How Do You Handle Inventory that You Can No Longer Make A Profit on?

Accounting for Distressed Inventory

Article written by EricBank

The profitable management of a merchandising business requires that you sell your inventory for more than its cost. Your gross profit margin is your sales revenues minus the cost of goods sold (COGS). In the best of all worlds, you'd sell each item at its anticipated gross profit margin, but sometimes you have to deal with spoiled, damaged, distressed or otherwise devalued inventory. In this article, we'll describe the proper methods to account for distressed inventory.

Distressed Inventory

Inventory can become distressed for all sorts of reasons, including:

·       Damage from shipping and storage

·       Spoilage

·       Defects in its manufacture

·       Obsolescence

·       Health and safety issues

Distressed inventory boosts your COGS and reduces the value of your ending inventory, as seen in the inventory equation:

COGS = inventory purchases + beginning inventory - ending inventory

Sometimes, perfectly good inventory disappears -- a problem called "shrinkage" -- which also lowers the value of your ending inventory for the period. The net result is that a higher COGS means a lower amount of taxable income. In effect, your inventory losses are a tax deduction.

Write-Offs

If you do cash accounting, you can write off inventory losses directly as you become aware of them. The proper entry is to debit COGS, an expense account, and to credit the inventory account, a current asset. The problem with this procedure is that you will be potentially allocating the loss well after it occurs, and generally accepted accounting principles (GAAP) do not allow this if you use accrual accounting. The famous "matching principle" instructs you to recognize expenses in the period they actually occur, and match them to the revenues for that period. To apply the matching principle to inventory write-offs, you must establish inventory reserve accounts.

Inventory Reserves

The inventory reserve account appears right below the inventory line on the balance sheet -- it is a contra-asset account that reduces the net value of ending inventory. The account usually has a name like "allowance for inventory losses." At the start of a reporting period, make an estimate of how much you expect to lose in the period due to distressed inventory and shrinkage. Debit this amount to COGS (or to a special expense account for this purpose, if you wish) and credit it to the reserve account. This accounting entry fulfills the requirements of the matching principle by recognizing losses up front, in the period they are likely to occur. When you eventually encounter an actual inventory loss, debit the loss amount to the reserve account and credit it to inventory. In this way, you reduce the remaining reserve amount and lower your inventory value without creating another expense, since you already took the expense at the start of the period.

Lower of Cost or Market

Sometimes, your inventory can lose value because it becomes unfashionable or obsolete. When this occurs, you might find that the selling price is below the amount you spent to acquire the inventory. GAAP requires you to recognize this loss. To do so, employ the "lower of cost or market" method (LCM) to reduce the value of your inventory to its realizable worth. The realizable value is how much you can obtain by selling the inventory minus whatever it costs you to prepare and sell it. With LCM, you should create a reserve account for LCM losses and an expense account, such as "LCM write-down losses" to record the estimated loss. GAAP doesn't allow you to reverse an LCM markdown once it's made, even if the price of the inventory recovers.