required process used to reflect when an inventory loses value and its market value drops below its book value. The write-down impacts the balance and income statement of a company—and ultimately affects the business’s net income and retained earnings. Considering its implications, it’s valuable for companies to understand what it is, 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? The term refers to a required accounting process that must be conducted when inventory decreases in value—but does not lose its value completely. When an inventory’s fair market value drops below its book value, a journal entry is made in the inventory write-down expense account or cost of goods sold (COGS) account depending on the significance of the write-down. The adjustment must be made as soon as possible. This ensures accounting accuracy and lessens tax liability. Ultimately, an inventory write-down reduces the value of the ending inventory for the period, which has implications on both the income statement and balance sheet of a business.
Inventory Write-Down Journal Entry Example
As an example, online retailer Case City sells phone cases and a new version of the most popular cell phone brand has come out. Case City’s current inventory of phone cases will not fit the new device. Because the cases in the inventory are becoming obsolete, they drop in value 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 a few of that particular model left. The journal entry on the income statement would appear as such:
However, let’s say the inventory write-down is significant—the company had 100 cases left. The journal entry on the income statement would instead appear:
- If inventory loses value, an accounting process called an inventory write-down is required to show on the financial statements that the net realizable value is less than anticipated.
- An inventory write-down differs from an inventory write-off because it deals with inventory 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 balance sheet—reducing net income, retained earnings and shareholder equity.
- Companies can reduce incidents of inventory write-downs through effective inventory management strategies like avoiding excessive inventory, reviewing order frequency, tracking trends in demand and implementing precautionary measures to avoid theft or damage.
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 different scenarios—like damage, theft and shifting market trends—are all subject to an inventory write-down if their actual worth drops below the book value. It should be noted though that if a piece of inventory loses all its value as opposed to just some, it would not be 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 can happen for a multitude of reasons. Obsolescence tends to be a common reason why inventory might be written down. If a new model of a product comes out, consumer demand decreases, or market trends shift, and companies may be left holding inventory that is a fraction of its original value. This is especially frequent in industries like technology and retail where there are short 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 and security 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-down is treated as an expense, which means net income and tax liability is reduced. A reduction in net income thereby decreases a business’s retained earnings, which would then decrease the shareholder’ equity on the balance sheet. The inventory’s asset value on the balance sheet must be reduced as well to its accurate net realizable value (NRV). Small business accounting software can help you keep track of expenses and accurately record inventory write-downs.
An inventory write-down also impacts several financial ratios:
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, it will be listed as a part of the COGS. In this case, the company would debit the general COGS account on the income statement and credit the inventory the difference between the original value and its current value. This approach will increase the COGS.
However, if the inventory write-down is significant, record the expense in a separate impairment loss line item (inventory write-down) so the aggregate size can be tracked. As a general 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 income and taxable income will be reduced.
Inventory Write-Down vs. Write-Off
The difference between an inventory write-down and an inventory write-off essentially comes down to a matter of degree. Whereas write-downs deal with a reduction in value, write-offs deal with an elimination of value. While it tends to occur for similar reasons—obsolescence, market changes and damage, as well as lost, stolen or spoiled—an inventory write off removes inventory 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 a company’s products are no longer worth as much, the business’s financials need to reflect that by revising the listed book value to its accurate NRV. While any company can be forced to write-down the value of inventory due to unforeseen circumstances, many write-downs could be reflective of poor inventory management, which constitutes having the right stock, at the right 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 the books as the value of the inventory and what is its actual value now?
- Determine where to record journal entry: Depending on the materiality of the value change, an inventory write-down can either be recorded in the COGS or as a separate line item on the income statement.
- Report the write-down: If the write-down is determined to be relatively small, 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 and credit the inventory account of the value difference.
- Review circumstances: Understand why the inventory write-down occurred and 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 may need to do an inventory reversal. For instance, there might be an increase in the inventory’s market value or perhaps the initial write-down was too aggressive. It should be noted that the reversal of write-downs is prohibited by the U.S. Generally Accepted Accounting Principles (GAAP). However, under the International Financial Reporting Standards (IFRS), a reversal is permitted. A value difference must be identified in the period in which 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 of faulty batteries. The company’s phone cases can be sold at the original price with the previous phones being the mainstay. Case City would reverse the write-down if the cases reached the same or more than their previous value. Remember, a reversal cannot be more than the original write-down.
If Case City had only written down a few phone cases, the income statement reversal would look like this.
If Case City had written down 100 cases, if might look like this.
If the value increases, but not back to its full amount, then the entries would be the new value difference.
How to Reduce Inventory Write-Downs
Considering the effects of inventory write-downs, it’s in a company’s best interest to avoid them 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 expose the company to increased risks of obsolescence damage and spoiling in the case of perishable inventory.
Reviewing order frequency:
Revising order frequency to be smaller amounts and more frequent intervals can right-size inventory 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 phone with different dimensions was coming out and that demand was likely to drop. They could adjust their inventory ahead of time.
Protecting the inventory:
Damage or theft are common causes of write-downs. Implement protective measures like installing locks, security cages, video surveillance, smoke detectors, security alarms, etc. Additionally, implement intensive inventory control policies and 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 the most recently-produced items are sold first tend to have less write-downs than companies that use the first in, first out (FIFO) method. Under LIFO, the remaining balance sheet value for inventory reflects the older, and lowest, prices.
Implementing inventory management software:
Investing in inventory management software can help companies enact the strategies above through features like cycle counting, tracking inventory in multiple locations and demand planning.
Inventory Write-Down FAQs
When is an inventory write-down considered significant enough to be recorded as its own line item?
As a general guideline, writing-down 5% or more of the inventory is a material adjustment and should be recognized separately.
Why does an inventory write-down increase the COGS?
This is best explained by looking at the COGS equation:
COGS = Beginning inventory + purchases – ending inventory
If the value of the ending inventory has decreased, as it does with a write-down, the COGS will 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 a large decline in the gross profit ratio, which would require explanation.