Excess and Obsolete Inventory Policy Guide

Inventory refers to the goods and materials in a company’s possession that are ready to be sold. It is one of the most important assets of a business operation, as it accounts for a huge percentage of a sales company’s revenues. Though there are several ways to help avoid accumulating obsolete inventory, carrying any type of dead stock is inevitable. Here is what to do if you end up carrying inventory that has become unsellable. The best way to identify obsolete inventory is by implementing the right tools, technology, and processes to identify slow-moving inventory on hand.

Direct Write-Off Method

The inventory includes raw material, working in process, and finished goods that are ready to sell to customers. These items will be recorded as the inventory which is the current assets on balance sheet. The journal entry is debiting inventory reserve and credit inventory, the difference between inventory loss and reserve needs to debit to expense (inventory write down). When actual inventory writes down incur, the company needs to make a journal entry by debiting inventory reserve and credit inventory. In order to record inventory provision, we need to debit expense and credit inventory reserve which is the inventory contra account. Most companies use the cost of goods sold in the account to record this expense, but they may separate subaccounts for easy control.

• This can be really important to companies that must meet debt covenants or other reporting metrics for obligations.
• If the actual loss is lower than the estimated expenses, the company already record expense more than it should be.
• It happens when a business considers it to be no longer sellable or usable and most likely will not sell in the future due to a lack of market value and demand.
• Say goodbye to inventory headaches and hello to smoother operations and greater profitability.
• This is an example where, even though GAAP does not require more frequent analysis, it may be good for the company to address this issue more often than required.

What Is Obsolete Inventory, and How Do You Account for It?

After the adjusting entry, the inventory reserves account should show a balance of $5,000. Generally Accepted Accounting Principles or “GAAP” is a set of accounting standards established by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). These standards govern how financial statements are prepared by organizations, companies, governments, and nonprofits. Inventory reserve is an estimation of future inventory spoilage based on the company’s past experiences.

Inventory Reserve vs Inventory Write-off

However, small businesses can still use inventory reserves to anticipate sudden write-offs and reduce their impact on current period income. An inventory reserve is a contra asset account on a company’s balance sheet made in anticipation of inventory that will not be able to be sold. Every year, a company has an inventory that will not be able to be sold for various reasons. It may spoil, fall out of fashion, or become technologically obsolete. The journal entry for obsolete inventory reserve is often a best guess rather than hard numbers.

How to Identify Obsolete Inventory

The actual write-off didn’t affect net income because we already have an allowance for inventory breakage and spoilage. Let’s say that during our first quarter audit of inventory in the following year, we found that $3,500 of inventory had been damaged or spoiled. Instead of recording COGS, we remove the inventory from the inventory reserve. Let’s assume that, based on our calculations, the beginning balance of the inventory reserve should be $3,900.

Excess and Obsolete Inventory Reserves

The normal balance of an inventory reserve account is credited because it is a contra asset account, which means that it reduces total assets in the balance sheet. The inventory reserve account is also permanent because it rolls over from one accounting period to another. When the actual inventory goes obsolete, the company has to quantify them in the dollar value and make the adjustment. By this time, the obsolete inventory will be disposed, so it should be removed from the balance sheet.

With more visibility, you can find ways to optimize inventory to meet demand and avoid common inventory issues, such as overstocking. Though inventory forecasting is rarely 100% accurate, it becomes even more challenging when there isn’t enough historical order data or market insights to help make the best decisions. With today’s technology and customers’ high expectations, the product lifecycle has become shorter across industries, making inventory become obsolete much faster (e.g., fast fashion). Our Excess and Obsolete Inventory Policy is your comprehensive guide to navigating the complexities of managing shrinkage, obsolescence, and surplus inventory within your organization’s allowance accounts.

Currently, with technology, the state of abundance, and customers’ high expectations, the product life cycle has become shorter and inventory becomes obsolete much faster. After the year-end closing, the company has quantified that inventory of $ 5,000 is obsolete, so they destroy them immediately. Get ShipBob WMS to reduce mis-picks, save time, and improve productivity. There’s also the option of remarketing items that are at risk of becoming obsolete. As such, they might predict a much higher demand and end up ordering an excess amount of inventory. For most ecommerce business, having enough inventory to meet demand is often a top concern.

• A business will record a credit to the inventory asset account and a debit to the expense account using the direct write-off method.
• The allowance for inventory obsolete is the contra account of the inventory, it will reduce the inventory amount on balance sheet.
• The net realizable value (NRV) is the selling price less the cost to sell.
• Management estimates the obsolete inventory base on the historical data and nature of product.
• The inventory reserve account is also permanent because it rolls over from one accounting period to another.
• The journal entry removes the value of the obsolete inventory both from the allowance for obsolete inventory account and from the inventory account itself.

Journal Entry for Obsolete Inventory

From finished goods to work-in-process (WIP), our guide caters to all inventory categories. Maintain accuracy across all inventory levels with robust planning tactics. There is no standard formula to apply for kind of inventory and business operation.