What Is Obsolete Inventory, and How Do You Account for It? (2024)

What Is Obsolete Inventory?

Obsolete inventory is a term that refers to inventory that is at the end of its product life cycle. This inventory has not been sold or used for a long period of timeand is not expected to be sold in the future. This type of inventory has to be written-down or written-off and can cause large losses for a company.

Obsolete inventory is also referred to as dead inventory or excess inventory.

Understanding Obsolete Inventory

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 abusinessoperation, as it accounts for a huge percentage of a sales company’s revenues.

In the past, if the inventory was held for too long, the goods may have reached the end of their product life and become obsolete. Currently, with technology, the state of abundance, and customers' high expectations, the product life cycle has become shorter and inventory becomes obsolete much faster.

Obsolete inventory is inventory that a company still has on hand after it should have been sold. When inventory can’t be sold in the markets, it declines significantly in value and could be deemed useless to the company. To recognize the fall in value, obsolete inventory must be written-down or written-off in the financial statements in accordance withgenerally accepted accounting principles (GAAP).

A write-down occurs if the market value of the inventory falls below the cost reported on the financial statements. A write-off involves completely taking the inventory off the books when it is identified to have no value and, thus, cannot be sold.

Risks Associated With Obsolete Inventory

There are a number of reasons why a company doesn't want to hang onto obsolete inventory. Below is a list of some of those reasons, and each company that does carry obsolete inventory may not necessarily experience each downside.

• Tied-Up Capital: Obsolete inventory represents a significant amount of capital that is stuck in products that are no longer selling. This capital cannot generate any return and prevents the company from investing in other areas that could drive growth. This is sometimes referred to as opportunity cost.
• Storage Costs: Maintaining obsolete inventory involves ongoing costs for warehousing, utilities, insurance, and labor. This article does not go into the accounting for these costs, though companies often have to recognize expenses tied to carrying old inventory.
• Operational Risk: Companies that hang onto too much inventory run the risk of that inventory being stolen. Though obsolete inventory may not hold as much value, a company stuck with products still has to protect, insure, and monitor the inventory.
• Financial Reporting Impact: Accounting standards necessitate that obsolete inventory be written down or written off, reflecting its reduced value on financial statements. This can lower the company’s net income and can negatively affect financial ratios, in addition to creating more work for the administrative group to track. Let's take a look at this more in-depth in the next section.

Accounting for Obsolete Inventory

GAAP requires companies to establish an inventory reserve account for obsolete inventory on their balance sheets and expense their obsolete inventory as they dispose of it, which reduces profits or results in losses. Companies report inventory obsolescence by debiting an expense account and crediting a contraasset account.

When an expense account is debited, this identifies that the money spent on the inventory, now obsolete, is an expense. A contraasset account is reported on the balance sheet immediately below the asset account to which it relates, and itreduces the net reported value of the asset account.

Examples of expense accounts include cost of goods sold, inventory obsolescence accounts,and loss on inventory write-down. A contraasset account may include an allowance for obsolete inventory and an obsolete inventory reserve. When the inventory write-down is small, companies typically charge the cost of goods sold account. However, when the write-down is large, it is better to charge the expense to an alternate account.

Financial Statement Impacts of Obsolete Inventory

Some of this has been discussed in the prior section; still, let's dig into the specific financial statement implications of booking the entries discussed above (and in more depth below.

First, when inventory becomes obsolete, it must be written down or written off. This adjustment is recognized as a loss on the income statement, directly reducing net income. The write-down or write-off is recorded as an expense, meaning the loss is recognized in the current period.

Second, the balance sheet is affected as the value of inventory under current assets decreases. The write-down reduces the carrying amount of inventory to its net realizable value which impacts the total asset value reported. This reduction in assets can affect various financial ratios such as the current ratio and inventory turnover ratio. This can be really important to companies that must meet debt covenants or other reporting metrics for obligations. The decline in inventory value also reduces the overall book value of the company.

Third, the impact extends to the statement of cash flows, specifically in the operating activities section. While the write-down of inventory does not directly affect cash flow, the reduced net income decreases the cash generated from operations when using the indirect method. Plus, if the company decides to dispose of the obsolete inventory at a lower price, any cash received will be less than originally anticipated, further affecting cash flows from operating activities.

Example of Obsolete Inventory

For example, a company identifies$8,000 worth of obsolete inventory. It thenestimates that the inventory can still be sold in the market for $1,500and proceeds to write-down the inventory value. Since the value of inventory has fallen from $8,000 to $1,500, the difference represents the reduction in value that needs to be reported in the accounting journal, that is, $8,000 - $1,500 = $6,500.