(Courtesy: Cfredericks34 at flickr.com)
You just finished a massive count of your inventory and the results are that there is a significant amount of products that are obsolete, damaged, and spoiled and a small, but significant amount of goods that have been stolen.
So how are you going to account for these items that won’t sell and won’t generate revenue for your company?
There are three accounting methods that permit you to deal with these inventory problems without affecting revenue. They are Inventory Reserves, Inventory Write-Offs, and Write-Downs.
You all know that inventories are identified as assets on your balance sheet. When these products are sold, then the company that sells them earns revenue. So when the products come into the warehouse, they represent future economic value and companies are required to report the assets as close to their current value as possible. Your accountant is allowed to make some estimates when calculating this figure.
Inventory Reserve
In determining the value of the inventory, your accountant can estimate how much of that inventory will “go bad” based on what has happened in the past, current conditions in your industry that affect the value of the inventory, and knowledge of customers likes and dislikes. This classification is referred to as “Inventory Reserve.”
So, your accountant concludes that the value of the inventory is say $200,000. He guesses that 1 percent of the inventory will never be sold. So on the balance sheet, the accountant writes that gross inventory has a value of $200,000. He then creates a negative balance of $2,000 (1 percent of $200,000) –- the inventory reserve. Based on this, the accountant claims for the company has a net inventory of $198,000 ($200,000 minus $2,000). Then the accountant claims $2,000 expense on the income statement.
Inventory Write-Offs
So you take the results of your massive inventory count and discover that there are items that can’t be sold because they have spoiled if food, or there are a number of items that are outdated. The accountant will write-off these products –- or take them off the books. The company ends up “eating” the cost of these items.
So, in our example, the accountant has noted that the gross value of the inventory is $200,000; and there is an inventory reserve of $2,000. Now he writes off $500 in inventory as the value of the spoiled or outdated products.
The value of the gross inventory changes from $200,000 to $199,500. The reserve inventory is also affected by $500 changing that to $1,500. The value of the net inventory stays at $198,000 because the write-off was already accounted for on the income statement as an expense when the inventory reserve was calculated.
Write-Downs
Remember that your accountant reports the value of the inventory based on the wholesale price of the products, not the retail price. There are occasions when the market wholesale price of products drops below the cost your company originally paid for the products. A good example of this involves the computer industry. A computer that is one or two generations older than the current computer won’t sell for the same price it did when it was new. The computer still has value, but not as much as it did. So your company will have to sell the computer for less than cost.
In this case, your accountant can write-down the value of the product to the market price. The value of the write-down can then be taken off both the value of the gross inventory and the inventory reserve.