Do You Show a Write-off for Obsolete Inventory on the Income Statement?
Items in inventory have value to the business because it is expected that those goods will generate profit at some point. Sometimes, market conditions or environmental factors can lead to items in the inventory to become obsolete, preventing the business from selling them as expected. When a business realizes that a portion of its inventory is obsolete, causing the asset to decline in value, it must create an allowance on its balance sheet. The effect of this allowance will increase the cost of goods sold, which modifies the income statement appropriately.
Inventory Issues Defined
Inventory is the collection of goods available for sale by a business. According to Accounting Coach, inventory is reported as an asset on the balance sheet. While reporting each good in inventory is valued based on either its total cost to manufacture or how much it cost to purchase. If you manufacture the good, the cost to produce it includes materials used and the labor expended. When an inventory item is sold, the value of the item when it was in the inventory is added to cost of goods sold. At the end of the year, the cost of goods sold is then subtracted from revenues to determine profit.
Income and Balance Sheets Defined
Writing off obsolete inventory affects two financial statements. The balance sheet lists assets, liabilities and the book value of the business owners’ equity as of a certain date. The carrying value of inventory to the business is included on the balance sheet. As reported by Accounting Coach, income statement details all income, gains, expenses and losses incurred during a given period of financial activity.
Under US GAAP, all businesses must record a contingency for future obligations that are probable and can be reasonably estimated. According to the Financial Accounting Standards Board, a contingency is a situation involving uncertainty as to possible gain or loss. Once a business reasonably expects that a portion of their inventory will become obsolete, it should create a contingency.
If a computer manufacturer determines that $200,000 of their inventory is comprised of obsolete computers that business can sell the computers for only $50,000. The business would draft a journal entry for $150,000, debiting cost of goods sold and crediting allowance for obsolete inventory.
Debits are accounting notations that increase the balance of assets and expenses and decrease the balances of liabilities, equity and income. Credits have the opposite effect. The increase in the cost of goods sold would affect the income statement because that statement lists all expenses. The allowance is listed on the balance sheet as a contra-asset, or a negative balance that offsets the value of an asset. In this way, the inventory balance is carried at its full value until the assets are sold, but the overall value of total assets reflects the expectations of the business.
Write-Offs for Obsolete Inventory
Obsolete inventory should be written down or written off the company's books as they are reached their end of the life cycle. When the obsolete product is eventually thrown out or abandoned, the value of the inventory requires further adjustment to reflect the actual loss sustained on the items.
Using the computer example, if the computers are sold for $50,000, you would record the sale by debiting the cost of goods sold by $50,000 and crediting inventory by $50,000. Then you would “zero out” the reserve balance by debiting the reserve by $150,000 and crediting inventory by $150,000. This would allow the inventory to be accurately valued.
The contingency is an estimate, so it is unlikely that the loss you will sustain on the disposal of the goods will equal the amount you planned. If you initially overestimated your reserve, you would credit the difference between the reserve and your loss to the cost of goods sold. If you underestimated your reserve, you would debit--or increase--the cost of goods sold by the difference.