Accounting Methods for Obsolete Inventory by GAAP
Generally accepted accounting principles require that companies periodically examine their inventory balance for inventory that is no longer able to be sold for as much as the company paid for the goods. These products are known as obsolete inventory. Understanding how to account for obsolete inventory in accordance with GAAP can help you make sure that your financial statements are properly presented and your books are in order.
The reason generally accepted accounting principles require small-business owners to build a reserve for obsolete inventory is that accounting requires inventory to be held on the balance sheet at the lower of the cost of the inventory or market value. Spoiled or obsolete inventory will almost always have a value that is less than cost. This new, lower value is now the market value of the inventory. As such, the company must make an adjustment to bring the inventory value down to market price.
Even though inventory costs must be adjusted down to the lower of cost or market, this does not mean that inventory costs are adjusted upward if the price recovers. GAAP specifically prohibits companies from writing up the cost of inventory in almost all circumstances.
The inventory obsolescence reserve is an accounting figure used to reduce the value of the company's inventory balance to market value. In most companies, inventory will specifically be identified as added to the reserve.
For example, say your company sells three products, known as products A, B and C. Say that each of these products had an initial cost of $1,000 each, and you have 10 on hand of each of the items. It turns out that a competitor is selling a good that is identical to Product A for $300 each, and the price decrease is more than temporary. This is evidence that your inventory is over-valued. As such, you would need to reduce the value of Product A on your books to $300, because that is the new market value. To do so, you would debit obsolete inventory expense for $7,000 and credit the inventory obsolescence reserve for the same amount. You get the $7,000 figure by taking $700 for Product A and multiplying by the 10 units on hand.
While some obsolete inventory items can be sold at a deep discount, some items are simply disposed of. This is common in the service industry. For example, even though there is some market for obsolete computer equipment, you will be hard-pressed to sell expired food and drink. In this case, you will be discarding the product, so you will need remove the inventory from the company's books. In addition, if the inventory is included in the obsolescence reserve, you must remove it from the reserve as well.
To dispose of inventory not previously reserved for, debit the obsolete inventory expense account and credit inventory for the value of the inventory on the books. However, if the inventory is already reserved for, the entry is slightly different. Credit the inventory account for the original cost of the inventory, then debit the inventory obsolescence reserve for the amount previously reserved and finish the entry with a debit to inventory obsolescence expense for whatever balance remains.
Generally accepted accounting principles require that estimates for obsolete inventory are reviewed on a regular basis. For most small businesses, this means doing the review annually. However, manufacturing companies and companies that are in industries prone to obsolescence, such as technology or food service, may wish to re-evaluate this reserve on a quarterly basis. While the annual review is required for accounting compliance, the quarterly review can help management identify ordering issues that increase the chance of products becoming obsolete. 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.