Inventory Write-Down Definition
Inventory write-down essentially means to reduce the value of the Inventory due to economic or valuation reasons. When the value of the Inventory reduces because of any reason, the management has to devalue such Inventory and reduce its reported value from the Balance Sheet.
Inventory is materials owned by any business to be sold for revenue or useful for converting into final goods to be sold for revenue. Inventory may become obsolete or become less in value; at that time, the management has to write down the value of the Inventory. The management has to compare the difference between the actual value of the Inventory vs. the original value of the Inventory when it was purchased initially, and the difference between two will be transferred to Inventory write down the account.
Inventory Write-Down Explanation
We use Inventory Write-down in the condition where the value of the Inventory reduces because the value has fallen because of the market or other economic reasons. It is the opposite of an Inventory write-up where the value of Inventory increases from its book value. A write down and write off are entirely different terms in the nature of accounting. We use a write-down when the value has decreased from its book value, but a write off means the value of the Inventory has become zero.
During quarterly or annual inventory valuation, the management has to put the fair value of Inventory in the books. Inventory has to be appropriately valued as per accounting methods and according to market valuation as well. Sometimes the value of the inventory increases, and sometimes we have to write-down the value of the Inventory, which is called inventory write-down. It also depends on the physical structure of the Inventory as well.
For the same lot of Inventory, the management may write-off, write-down, or sometime write-up of the valuation of the Inventory.
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Steps to Record Inventory Write-Down
To record the Inventory write-down in the books, we need to reduce the Inventory by creating a contra inventory account. Let’s understand in the following manner,
- First, the management has to understand the effect and also the value of the inventory write-down as these decisions will affect the process of the accounting treatment for Inventory write down.
- Once the management determines the value of the Inventory, which has to be written down, they need to decide whether that value is relatively small or large for the management. This decision will change from company to company.
- It is the process of reducing the value of the Inventory to keep the fact in the mind that the same part of the Inventory is estimated to be valued worthless, which is showing in the books.
- A certain amount of inventory write-down will be recorded as an expense for that particular period. And this process is done at one time, unlike depreciation, which is recorded for more than one period.
Accounting Journal Entries for Inventory Write-down
Let us take an example, there is a product that costs $100, but due to weak economic conditions, the cost of the product reduced by 50%. So, the value of the Inventory has gone down or has only scrap value. Thus, the management will record this difference in the books, which is called Inventory write down.
There are two ways of recording this as per the below example,
#1 – Journal Entries when Inventory Write-down is Small and Note Significant
#1 – Journal Entries when Inventory Write-down is Significantly high
The management should be aware of this part of Inventory management, as this affects the business in many ways. Recoding the true value of the Inventory in the accounts will provide the right picture of the business.
We should not record the value of this write-down in a future period. It should be recorded in a particular period when it was calculated.
Effect of Inventory Write-Down on Financial Statements
Inventory write-down is an expense in nature which will reduce the net income in the particular financial year. During the fiscal year, any damaged goods in production or damage during delivery from one place to another, goods stolen or used as trials and samples can also affect write-down inventory.
The effect of the inventory write-down can be summarized as per below,
- It reduces the value of the Inventory, which is recorded as expenses in the Profit & Loss Account, which reduces the net income for any particular financial year.
- If any business uses cash accounting, then the management write-down the value of the Inventory whenever problems occur, but in case of accrual accounting, the management may choose to make inventory reserve account to cover future losses because of inventory valuation changes.
- It also affects the COGS for any particular period. Let’s understand from below mentioned formula, COST OF GOODS SOLD = OPENING INVENTORY + PURCHASES – CLOSING INVENTORY. When we use this write-down, it increases the Cost of Goods Sold (COGS) for any particular period, because the management will not be able to receive payment of the said goods, which reduces the net income and taxable income as well. The value of the Inventory, which is written down, will not make any money for the business.
- It has a significant impact on any business’s net profit or balance sheet, as changes in the value of any inventory or assets will affect the profitability of the business.
This article has been a guide to Inventory write-downs. Here we discuss how inventory write-down affects financial statements and its journal entries along with practical examples. You may learn more about accounting from the following articles –