Inventories do not stay the same for long; their value can decrease due to changing markets, damage, theft, or outdated items. This change needs to be taken into account.
An inventory write-down is like a correction for when the value of inventory drops below what's listed on the books. This correction affects a company's balance and income statements, ultimately affecting its overall earnings.
Businesses need to learn what write-downs of inventory are and ways to manage inventory to avoid needing write-downs. In this article, we will learn everything about inventory write-downs.
Define Inventory Write-Down
Let's see the inventory write-down meaning:
It's an important accounting step when the value of your goods in stock goes down but not all the way to zero. When your inventory's worth in the market is less than what you said it was worth in your records, you put this in your books.
You might write this in the "inventory write-down expense" or "cost of goods sold" section, depending on how big the change is. This fix needs to happen quickly. It keeps your accounting accurate and can lower how much tax you have to pay.
Journal Entry for Inventory Write-Down
Here is an example of an inventory write-down journal entry:
Imagine an online store called Case Haven. They sell phone cases, but a brand-new phone is on the market. The problem? Their current cases won't fit this new phone. So, the cases they have aren't as valuable anymore. Each case was worth Rs. 25, but now they drop in value to Rs. 10, making each case Rs. 15 less valuable.
Let us assume that the write-down amount is not significant. Case Haven only had a few of these cases left. Here's how it would look in their financial records:
| Debit Entry | Credit Entry | |
|---|---|---|
| Cost of Goods Sold | Rs. 45 | |
| Inventory | Rs. 45 |
Now, let's say the write-down amount is significant. Case Haven had 100 of these cases left. Here's how it would look in their financial records:
| Debit Entry | Credit Entry | |
|---|---|---|
| Inventory write-down | Rs. 1,500 | |
| Inventory | Rs. 1,500 |
What Products Are Eligible for a Write-Down?
Items are eligible for a write-down when they become less valuable, like the materials you're using, the half-done goods, or the finished products. You need to write down their value in the financial records. It happens when the goods are not worth as much as you thought.
It happens in different situations. Imagine things getting broken or stolen or customers not buying them as much. In addition, if any product becomes completely worthless instead of just a bit less valuable, you can't do a write-down for it. Instead, you call it a "write-off" and remove it from your records.
Accounting Practices for Inventory Write-Down
Here is the accounting for inventory write-down methods.
Direct Write-Off Method
This method involves writing down unsold inventory with lost value as a "bad debt expense." Imagine a company selling phones. At the start of the year, they had Rs. 10,000 worth of phones, but by the end, Rs. 1,000 worth became old.
So, they'll lower the phone value in their records by Rs. 1,000, and the cost of goods sold (COGS) goes up by the same amount. Remember, if the decrease in value isn't too big, it can be added to the COGS column. But a bigger value decrease must be recorded in a separate line on the financial report.
Allowance Method
This one's more complex. It's like setting aside money for items that might lose value later. Unlike the direct method, this one needs yearly reports on money lost.
This method involves creating a special account to predict how much value might drop (inventory reversal). This account balances out the value of the books.
For example, a phone store has items worth Rs. 10,000 and tags goods worth Rs. 1,000 for disposition. Then, they quickly create an inventory reserve account, adding Rs. 1,000 and subtracting the same amount as an expense.
Remember, talking to your financial expert about handling the write-offs is important, especially if you do it often.
How Does Inventory Write-Down Affect Business?
An inventory write-down affects a company's financial statements (balance sheet and income statement) and overall financial health. When inventory is written down, it counts as an expense. It lowers the company's reported income and the taxes it needs to pay.
As a result, the company's net income decreases, leading to a drop in retained earnings, reducing the shareholders' stake in the company, as shown on the balance sheet. The value of the inventory on the balance sheet is also adjusted to its actual value after considering potential losses.
Moreover, financial ratios like (current ratio, gross profit, net profits, inventory turnover, and days of inventory on hand) which help measure a company's financial health, are impacted by an inventory write-down.
Write-Down Effects on the Income Statement?
The way a write-down affects a company depends on where it's recorded. If it's not a big change, it goes into the cost of goods sold (COGS) column. It means the company adds the reduced value to COGS on the income statement and takes it away from the inventory value on the balance sheet. It increases the COGS, showing higher costs.
