Understanding inventory write-down: impact on accounting statements

In this article, we consider what causes inventory write-downs, how to record them, the effects they have, and how to reduce their impact.

Why inventory write-downs occur

Inventory write-downs are caused by an impaired inventory, which are items that have a value that has declined since they were initially acquired. This inventory can include finished products, works in progress and raw materials.

When the valuation of these assets falls below the book value at which they are recorded in a company´s account, they may still have commercial value, but the partial loss of value must be recorded as a write-down on the company´s balance sheet.

The amount of the write-down is typically determined by the company's assessment of the market value of the inventory, based on market research, sales trends, industry reports, and other relevant data.

There are accounting standards and principles, such as the Generally Accepted Accounting Principles (GAAP), to guide companies on this.

Factors that can cause an inventory’s value to depreciate include:

• Changing market conditions
• Obsolescence
• Damage

Effective inventory management can help to prevent this (and is explored later in this article).

By accurately recording the change in value helps organizations maintain precise records, make important business decisions, and fully understand their financial position.

Write-downs can contribute to lower tax liabilities, but it may also cause a drop in reported net income, which reduces shareholder equity and retained earnings – effectively lowering the value of the business.

Write-down or write-off?

The difference between a write-off and a write-down is a matter of degree. A write-down reduces the value of an asset to offset a loss or expense. It becomes a write-off when the entire balance of the asset is eliminated and removed from the books altogether.

The decision to write down or write off an asset is usually made by the company's management based on assessments by auditors, accountants, financial analysts, or tax professionals.

Accounting treatment

The accounting treatment for write-downs captures the decrease in the inventory's market value relative to its recorded value on the balance sheet.

First, the accountant ascertains the scale of the inventory’s reduction.

1. If it is relatively small, they may choose to record the decrease in a company’s cost of goods sold (COGS). This is done by crediting the inventory account and debiting the COGS.
2. If the decrease is larger, however, it is usual to reduce the value of the inventory by crediting a contra asset. This contra asset is often called a “reserve for obsolete inventory” and is recorded as a debited expense.

Ultimately, an inventory write-down will reduce the value of the inventory for the period. This has implications for both the balance sheet and the income statement of a business.

Impact on balance sheet

An inventory write-down has several effects on a company's financial statements, including the balance sheet, current assets, and equity:

• Balance sheet: Inventory is considered a current asset on the balance sheet. When a company decides to write-down its inventory, it reduces the value of the inventory asset on the balance sheet. This reduction decreases the value of the total assets on the balance sheet.
• Current assets: As inventory is part of a company's current assets, any reduction represents a decline in the amount expected to be converted into cash.
• Equity: The equity section of the balance sheet is affected rather more indirectly. The reduction in value is considered an expense, specifically a COGS expense. This expense reduces the company's net income for the period in which the write-down occurred.

Reduced net income leads to a decrease in retained earnings, which is a component of shareholders' equity on the balance sheet. The result: the company's profitability is negatively impacted by the write-down.

Impact on income statement

Similarly, an inventory write-down has an impact on a company's income statement. By increasing the COGS, it can impair profitability:

• COGS: The primary impact of an inventory write-down is reflected in the COGS section of the income statement. Written-down inventory is recorded as an expense. This will be subtracted from the revenue earned from the sale of goods during the accounting period.
• Gross profit: Gross profit records the difference between revenue and COGS. An inventory write-down increases the COGS and decreases the gross profit.
• Operating profit: Operating profit is the profit a company generates from its core business operations. It's calculated by subtracting operating expenses from gross income. It excludes certain non-operational items such as interest expenses, taxes, and other non-recurring items.
• Net income: Net income is the bottom line of the income statement and represents the company's profit after all expenses (including taxes and interest). The inventory write-down is part of the expenses that will decrease net income.

Financial ratios and metrics

There are also several effects on other financial ratios which are used to interpret a company's financial health.

Write-downs are sometimes regarded as warning signs for commercial and financial issues within a company, such as declining market demand or poor inventory management. Frequent or significant write-downs are likely to raise concerns about the quality of the company's financial reporting and its ability to value its assets accurately.

Investors and creditors typically view a company with a history of inventory write-downs as riskier, which can affect its creditworthiness and stock valuation.

The key metrics are:

• Inventory turnover ratio

[COGS / Average inventory]

This metric measures how often a company´s inventory is sold and replaced and is considered a crucial indicator in how effectively a company manages its inventory. The reduced value of inventory leads to an increase in the inventory turnover ratio, which may be interpreted as a sign of reduced inventory quality.

• Current ratio

[Current assets / Current liabilities]

The current ratio measures a company´s short-term liquidity and is seen as an indicator of its ability to meet its financial obligations. A reduction in a company´s current assets – those assets it can sell to turn into cash – can lower a company’s current ratio potentially causing alarm bells to ring about its financial security.

• Return on assets (ROA)

[Net income / Total assets]

The return on assets reflects a company´s ability to generate profit from its inventory. An inventory write-down results in a lower net income thus reducing the ROA indicating that a company is less effective at generating profit relative to its assets.

• Return on equity (ROE)

[Net income / Shareholders' equity]

The reduced ROE may signal to investors that the company is becoming less profitable in relation to the equity invested and as a result is less attractive to investors.

Disclosure and reporting requirements

Inventory write-downs are subject to specific disclosure and reporting requirements in financial statements.

These requirements are often governed by accounting standards, such as the Generally Accepted Accounting Principles (GAAP) in the US or the International Financial Reporting Standards (IFRS) in many other countries.

The nature and amount of the write-down will be recorded in footnotes to financial statements. Similarly, a clear record of the write-down must appear in income statements and other reporting to key stakeholders.

In the Management's Discussion and Analysis (MD&A) section of financial statements, companies may need to discuss the risks associated with inventory write-downs and how they affect their financial position and prospects.

Compliance with these disclosure and reporting requirements is critical for providing stakeholders, including investors, creditors, and regulators, with a clear understanding of a company's financial performance.

Failure to meet these requirements can result in regulatory penalties and a loss of trust from investors and other stakeholders.

Reversal of an inventory write-down

There are certain conditions in which reversals of inventory write-downs can be made. These typically occur where the conditions that led to the initial write down no longer exist and there has subsequently been an increase in the inventory’s market value.

The reversal of write-downs is very limited under GAAP rules but is permissible by IFRS where a reversal is permitted as long as a value difference is identified in the period in which it occurs. The reversal is also limited to the amount of the original write-down.

Strategies to avoid inventory write-downs

There are a number of inventory management best practices and risk mitigation strategies that can help a business with write-down protection.

These include:

• Limiting excess inventory. By understanding and tracking trends in demand, organizations can meet consumer needs without storing excess inventory that might not hold its value.
• Implementing inventory management software. Inventory management software can help firms track inventory in various locations, manage cycle counts, and plan for changes in customer demand.
• Increasing order frequency. Smaller orders placed more frequently can reduce exposure to write-down risk.
• Keeping inventory safe. Theft or damage are common causes of inventory depreciation. Consider reviewing security procedures or auditing compliance.

The bottom line

Inventory write-downs are an essential tool for directors, investors, creditors, and regulators to understand businesses.

They affect financial statements and ratios and are also regulated by compliance and reporting rules.

There are many practical strategies that can decrease the need to write-down inventory that will also help improve a business’s financial health and reputation.

Looking for tax tips? Find them here.