How to Account for the Impairment of Inventory

Inventory impairment is an accounting principle requiring businesses to recognize a loss if the inventory’s carrying value on the balance sheet is higher than its current market value. This process is an application of the conservatism principle, which guides accountants to anticipate potential losses but not potential gains. By writing down inventory to its lower value, a company prevents the overstatement of its assets and net income. This adjustment provides a more realistic picture of its financial health by ensuring the balance sheet reflects the true economic benefit the inventory is expected to provide.

Identifying Triggers for Impairment Testing

A company does not test its inventory for impairment on a fixed schedule but in response to specific events or changes in circumstances. These triggers suggest that the cost of the inventory may no longer be recoverable. According to accounting guidance, a loss must be recognized when the utility of goods is diminished by damage, obsolescence, or changes in price levels. These events signal the need for an impairment review.

Physical deterioration is a primary trigger. This includes any form of damage that reduces the inventory’s worth, such as goods damaged in a fire, flood, or through improper storage leading to spoilage. For example, a warehouse leak that ruins a pallet of electronics or a batch of perishable food that passes its expiration date would necessitate an impairment test. The damage makes it clear that the items cannot be sold at their original price.

Obsolescence is another trigger, particularly in industries with rapid innovation or changing consumer tastes. Technological advancements can render products like older smartphone models or computer hardware less desirable, forcing sellers to discount them heavily. Similarly, shifts in fashion trends can leave a clothing retailer with a stock of apparel that is no longer in demand. In these cases, the original cost of the inventory is unlikely to be recovered, prompting an impairment analysis.

A substantial decline in selling prices is a clear market-based trigger for impairment testing. This can occur due to increased competition, a general economic downturn, or a drop in demand for a specific commodity. If the market price for a company’s products falls significantly below its recorded cost, the company must assess whether a write-down is necessary to reflect its current revenue-generating ability.

Calculating the Impairment Loss

Once a trigger has been identified, a company must calculate the amount of the impairment loss, and the method depends on how the inventory is valued. For inventories accounted for using methods like first-in, first-out (FIFO) or weighted-average cost, U.S. Generally Accepted Accounting Principles (U.S. GAAP) mandate the Lower of Cost or Net Realizable Value (LCNRV) model. This rule is detailed in Accounting Standards Codification Topic 330.

Net Realizable Value (NRV) is the estimated selling price of the inventory, less any predictable costs of completion, disposal, and transportation. To calculate the impairment loss, the company compares the historical cost of the inventory to its NRV. If the NRV is lower than the cost, the difference is recognized as an impairment loss. For instance, inventory with a cost of $50,000 that is estimated to sell for $55,000 with $8,000 in commissions has an NRV of $47,000. Since the $47,000 NRV is lower than the $50,000 cost, the company must record an impairment loss of $3,000.

A different rule applies to inventories valued using the last-in, first-out (LIFO) or the retail inventory method. For these inventories, U.S. GAAP requires the application of the Lower of Cost or Market (LCM) model. Under this model, “market” is the median value of three figures: the replacement cost, a “ceiling” equal to the NRV, and a “floor” equal to the NRV minus a normal profit margin.

To apply the LCM rule, a company first determines the designated market value by identifying which of the three figures falls in the middle. For example, consider inventory with a cost of $100. Its replacement cost is $85, its NRV is $95 (the ceiling), and its NRV less a normal profit margin of $15 is $80 (the floor). The replacement cost of $85 is selected as the designated market value, and this is then compared to the $100 cost to record an impairment loss of $15.

Recording the Inventory Write-Down

After calculating the impairment loss, the company must record the write-down in its accounting records. There are two primary methods for this entry: the direct method and the allowance method. The choice depends on the materiality of the write-down and a company’s accounting policy. Both methods reduce the reported value of inventory on the balance sheet and decrease net income.

The direct method, also known as the cost-of-goods-sold method, is a straightforward approach where the impairment loss is absorbed directly into the Cost of Goods Sold (COGS). The journal entry involves a debit to the COGS account and a credit directly to the Inventory account. This increases COGS, which reduces the company’s gross profit and net income. This method is often used for smaller write-downs because it is simpler, but it can obscure the impact of the impairment.

The allowance method provides more transparency by separating the impairment loss from the regular costs of inventory. The journal entry involves a debit to a separate expense account, such as “Loss on Inventory Write-Down,” and a credit to a contra-asset account like “Allowance for Obsolete Inventory.” This allowance account is presented on the balance sheet as a reduction from the inventory’s original cost. The loss is reported as a separate line item on the income statement, clearly distinguishing it from COGS.

Reversal of Inventory Write-Downs

The possibility of reversing an inventory write-down depends on the accounting standards a company follows. The rules under U.S. GAAP differ significantly from those under International Financial Reporting Standards (IFRS). This distinction is important for investors comparing companies that operate under different reporting frameworks.

Under U.S. GAAP, the reversal of an inventory write-down is prohibited. Once an inventory item is written down, its new lower value becomes its new cost basis for all future accounting purposes. If the market value of that inventory subsequently recovers, the company cannot write the value back up. This conservative approach prevents companies from manipulating earnings by reversing previous write-downs.

In contrast, IFRS permits the reversal of inventory write-downs under certain conditions. If the circumstances that previously caused the inventory to be written down no longer exist, or if there is clear evidence of an increase in net realizable value, a company can reverse the write-down. The reversal is recognized as a reduction in the amount of inventories recognized as an expense in the period it occurs. However, the reversal is limited to the amount of the original write-down, meaning the inventory’s carrying value cannot exceed its original cost.