Inventory Write Down
Inventory write-downs are accounting principles that involve reducing the value assigned to inventory on the balance sheet.
What is Inventory Write-Down?
Inventory write-downs are accounting principles that involve reducing the value assigned to a given inventory market value on the balance sheet.
Inventories are susceptible to depreciation when assets lose value over time until the asset’s value tends to zero. Depreciation is controlled by factors such as market conditions (climate), damage, obsolescence, or even theft.
As a result, the market value of given inventory items can sometimes be lower than the asset's book value. Book value is defined as the net value of the asset in the balance sheet or the original price used to purchase the asset.
Market value is defined as the amount in which the given asset can be sold in the open market, or specifically, the spot price of the given asset (inventory) given current market conditions (demand and supply). This realizable value might sometimes be above or below the book.
As a result of such write-downs, the company's balance sheet and income statement are affected, and the business net income and related earnings are likewise impacted.
Write-downs should also be done as soon as possible so that financial statements would immediately reflect the current state of the company’s inventory and, by extension, the reduced value of the inventory.
Suppose the inventory asset value and the cumulative value of the inventory reflected in the balance sheet are seen as too high. In that case, this is misleading to the readers of the companies’ financial statements, which might implicate the company in lawsuits or legal challenges.
Key Takeaways
- Inventory write-downs involve reducing the value assigned to inventory on the balance sheet.
- Inventories can depreciate due to factors like market conditions, damage, obsolescence, or theft.
- The market value of inventory can be lower than the book value, which is the net value of the asset in the balance sheet.
- Inventory write-downs affect financial ratios such as current ratio, inventory turnover, days of inventory on hand, net profit margin, and gross profit margin.
- Reversals in inventory write-downs are rare but can occur if the net realizable value of inventory changes significantly.
- Inventory write-offs are treated as expense items, reducing net income and tax liability and affecting the balance sheet.
Accounting For Inventory Write-Downs
When an item is identified for inventory write-down, the write-down will occur immediately, i.e., the entire amount is charged to expense at once.
This write-down will not be spread over multiple future periods, as this would indicate some benefit accruing to the business over the write-down period, which is not the case in these instances.
For instance, with an original value of $1,000 in computers, a software company that had its hardware stolen of a total value of $400 would reflect an inventory write-down in its accounts.
Since this inventory write-down is significant in size, the expense is recorded in a separate account so that aggregate size can be tracked. The write-downs are debited, and the inventory is credited.
| Debit | Credit | |
|---|---|---|
| Inventory write-down expense | 400 | - |
| Inventory | - | 400 |
The opposite case, where the inventory write-down is not significant in size, is seen. In this, the general cost of goods sold is debited, and inventory is credited.
| Debit | Credit | |
|---|---|---|
| Cost of goods sold | 400 | - |
| Inventory | - | 400 |
As seen in the examples above, both inventory accounts are credited, regardless of whether the inventory write-down is seen as significant in size or not.
Further, the determination of whether the inventory write-down is significant in terms of size is fully based on the company. The company could impose specific matrices or assessment criteria that determine the severity of the write-down and is not fixed company to company.
Reversal of Inventory Write-Down
In rare specific cases, inventory write-downs can be reversed. This could come in cases that involve the estimated initial write-down being lower than the net realizable value of inventory.
For instance, this specific case could happen if market conditions change drastically. Basically, any change that fundamentally alters the inventory’s spot market value to the green.
Since assessments are conducted every reporting period, the assessment coordinator would determine if there is clear evidence of value differences.
If there are, then this individual would reflect it properly and promptly to superiors, who would initiate this reverse in inventory write-downs.
However, Generally Accepted Accounting Principles (GAAP) do not allow for reversals in inventory write-downs; hence, the lower inventory value will be kept and reflected.
However, the International Financial Reporting Standards (IFRS) allows for reversals in inventory value due to causes of depreciation but not because of goodwill.
Why Do Write Downs Happen?
In terms of what assets/items/inventory accounts should be considered for a write-down, the list is extensive. Raw materials, in-progress products (secondary goods), and even finished merchandise can all be considered for inventory write-down and are subject to depreciation.
If the inventory loses all its value, the item is written off as “inventory write-off” instead of inventory “write-down”.
Such “write-downs” are treated as expense items. As a result, this impacts both net income and tax liability, reducing them. Inventory write-downs also affect both the balance sheet and the income statement, resultantly.
When there is a reduction in net income, the business’ retained earnings fall as well. While this affects the income statement, the fall in net income will cause shareholders’ retained earnings to minimize, affecting the balance sheet aspect as well.
