Accounting for obsolete inventory...

Definition of obsolete inventory 

Obsolete inventory is the inventory that is non-useable (raw materials, parts) or non-resalable (finished goods).

 

Inventory can become obsolete in the following cases:

• Inventory no longer purchased by customers
• Inventory no longer used in manufacturing process
• Excessive purchasing of inventory (e.g., raw materials, finished goods)
• Development of new technology (e.g., change in product design)
• Inventory with short-shelf life
• Commodity items with rapid obsolescence

Obsolete inventory is carried at net realizable value (NRV), also called net selling price. That is, obsolete inventory is carried at estimated selling price in the ordinary course of business less predictable costs of completion and disposal. 

To dispose obsolete inventory, management can do the following:

• Return goods to the original supplier (if possible and makes sense)
• Sell online through an auction
• Use obsolete inventory for warranty replacements and repairs (if possible)
• Donate to charity (and claim tax deduction)
• Throw away

 

To control obsolete inventory, management can do the following:

• Schedule regular obsolete inventory reviews
• Review perpetual records that show last date of usage (e.g., stock levels, last usage date)
• Review work-in-progress inventory for old items
• Review physical storage methods
• Review bills of material for product withdrawals (“where used” report)
• Compare on-hand inventory to historical usage
• Compare purchase requisitions to reorder points
• Flag potentially obsolete inventory in the database (e.g., to stop repurchasing)
• Turn-off automatic reordering
• Move obsolete inventory to a designated area

 

Accounting for obsolete inventory 

 To record inventory obsolescence, companies can:

• Debit an expense account (examples are listed below):
  • Cost of sales-inventory write-downs
  • Cost of goods sold
  • Inventory obsolescence
• Credit a contra-asset account (examples are listed below):
  • Allowance for obsolete inventory
  • Obsolete inventory reserve

Let’s assume that on June 1, 20X2 Obsolete Company (a fictitious entity) realized that $5,000 (book value) of its inventory became obsolete because it is no longer used in the manufacturing process. The company estimates that it could sell the inventory for $1,000. Therefore, the inventory value was reduced by $4,000 (i.e., $5,000 - $1,000). To record inventory obsolescence, the company would make the following journal entry: 

Account Titles	Debit	Credit
Cost of goods sold	4,000
Allowance for obsolete inventory		4,000

Cost of goods sold represents an expense account while allowance for obsolete inventory is a contra-asset account. The allowance for obsolete inventory account is reported in the trial balance below the inventory account. 

When the inventory write-down is small, companies usually charge the cost of goods sold account. However, when the write-down is large, it is better to charge the expense to a separate account.

On July 2, 20X2, the company disposed obsolete inventory. Let’s review several possible scenarios of accounting for such disposal.

Scenario 1: On July 2, 20X2, Obsolete Company decided to dispose obsolete inventory by throwing it away in the dumpster. In this scenario the net book value of inventory is $1,000 (i.e., $5,000 - $4,000) and the company does not receive the anticipated selling price of $1,000. So, in addition to writing of the inventory, the company also needs to recognize an additional expense of $1,000. The company would make the following journal entry:

Account Titles	Debit	Credit
Allowance for obsolete inventory	4,000
Cost of goods sold	1,000
Inventory		5,000

Scenario 2: On July 2, 20X2, Obsolete Company decided to sell the obsolete inventory through an auction. The actual selling price is only $500 (i.e., $500 less than the expected selling price of $1,000). As the actual selling price is $500 less than the expected selling price, the company has to charge $500 to an expense account (cost of goods sold). On July 2, 20X2, the company would make the following journal entry to record disposal of the inventory and receipt of $500 in proceeds from its sale:

Account Titles	Debit	Credit
Cash	500
Allowance for obsolete inventory	4,000
Cost of goods sold	500
Inventory		5,000

Scenario 3: On July 2, 20X2, Obsolete Company decided to return the obsolete inventory to the original supplier. The actual selling price was $2,000 (i.e., $1,000 more than the expected selling price). As the actual selling price is higher than the expected selling price, the company can “reverse” the $1,000 expense recognized earlier. In addition, because the company is expected to receive a $2,000 credit from the vendor, accounts payable are decreased (debited). On July 2, 20X2, the company would make the following journal entry:

Account Titles	Debit	Credit
Allowance for obsolete inventory	4,000
Accounts Payable	2,000
Cost of goods sold		1,000
Inventory		5,000

As we can see from this example, the valuation of inventory as obsolete affects both balance sheet (through the allowance for obsolete inventory account) and income statement (through an expense account). Because inventory obsolescence represents an expense (e.g., cost of goods sold) that affects profits in the current accounting period, management might have an incentive to manipulate the allowance for obsolete inventory. This practice is not appropriate and auditors usually watch out for it. For instance, a company might recognize excessive inventory write-downs due to obsolescence in the accounting period when profits are higher than expected (i.e., debit cost of goods sold). Later on, when profits are lower than expected, the company might sell the written-down obsolete inventory at high profit margins in order to increase the reported profits (i.e., credit cost of goods sold).