But if the write-down is big, it's shown as a separate expense called an "impairment loss" in the inventory write-down section. It helps keep track of all the write-downs together. Generally, if you write down 5% or more of your inventory, it's a big write-down.
Treating the write-down as an expense means the company's reported profit and the amount it needs to pay in taxes both decrease.
Write-Down vs. Write-Off of Inventory
The difference between an inventory write-down and an inventory write-off boils down to how much value is involved. Write-downs mean lowering inventory value, while write-offs mean completely removing the value. Both happen for similar reasons, like things getting old, market shifts, damage, or items being lost, stolen, or spoiled. But when you write off inventory, you take these worthless items off the books.
An Overview of Inventory Write-Down
An inventory write-down might sound complicated, but it's simple. If a company's inventory isn't worth as much anymore, its financial records need to show that by changing the stated value to the actual lower value. Sometimes, a company has to do this because of unexpected things. But often, loss on inventory write-down happens because of bad inventory management.
The 4 Steps to Writing Down Inventory
Here are the 4 steps to writing down inventory:
1. Check the Value Difference
Look at what the company says its inventory is worth and what it's actually worth.
2. Decide Where to Write It in Journal Entry
Depending on how much the value changed, you can either write it as part of the COGS or as a separate item on the income statement.
3. Note the Write-Downs
If the change isn't big, debit the lower value to the COGS and credit it from the inventory account. If it's a big value change, note it separately and do the same thing.
4. Understand What Happened
Figure out why the inventory value changed and think about how to stop it from happening again.
Reversal of an Inventory Write-Down
If a company lowers the value of its inventory, but then the value goes back up later, it is called a reversal of inventory write-down. It happens if the inventory becomes more valuable, maybe because its market value increased or because the first write-down was too big.
Inventory Write-Downs: How to Reduce Them
Here are some tips to reduce inventory write-down:
1. Avoid Over-Ordering
Don't over-order products. Ordering a lot might sound good, but it could make items useless or spoiled in the long run.
2. Order Smarter and More Often
Order smaller amounts more often. It helps you handle your inventory better and avoid having too much stock.
3. Watch What People Want
Keep an eye on what customers are buying and what's in demand. If you know a new version of a product is coming out, you can adjust your inventory accordingly.
4. Protect Your Goods
Protect inventory from damage or theft. Use locks, cameras, alarms, and other security measures. Keep a close watch on your inventory and do audits to prevent fraud.
5. Use LIFO Method
If you use a method like LIFO (last in, first out), where you sell the newest stuff first, you might have fewer write-downs. This method shows the oldest and lowest price inventory.
6. Use Software
Use inventory software to do all this better. It helps you count and track inventory, plan for your needs, and manage stock in different warehouses.
Manage Inventory Write-Down With TranZact
Using TranZact's inventory management software can make managing inventory write-downs easier. By following the tips mentioned earlier, like avoiding excessive inventory, tracking demand, and protecting your inventory, our software features can help keep your inventory in check. With TranZact, you can make sure your business runs smoothly and avoids unnecessary losses from inventory write-downs.
FAQs on Inventory Write-Down
1. What is the write-down of inventory?
An inventory write-down is when a company lowers the value of its products because they are worth less than originally thought.
2. Why do companies do inventory write-downs?
Companies do this when a product's value drops or it becomes damaged, outdated, or is not selling well.
3. How does an inventory write-down affect the company's finances?
Inventory write-down affects a company's finances because it reduces its reported profit and can also lower the amount of taxes the company needs to pay.
4. Where is an inventory write-down recorded?
Inventory write-down can be recorded as part of the cost of goods sold (COGS) on the income statement or as a separate expense.
5. What's the difference between an inventory write-down and a write-off?
An inventory write-down lowers the value of the goods, while a write-off removes the value completely from the company's financial records.
6. How can companies prevent inventory write-downs?
- Companies can prevent inventory write-down by:
- Ordering the right amount of products
- Keeping an eye on demand
- Protecting against inventory damage
- Using smart inventory methods, etc.
7. How can inventory management tools help with inventory write-downs?
An inventory Management tool that can assist in managing and tracking stocks makes it easier to distribute stock and follow best practices to avoid write-downs.
