A balance sheet's format reflects the fact that assets equal liabilities plus equity. Therefore, an adjustment to an asset without an offsetting adjustment to a liability is bound to affect equity. Inventory is a current asset that you may need to adjust from time to time. When you need to write down inventory, you increase costs and decrease income.
Under U.S. generally accepted accounting principles, you can mark down inventory to reflect losses, but the rules don’t allow you to mark up inventory value. Losses stem from many causes, including theft, damage, spoilage, obsolescence, fraud, product tampering and tariffs. Whatever the cause, the result is the same -- an expense to reflect the loss in value of ending inventory for the period. The inventory equation states that the cost of goods sold equals beginning inventory plus inventory purchases minus ending inventory. Therefore, when ending inventory loses value, COGS goes up.
The income statement of a merchandising or manufacturing company sets gross profit equal to sales revenues minus COGS. Any inventory write-down decreases gross profit by raising COGS. This ultimately results in lower net income. Accounting procedures require you to add a period's net income to retained earnings, an equity account on the balance sheet that accumulates profits since the inception of the company. The chain of events connecting an inventory adjustment to equity is as follows: an adjustment lowers ending inventory and raises COGS, which lowers net income and decreases the amount added to the retained earnings equity account. In short, inventory losses hurt equity.
You normally charge COGS for inventory losses. However, if you suffer a substantial loss, the best practice is to highlight it in its own account. For example, if 20 percent of your inventory becomes obsolete and worthless, you can record the loss in an expense account with a name such as “loss on obsolete inventory.” This gives investors and analysts a better understanding why inventory costs suddenly spike upward. GAAP calls for you to mark down inventory to the lower of cost or market price and to show the loss in an expense account with a name such as “loss from LCM.”
Under cash accounting, you write down inventory directly to COGS or to an expense account when you discover a loss. However, if you use accrual accounting, GAAP requires you to estimate your inventory losses for the upcoming period. At the beginning of the period, debit COGS and credit the reserve account “allowance for inventory losses” for your estimated loss. This allows you to recognize the expected loss up front, so that the expense matches the period in which you incur it. When you need to adjust inventory, debit the reserve account and credit inventory. In this way, the allowed loss rather than the actual loss reduces equity.