Accounting for Inventory Obsolescence

Understanding Inventory Obsolescence

Inventory obsolescence occurs when the value of inventory declines due to factors such as:

• Technological advancements: Older products become outdated or less desirable.   
• Changes in consumer preferences: Market demand shifts, leading to decreased sales.   
• Damage or spoilage: Inventory becomes unusable due to physical deterioration.
• Economic conditions: Recessions or downturns can reduce demand and lower prices.   

The Impact of Inventory Obsolescence

Inventory obsolescence can have significant financial implications, including:

• Reduced profitability: Decreased sales and lower inventory values can lower net income.   
• Increased costs: Expenses related to storing, disposing of, or writing off obsolete inventory.   
• Distorted financial statements: Overstated inventory values can lead to inaccurate financial reporting.   

Accounting Methods for Inventory Obsolescence

There are several methods to account for inventory obsolescence:

1. Lower of Cost or Net Realizable Value (LCNRV)
   • This method requires that inventory be valued at the lower of its cost or its net realizable value.   
   • Net realizable value is the estimated selling price minus the estimated costs of completion and sale.   
   • Example: If the cost of a product is $100 but its net realizable value is $80 due to obsolescence, the inventory should be valued at $80.
2. Allowance for Inventory Obsolescence
   • An allowance account is created to estimate the expected loss from inventory obsolescence.
   • The allowance is adjusted periodically based on factors such as age of inventory, market conditions, and damage.
   • Example: If a company estimates that 5% of its inventory will become obsolete, it can create an allowance account for $5,000.
3. Direct Write-Off
   • This method involves directly writing off the cost of obsolete inventory when it is identified.   
   • This method can result in uneven income recognition throughout the year.

Practical Example

A company has a product with a cost of $50 per unit. Due to technological advancements, the product's estimated selling price has decreased to $40. The estimated costs of completion and sale are $5. Using the LCNRV method, the inventory should be valued at $35 per unit ($40 - $5).

Formula

LCNRV = Estimated selling price - Estimated costs of completion and sale   

Key Considerations

• Frequency of valuation: Inventory should be reviewed regularly to assess obsolescence.
• Documentation: Proper documentation is essential to support the valuation of obsolete inventory.
• Cost of obsolescence: The cost of obsolescence should be recognized in the period in which it is determined.

By effectively accounting for inventory obsolescence, businesses can improve their financial reporting and mitigate the negative impact of outdated inventory.