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Inventory Write-Down

Step-by-Step Guide Guide to Understanding the Inventory Write-Down Concept in Accounting

Last Updated December 30, 2023

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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.

Inventory Accounting Method Description
FIFO (“First In, First Out”)
  • The inventories purchased on an earlier date are first in line to be recognized and expensed on the income statement, usually within the cost of goods sold (COGS) line item.
LIFO (“Last In, First Out”)
  • The inventories purchased more recently are recorded ahead of those purchased in the past (and recognized sooner on the income statement).
Average Cost Method
  • The total cost of production is divided by the quantity of units produced, which serves as a compromise between FIFO and LIFO.

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

Principle of Conservatism

The principle of conservatism establishes the guideline that revenue and assets can only be recognized when the probability of occurrence is near certain.

Further, conservatism in accounting is rooted in the notion that understated revenue and asset values are preferable over the opposite scenario, where recorded costs and liabilities are understated.

With that said, the conservatism principle is the centerpiece of the lower of cost or market rule (LCM), which requires assets like inventory to be reported at the lesser value between historical cost or market value as of the present date.

On the other hand, losses must be recognized promptly soon after the cost or expense is quantifiable — for example, the receipt of an invoice from a supplier or vendor is enough to warrant an adjustment.

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:

Inventory Issue Description
Obsolescence
  • Technological developments or significant secular shifts in a given market can completely alter an industry, resulting in obsolete inventory.
  • Since the inventory could technically still be sold, the reduced value remains on the balance sheet — albeit, the pool of potential buyers is likely substantially reduced.
Inventory Damage (or Physical Deterioration)
  • Inventory can often become damaged from various factors such as accidental mistakes by employees or natural disasters.
  • If the inventory is deemed repairable, the write-down must include the cost of repair.
  • In the case of spoilage, the trade-off in spending between restoring the inventory and purchasing new inventory must be considered.
  • If restoration costs more than placing a new order, it would not make sense economically to recover the inventory.
Inventory Expiry
  • Certain inventory, such as products with a limited shelf life, can approach their expiration date while under possession of the company.
  • While the inventory could technically be sold, the company will likely need to discount any pricing (and once the estimated value is quantified, the downward adjustment must then be recorded).
  • For inventory left unsold past the expiration date, the write-down would eventually become a write-off, which we’ll elaborate upon in a later section.
Unfavorable Secular Trends (Changes in Demand)
  • Consumer behavioral patterns and preferences are continuously changing, and new product innovations can disrupt existing incumbents in the market and traditional norms.
Regulatory Risk
  • Regulations enforced by the federal government or related governmental bodies can influence margins and marketability (or perhaps even legality in certain states) for certain products.
  • The incurred fees to adjust to the new regulatory environment and reduced market demand can create problems for the company, which must be reflected on the balance sheet for transparency.
  • For instance, one sector prone to such risks and “hurdles” is healthcare (e.g. telemedicine).
Quality Issues
  • Inventory orders can often arrive with quality issues that render them unusable (and thus unsellable). Inventory unable to pass quality control inspections will likely need to be adjusted by a write-off.
Excess Inventory
  • Management can often order excess inventory, causing overstocking (i.e. the pile-up of unsold products).
  • Over time, management’s ability to perform internal demand planning and forecasting should improve, reducing the risk of excess inventory.
Apple, Inc. Risk Factors

Inventory Write-Down Example

Apple, Inc. Risk Factors Section (Source: AAPL 2023 10-K)

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.

Inventory Write-Down = Historical Cost Lower of Cost or Market (LCM)

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

Inventory Write-Down = Historical Cost Lower of Cost or NRV (LCNRV)

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.

Net Realizable Value (NRV) = Expected Sale Price – Total Sale Costs
  • 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.

Quick Concept Check

If the inventory market value increased to $140k, rather than declining to $100k, the higher value would not be recognized per the lower of cost or market (LCM) guidelines.

The lower figure is still the amount that appears on the balance sheet, reflecting the conservatism principle.

Therefore, even if the market value exceeds the cost, the “gain” is not recognized until a sale occurs, such as after an acquisition.

Note: The reversal of an inventory write-down is not permitted under US GAAP. In contrast, a reversal is permissible under IFRS.

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

Journal Entry Debit Credit
Loss on Inventory Write-Down $20,000
        Allowance for Inventory Losses $20,000

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

Journal Entry Debit Credit
Loss on Inventory Write-Down $20,000
        Inventory $20,000

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.

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