Obsolete Inventory Definition
Obsolete inventory, also known as excess inventory or dead inventory, is the inventory that remains unused when the product life cycle ends. This inventory remains unsold or unutilized for a long time, and even in the coming years, it holds very less possibility of being sold. Such inventory should be written off and can negatively affect the profitability of an organization.
A Little More on What is Obsolete Inventory
Inventory refers to the materials and goods that are a part of a firm’s stock, and are up for sale. It is considered to be the most significant asset that any firm would have for keeping its production smooth and ongoing. It counts for a big chunk of the revenues of an organization. The inventory becomes obsolete when the goods and materials are the final stage of their product life cycle, and are actually present for a long period of time.
Obsolete inventory is that type of inventory that the firm still holds after being sold. The inventory than remains unsold for a long time faces a gradual decrease in its value, and becomes useless or obsolete for the company. For knowing the decline in its value, it should be either written down or written off as per the Generally Accepted Accounting Principles (GAAP). When the inventory is entirely taken off the accounting books, it will lose its value, and hence, won’t have any selling value. This process of taking off the inventory is called writing off. A write down takes place when there is a decline in the market value of the inventory beyond the value mentioned in the financial statements of the company.
As per GAAP regulations, organizations must have an inventory reserve account where they can add obsolete inventory on the balance sheet, and value their obsolete inventory at the time of disposition that ultimately increase losses or decreases profits. For making a journal entry for obsolete inventory, the company debits an expense account and credits a contra-asset account. The debit in expense account signifies that the expenses incurred on obsolete inventory. While the contra-asset account will get recorded in the balance sheet right under the related asset account, and diminish the net reported value of that asset account. Some of the expense accounts are inventory obsolescence account, cost of goods sold, and loss incurred on writing down inventory. A contra-asset account may provide allowance for obsolete inventory reserve and obsolete inventory itself. In case of the inventory write-down being small, firms usually charge the cost of goods sold account. And if the write-down of inventory consists of a big value, firms charge it to some other account.
A reserve created as an allowance for obsolete inventory needs to be set up as a contra-asset account so as to retain the original value of inventory till the time it is not disposed off. After the final disposition of inventory, the allowance created for obsolete inventory is eliminated. For instance, in case a company disposes off obsolete inventory, it won’t be able to sell it at $1,500. Besides writing off the inventory, the company should identify an added expense of $1,500. The following journal entry can treat the allowance for obsolete inventory.The transaction recorded in the journal entry eliminates the value of the obsolete inventory from two accounts: inventory account and allowance for obsolete inventory account.
As an alternative, the firm could dispose off the inventory in action for an amount of $800. There is a difference of $700 between the market value ($1,500) and proceeds ($800). The difference will be recorded in an expense account, and the transaction recorded in journal will include the amount of inventory at which it is disposed of and proceeds of $800 gained in the auction.
The inventory’s net value of $1,500 when subtracted from the sales proceeds of $800 results in an added loss of $700 on disposal amount that gets recorded in the cost of goods sold account.
Obsolete inventory, if present in a huge amount, tends to be an alarming sign for investors. It can represent company’s inferior products, its poor management decisions, vague predictions of demand, or ineffective management of inventory. By seeing how much obsolete inventory is there with a company, the investors can predict the selling potential of a product, and the effectiveness of its inventory system.
References for “Obsolete Inventory”