Along with this, the inventory asset value in the balance sheet is also further reduced along with its accurate net realizable value (NRV).
Note
Net realizable value (NRV) is defined as the difference between the expected sale price of the asset and the total sale or disposal cost. NRV is commonly used to determine a specific asset's lower cost or market rule.
The lower cost or market rule means that businesses have to ensure that the cost of inventory is reflected at whichever value is lower – market or the original cost of the asset.
For instance, if NRV is positive, that means that the expected sale price is higher, and therefore, the original cost of the asset reflected in the sheets will be changed out to input the spot market price/cost of the asset.
Likewise, if NRV is negative, the market cost is higher. Therefore, the asset's original cost reflected in the sheets will be retained.
Impact of Inventory Write-Downs on Financial Ratios
Recorded inventory write-downs can affect various financial ratios. Some common multiples will be affected, as well as specific margins.
1. Current ratio
This decreases as a result of inventory write-downs. Current ratios are defined as the ratio between current assets and current liabilities. As a result of inventory write-downs, which are reflected as expenses, the company’s net income falls.
As a result of the company’s net income falling, the company would also see the company’s total current assets fall as cash or retained earnings fall. Since the amount of the current assets falls, the current ratio will reduce as a result.
2. Inventory turnover
It is defined as the rate at which inventory is used, sold, or replaced. It is calculated through the cost of goods sold divided by the average inventory at the selling price.
Inventory write-downs result in a reduction in the value of inventory on the balance sheet to reflect lower worth, reducing the net income and thus reducing the amount of cost of goods sold.
Note
When COGS are reduced, the inventory turnover ratio will increase.
3. Days of inventory on hand
Days of inventory on hand, or inventory days, are calculated through
(Average Inventory/ Cost of Goods Sold) * 365/ 366
Days of inventory on hand are defined as the number of days that a business takes to sell and finish its inventory stock.
Since net income falls, the cost of goods sold will fall, which will result in an increase in days of inventory on hand.
4. Net profit margin
Calculated as:
(Revenue - Cost)/ Revenue
Net profit margin is defined as the amount of profits generated per $1 in sales.
Specifically, it is calculated by deducting all company expenses (all costs, including COGS, tax liabilities, and administrative costs) from total revenue.
Note
Revenue minus cost is also the net margin; hence, the answer is in percentage form when divided by revenue.
When net income falls, the numerator in the equation, which is revenue-cost, falls. This results in the net profit margin falling.
5. Gross profit margin
Calculated as
(Revenue - COGS)/ Revenue.
This matrix is similar to the net profit margin, but instead of cost being deducted from revenue, COGS is used instead.
Unlike net profit margin, gross profit margin calculates the profit taken by the company after accounting for the direct costs involved in doing its business of creating the product.
As the value of inventory in the balance sheet falls, reflecting lower values, net income is reduced, and as a result, the cost of goods sold reduces as well. As COGS falls, the equation's numerator increases, resulting in the gross profit margin increasing.
Summary
Inventory write-downs play a crucial role in accurately reflecting the value of inventory on a company's financial statements. They address the depreciation and obsolescence of inventory, ensuring that the reported figures align with the economic reality.
By reducing the value of inventory to its market value, write-downs help prevent misleading financial statements that could have serious implications for stakeholders.
They directly affect the income statement by reducing net income, which in turn influences profitability ratios such as net profit margin and gross profit margin.
These ratios provide valuable insights into a company's ability to generate profits relative to its revenue and cost of goods sold. Furthermore, write-downs affect liquidity ratios, such as the current ratio, which measures a company's ability to meet short-term obligations.
Companies must promptly recognize inventory write-downs to ensure transparency and accuracy in financial reporting.
By doing so, they provide a clear picture of the company's financial health and mitigate the risk of potential lawsuits or legal challenges resulting from misleading information.
Note
Inventory write-downs demonstrate prudent financial management. They reflect a company's commitment to presenting reliable and realistic financial statements, enhancing investor confidence, and facilitating informed decision-making.
These ratios provide insights into a company's liquidity, efficiency in managing inventory, and overall profitability. They are very important to assess and continually update as the business goes through changes, transitions, or market changes.
Properly recording inventory write-downs is crucial for transparent financial reporting and ensuring the financial statements accurately represent the company's financial position.
Management needs to evaluate and determine the appropriate value for write-downs, considering factors such as market conditions and the physical condition of the inventory.
Overall, inventory write-downs are essential to inventory management and financial accounting, helping companies maintain accurate financial records and make informed business decisions.
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