Updated July 15, 2023
Definition of Inventory Write Down
Inventory is to be valued at lower of cost or Net Realisable Value as per Generally Accepted Accounting Principles, so whenever the value of inventory gets affected due to several factors, then it is to be written down to the actual realizable value, and at every balance sheet date, the assessment of the valuation of inventory is to be done to reflect the correct value.
Explanation
Inventory is a major part of every business organization. Inventory valuation also plays a major role in determining the company’s profit. The expenses related to inventory depend upon the nature of goods, storage period, etc. With the passage of time and changes in market situations, the value of inventory gets affected, so at every balance sheet date, inventory valuation is to be done. Suppose the net realizable value of inventory is less than the value shown in the accounts. In that case, inventory valuation is to be written down to its net realizable value to reflect the true and fair view of the accounts.
How to Perform Inventory Write-Down?
Inventory is to be valued at a lower cost or net realizable value, and this assessment is to be done at every balance sheet date. Net realizable value is to be assessed on the basis of market value, i.e., what will be the value of inventory if it is sold on the balance sheet date. Suppose the net realizable value is more than the value recognized in the balance sheet (i.e., its cost). In that case, inventory is to be valued at cost only, so there is no need to revalue the inventory as per generally accepted accounting policies. Suppose the net realizable value of inventory is less than the cost shown in the balance sheet. In that case, the inventory value is to be reduced to net realizable value, i.e., inventory is to be written down. If the difference between cost and net realizable value is low, then the difference is debited to the cost of goods sold, i.e., inventory is to be reduced, and the cost of goods sold is to be increased. Conversely, if the difference between cost and net realizable value is high, the difference is debited to the profit and loss account as inventory writes off.
Example of Inventory Write down
An Ltd. valued its inventory amounting to $ 35,000 at the end of February 2020. In 2020 due to a change in the market situation, A Ltd. realized that the selling price of goods reduced to below the cost. Hence, A Ltd decided to revalue the inventory in March 2020, and after assessment, it found that the inventory has a realizable value of $ 30,000 only. Give the accounting treatment and journal entries in the books of A Ltd by both methods, i.e., reducing the cost of goods sold and writing them off as expenses. Also, what will be the value of inventory if further, in March 2021, the same inventory is in stock and has a realizable value of $ 32,000
Solution:
As of March 2020, inventory is to be valued at a lower cost or net realizable value, i.e., $ 30,000, i.e., inventory is to be written down by $ 5000.
1. Journal Entry for reducing the inventory through increasing the cost of goods sold
| Date | Particulars | Debit($) | Credit($) |
| 20-Mar | Cost of Goods Sold A/c Dr. | 5,000 | |
| To Inventory A/c | 5,000 | ||
| (Being Inventory is to be written down to Net Realizable value, and the difference is added to the cost of goods sold) |
2. Journal Entry for Reducing the inventory by debiting as expenses
| Date | Particulars | Debit ($) | Credit($) |
| 20-Mar | Inventory write off Expenses A/c Dr. | 5,000 | |
| To Inventory A/c | 5,000 | ||
| (Being Inventory is to be written down to Net Realizable value by debiting the loss to P&L) |
| Date | Particulars | Debit ($) | Credit($) |
| 20-Mar | Profit and Loss A/c Dr. | 5,000 | |
| To Inventory write off Expenses A/c. | 5,000 | ||
| (Being Inventory is to be written down to Net Realizable value by debiting the loss to P&L) |
As of March 2021, As the Net Realizable value of inventory increases and is below the cost, the write down will be reversed. The value of Inventory is $ 32,000, i.e., $ 2,000 written off is to be reversed.
1. Journal Entry for reversal of write down of the inventory through decreasing the cost of goods sold
| Date | Particulars | Debit ($) | Credit($) |
| 21-Mar | Inventory A/c Dr. | 2,000 | |
| To Cost of Goods sold A/c. | 2,000 | ||
| (Being write down of inventory is to be reversed by decreasing the cost of goods sold as used earlier for the write down of inventory) |
2. Journal Entry for Reversal of the inventory by crediting the profit and loss account
| Date | Particulars | Debit ($) | Credit($) |
| 21-Mar | Inventory A/c Dr. | 2,000 | |
| To Inventory W/o Expenses A/c | 2,000 | ||
| (Being Inventory valuation reversed due to an increase in the net realizable value below the cost by crediting w/o expenses) |
| Date | Particulars | Debit ($) | Credit($) |
| 21-Mar | Inventory write off Expenses A/c Dr. | 2,000 | |
| To Profit and Loss A/c | 2,000 | ||
| (Being written off of Inventory is reversed by crediting the profit and loss account) |
Tax Deduction for Inventory Write Down
It is considered expenses that are allowable business expenditures per generally accepted accounting principles, and the income is reduced to the extent of the inventory’s write down. Hence the tax benefit is available as the income is reduced and expense is increased.
Inventory Write Down vs Write Off
- Inventory is to be written down when there is a reduction in inventory valuation. In contrast, inventory is to be written off when the inventory becomes absolute, and the same is useless.
- Inventory is to be written down for reasons like the decline in the sale price or adverse market conditions, whereas inventory is to be written off if inventory is burned due to fire or storage or bad conditions making its resale value zero.
- In inventory written down, inventory is to be valued at a lower cost or net realizable value, whereas in inventory write off, inventory is to be written off completely from the profit and loss account and valued at nil.
Why Is Inventory Write Down Happening?
It happens due to the following reasons:
- Adverse market conditions like lower cost of raw materials, availability of substitutes, etc.
- Due to declining in the sale price, of final product inventory is to be written down.
- When the part of the inventory has no realizable value.
Effect of Inventory Write Down
The following is the effect of inventory write down:
- Inventory is to be re-valued at net realizable value after writing down.
- The loss on write down of inventory is to be reduced from the net income.
- The tax benefit will be availed from inventory write down as income decreases.
Conclusion
Inventory is written down to net realizable value when the inventory cost is reduced due to several conditions like adverse market situations, lowering the sale price, substitutes available, etc. If, after writing down of inventory further, the net realizable value increases but the same is below the cost, then the write down is to be reversed. It is different from inventory written off as inventory is written off, the complete inventory cost is to be debited to the profit and loss account due to non-saleable condition.
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