What it means
Stock is recorded at cost on the assumption that it will be sold at a profit. When that assumption breaks, the accounting rule is to carry inventory at the lower of cost and net realisable value, which means the expected selling price less any costs still needed to sell it.
The gap between the two is written off as an expense. Obsolescence has several causes and they behave differently.
Technology and fashion items are superseded by newer models, food and pharmaceuticals expire on a fixed date, spare parts become stranded when the equipment they serve is retired, and ordinary items simply stop selling because a customer or a trend moved on. Only the second kind announces itself with a date.
The usual detection method is ageing analysis, which sorts stock by how long it has been held and how fast it is moving. Many businesses set policy triggers, for example reviewing anything held more than twelve months or with less than one sale in the last six.
Slow-moving is not the same as obsolete, so the trigger prompts a judgement rather than an automatic write-off. The financial effect runs in two directions at once.
The balance sheet loses value, which reduces net assets and can affect borrowing capacity where stock is part of the security, and the income statement takes a charge that usually lands in cost of goods sold. Cash is not affected at the moment of write-down, because the money was spent when the stock was bought, which is precisely the point: the loss happened earlier and is only being admitted now.
Managers sometimes delay recognition to protect reported profit, which turns a manageable problem into a large and embarrassing one. The better approach is a standing review cycle, so write-downs arrive as small regular adjustments rather than a single shock discovered by an auditor.
In practice
Real-world examples
Example 1
An electronics retailer holds 800 units of a discontinued handset at a cost of $220 each, a carrying value of $176,000. With the best available price now $90 a unit, net realisable value is $72,000 and a write-down of $104,000 is recorded.
Example 2
A clothing wholesaler has $300,000 of last season's range that will only move through outlet channels at 40% of cost. Net realisable value is $120,000, so $180,000 is written off before the year end.
Example 3
A food manufacturer scraps $45,000 of ingredients that passed their expiry date during a production shutdown. Because they cannot legally be sold at any price, the entire carrying value is written off rather than reduced.
Think of it
Imagine buying fresh milk that sits in your fridge past its use-by date. You cannot drink it and you cannot sell it to your neighbours, so it has zero value despite costing you money to buy and store.
Formula
Calculation
Inventory Write-Down = Carrying Cost - Net Realisable Value, where net realisable value is expected selling price less costs to complete and sell.
A distributor holds 4,000 units of a superseded controller board carried at a cost of $60 each. The only remaining buyer is a clearance dealer offering $15 per unit.
Carrying cost = 4,000 x $60 = $240,000.
Net realisable value = 4,000 x $15 = $60,000.
Write-down = $240,000 - $60,000 = $180,000.
The $180,000 is charged to cost of goods sold in the current period, and the inventory line falls from $240,000 to $60,000. If gross profit before the adjustment was $950,000, it becomes $770,000.Case study
Seen in the real world
Larkfield Instruments is an illustrative and clearly fictional maker of laboratory equipment used here to show how a review cycle works. Its balance sheet carried inventory of $2,400,000, and the finance team had never run a formal ageing analysis because stock turned reasonably well overall.
The first review sorted every line by age and movement. It found $310,000 of stock that had not moved in over a year, of which $190,000 related to sensors for a discontinued instrument with no remaining installed base and no realistic buyer. Gross profit for the year fell from $1,900,000 to $1,710,000 once the write-down was recorded.
The more valuable outcome was procedural. Larkfield introduced a quarterly review, a rule that no component would be ordered for a product within twelve months of its planned retirement, and a small end-of-life provision built up over each product's final year. Write-downs became a routine line rather than an annual surprise.
Watch out
Common mistakes
- Treating slow-moving stock and obsolete stock as the same thing, which either overstates the write-down or delays it until the position is far worse.
- Waiting for the year-end audit to raise the issue, when quarterly reviews would spread the impact and prompt earlier commercial action.
- Writing stock down to zero out of caution when a clearance channel would still recover part of the cost, which understates assets and hands profit to a later period.
Questions
People also ask
Does writing down inventory affect cash?
Not at the moment it is recorded, because the cash left when the stock was purchased, though it does reduce taxable profit and therefore the tax payable.
Can a write-down be reversed?
Under international standards a reversal is allowed if the value genuinely recovers, up to the original cost, while some national frameworks prohibit reversal entirely.
Where does the charge appear?
Usually within cost of goods sold, though a large or unusual write-down may be disclosed separately so readers can see it clearly.