What Is Obsolete Inventory, and How Do You Account for It?

Understanding what inventory reserve is and how it’s applied in accounting is necessary if you’re strictly adhering to the US GAAP. However, small businesses can still use inventory reserves to anticipate sudden write-offs and reduce their impact on current period income. Inventory reserve accounting is merely an estimate of inventory that will not be sold due to physical deterioration, obsolescence, damage, or theft. We need to record an adjustment for inventory reserves to be consistent with the matching principle, i.e., costs and revenue of the current period must match. This transaction does not have any impact on income statement and balance sheet.

US GAAP Guidance

Costs of keeping inventory can come in many forms, and most of them are seen by the market as having the potential to negatively affect a corporation’s profitability. They may be in the form of holding costs, storage costs, shrinkage costs, or any type of cost arising from a decrease in the value of the inventoried assets. Inventory reserves or allowances are contra accounts as they may partially, fully, or more than fully offset the balance of the inventory account.

How QuickBooks Enterprise can help businesses avoid inventory reserves

Accounting rules require that a company must write down or reduce the reported value of inventory to the market value on the financial statement when the market price of the inventory falls below its cost. A business will often charge the inventory write-off to the cost of goods sold (COGS) account If the inventory write-off is immaterial. The problem with charging the amount to the COGS account is that it distorts the gross https://www.bookstime.com/ margin of the business because there’s no corresponding revenue entered for the sale of the product. Inventory reserve accounts are ultimately a tool for optimizing inventory management, which is further supported with QuickBooks Enterprise. Enterprise enables you to access real-time inventory levels across different locations, providing details on how many products are on hand, on sales order, or on a purchase order.

• By this time, the obsolete inventory will be disposed, so it should be removed from the balance sheet.
• There are two reasons why inventory reserves are important in financial reporting.
• The amount in this reserve should be the estimated amount by which the inventory asset will be written down, once specific inventory items have been identified as obsolete.
• In the case of crude oil, the market price is very easy to determine, as it’s a commodity that is traded internationally and the price has a very low bid-ask spread.
• The inventory account will be credited and the inventory reserve account will be debited to reduce both when the asset is disposed of.
• The upper boundary, called the ceiling, is in place to remove the opportunity for a company to overstate the value of its inventoried assets.

How Does Obsolete Inventory Affect the Income Statement?

When an expense account is debited, this identifies that the money spent on the inventory, now obsolete, is an expense. A contra asset account is reported on the balance sheet immediately below the asset account to which it relates, and it reduces the net reported value of the asset account. In our example on inventory write downs, an allowance for obsolete inventory account is created when the value of inventory has to be reduced due to obsolescence.

It simply deducts the inventory balance and increases the cost of goods sold balance. The company has to record the inventory of obsolete $ 40,000 on income statement. The inventory net balance will reduce by $ 40,000 as the allowance for inventory obsolete is the contra account of inventory. It requires the company to make estimates on inventory obsoletes and record expenses on every accounting period. The journal entry for obsolete inventory affects your financial statements by lowering the asset value. If it’s a significant amount, it implies that your inventory management isn’t as good as it should be.

• Sales orders are automatically tracked and accounted for by average costs and cost of goods sold (COGS).
• The account used for this adjustment is the “Allowance to Reduce Inventory to LIFO” account.
• Because this value is constantly changing, the percentage should be reassessed every sales cycle or accounting period.
• It is maintained as a contra asset account, so that the original cost of the inventory can be held on the Inventory account until disposed of.
• We need to record an adjustment for inventory reserves to be consistent with the matching principle, i.e., costs and revenue of the current period must match.

Ideally, a business should maintain an obsolete inventory reserve that is paired with and offsets the inventory asset accounts. The amount in this reserve should be the estimated amount by which the inventory asset will be written down, once specific inventory items have been identified as obsolete. By accounting for these as a contra-asset and reducing the total inventory value, companies are able to get a clear picture of their assets and overall business health. Improving the accuracy of your financial statements will ultimately increase the understanding of a company’s assets and help improve inventory management for greater future revenue.

Inventory Reserve vs Inventory Write-off

An inventory write-off is an accounting term for the formal recognition of a portion of a company’s inventory that no longer has value. It can be expensed directly to the cost of goods sold (COGS) account or it can offset the inventory asset account in a contra asset account. This is commonly referred to as the allowance for obsolete inventory or inventory reserve.

Firm of the Future

• However, small businesses can still use inventory reserves to anticipate sudden write-offs and reduce their impact on current period income.
• If you don’t think that will work, you might write them off completely.
• The percentage is applied to the gross inventory to determine how much of the company’s products is expected to remain unsold in the future.
• An alternative approach is to create a reserve based on the historical rate of obsolescence.
• The valued inventory should have demand and the market price should be more than the reported value.
• The actual write-off didn’t affect net income because we already have an allowance for inventory breakage and spoilage.

Under the allowance method, we record and estimate inventory reserves based on experience. You need to make a best estimate of the cost of inventory that can’t be sold. In other words, inventory reserves serve as a cushion for these sudden write-downs. If you meet both requirements, you should make adjustments for inventory reserves in the income statement and balance sheet (more on that in the succeeding sections). Generally accepted accounting principles (GAAP) require that all inventory reserves be stated and valued using either the cost or the market value method, whichever is lower. However, accountants who apply GAAP to inventory reserves often use a significant amount of personal judgment.

So they need to record credit inventory to reduce the inventory balance. However, the company already record inventory write down $ 5,000 for the whole inventory, which already impacts income statement. So this actual damage will not impact income statement but the inventory obsolete inventory reserve reserve. In order to record inventory provision, we need to debit expense and credit inventory reserve which is the inventory contra account. Most companies use the cost of goods sold in the account to record this expense, but they may separate subaccounts for easy control.

Inventory reserve is an estimation of future inventory spoilage based on the company’s past experiences. Once inventory that is unable to be sold is actually identified it is written down in official recognition of the loss. At the end of the year, company has to record the inventory obsolete which equals 5% of the total inventory.