Accounting for a Writedown of Subnormal Goods

An inventory writedown is an accounting adjustment that lowers the recorded value of a company’s inventory. This occurs when the inventory’s market value falls below its original cost, ensuring assets are not overstated on financial statements. This practice follows the principle of conservatism, where losses are recognized as soon as they are determinable. Properly accounting for these value reductions provides a more accurate picture of a company’s financial health.

Identifying Subnormal Goods

The first step is to identify “subnormal” goods, which are items that cannot be sold at their normal prices. Common categories of subnormal goods include:

• Damaged goods: Items with physical imperfections from events like shipping mishaps, which reduce or eliminate their marketability.
• Obsolete goods: Products no longer in demand due to innovation or changing trends, such as previous-generation electronics or past-season fashion items.
• Defective items: Products with manufacturing flaws that impair their function or safety, like tools with faulty wiring or apparel with incorrect stitching.
• Slow-moving or expired inventory: Items that have been on shelves for an extended period without selling or perishable goods that have passed their use-by date.

In each case, the inventory has lost a portion of its original value for an identifiable reason.

Calculating the Writedown Amount

Once subnormal goods are identified, the writedown amount must be calculated. Under U.S. Generally Accepted Accounting Principles (GAAP), the calculation method depends on the company’s inventory accounting system. Companies using the first-in, first-out (FIFO) or average cost methods use the “Lower of Cost or Net Realizable Value” (LCNRV) rule. Companies using the last-in, first-out (LIFO) or retail inventory methods apply the “Lower of Cost or Market” (LCM) rule.

The LCNRV rule requires inventory to be reported at either its original cost or its Net Realizable Value (NRV), whichever is lower. NRV is the estimated selling price in the ordinary course of business, minus predictable costs of completion, disposal, and transportation. These costs can include expenses for repairs, special packaging, or sales commissions. This prevents a company from carrying inventory at a value higher than it can expect to receive from its sale.

Under the LCM rule, “market” refers to the inventory’s replacement cost. This value is capped by the net realizable value (the ceiling) and cannot be less than the NRV minus a normal profit margin (the floor).

For example, consider a company with 100 obsolete electronic tablets that originally cost $300 each. The estimated selling price has dropped to $220 per tablet, and the company anticipates spending $20 per unit on sales commissions and shipping to sell them.

The NRV is calculated by subtracting the costs to sell from the estimated selling price: $220 – $20 = $200. This NRV of $200 is compared to the original cost of $300. Since the NRV is lower, the writedown amount per unit is the difference: $300 – $200 = $100. The total writedown for the batch is $10,000 (100 tablets x $100).

Recording the Inventory Writedown

After calculating the total writedown amount, the adjustment is recorded with a journal entry. The entry requires a debit to an expense account and a credit to the Inventory account. Companies may use the Cost of Goods Sold (COGS) account for smaller writedowns, while a specific account like “Loss on Inventory Writedown” is used for more significant amounts to provide transparency.

This entry reduces the carrying value of inventory on the balance sheet to reflect its lower market reality. On the income statement, the recognized expense lowers the company’s reported gross profit (if charged to COGS) or operating income (if charged to a separate loss account), which reduces the net income for the period.

Tax Implications and Documentation

The requirements for deducting an inventory writedown for tax purposes are more stringent than for financial accounting. While GAAP allows a writedown based on an estimated value decline, the Internal Revenue Service (IRS) has specific rules for the loss to be deductible. A reserve for estimated losses is not deductible for tax purposes.

For a writedown of subnormal goods to be tax-deductible, the business must offer the goods for sale at the reduced price within 30 days of the inventory valuation date. This rule provides objective evidence that the inventory has lost value. In contrast, GAAP does not require the items to be physically on sale at the new price to recognize the loss.

Maintaining meticulous documentation is necessary to sustain the deduction in an audit. Records should include detailed inventory reports that identify the damaged, obsolete, or otherwise subnormal items. Photographic evidence of the damage can also be useful. The business must keep records proving the goods were offered for sale at the written-down price, such as dated price lists, advertisements, or records of actual sales at the reduced price. Without this proof, the IRS may disallow the deduction, leading to a higher tax liability.