Inventory Basics
Inventory is a product that the company will sell to consumers in order to generate revenues. For companies that maintain an inventory balance on their balance sheet, the sale of inventory is likely a significant revenue stream.
Across many industries, certain inventory held for sale eventually struggles to sell. More often than not, each company holding inventory will have a product that may be collecting dust in the inventory room for months or even years. In a world that continually operates at a faster pace with a greater expectation for innovation and product quality, a company needs to determine on a periodic basis whether or not their inventory held for sale should be considered obsolete, for example, the product can be highly specialized and rarely in demand. The general public may not agree anymore with the ingredients used to develop a product, or technological advances may have made this product inefficient for the intended use.
Companies should consider each of these factors when determining whether inventory truly is obsolete or unlikely to be sold. In the business world, inventory is generally considered slow-moving if it has been on hand for six months or more. Obsolete inventory is generally defined as no usage or sales in the past twelve months. Additionally, each company needs to determine whether there is a likelihood of inventory sales in the coming year.
Accounting Methodology
It is typical for a company to determine its inventory reserve as a percentage of historical write-offs. For example, if a company has $10,000,000 in inventory and their estimated write-off percentage is 2%, then the company will debit a loss of inventory value account (mapped to Cost of Goods Sold) and credit an inventory reserve account (a Contra Asset mapped to Inventory) as follows:
| Debit Entry | Credit Entry | ||
| Loss of Inventory Value | $20,000 | Inventory Reserve | $20,000 |
If the company specifically identifies $15,000 of obsolete inventory during a mid-year cycle count, an entry should be made to debit the inventory reserve account and credit the actual inventory that is obsolete as follows:
| Debit Entry | Credit Entry | ||
| Inventory Reserve | $15,000 | Inventory | $15,000 |
The remaining balance in the inventory reserve is now $5,000. If there is a balance in the inventory reserve account at year-end, the company may enter a reversing journal entry to provide more accurate financial statements as such:
| Debit Entry | Credit Entry | ||
| Inventory Reserve | $5,000 | Loss of Inventory Value | $5,000 |
Occasionally, a company may determine an inventory item is obsolete, yet they have not incurred obsolete inventory items in prior years and do not carry an inventory reserve balance. If this is the case, a journal entry will be made to debit the loss of inventory to a Cost of Goods Sold account, and credit the inventory account that is now obsolete. An example for a $10,000 obsolete inventory write-off is shown below:
| Debit Entry | Credit Entry | ||
| Loss of Inventory Value | $10,000 | Inventory | $10,000 |
Conclusion
Appropriately writing off inventory is crucial to accurately stating a company’s financial position, as well as helping identify areas of weakness in the company’s inventory purchasing or related processes. Please contact a GBQ representative should you have any questions or to discuss these items further.
Article written by:
Chris Gerarde, CPA
Assurance Senior
