The inventory a company holds – sometimes also known as ´stock´- such as the products it sells and the raw materials used to make them – changes value over time, often decreasing. This change in value and its financial impact needs to be recognized in a company´s accounting statements and is known as an “inventory write-down”.
In this article, we consider what causes inventory write-downs, how to record them, the effects they have, and how to reduce their impact.
Inventory write-downs are caused by an impaired inventory, which are items that have a value that has declined since they were initially acquired. This inventory can include finished products, works in progress and raw materials.
When the valuation of these assets falls below the book value at which they are recorded in a company´s account, they may still have commercial value, but the partial loss of value must be recorded as a write-down on the company´s balance sheet.
The amount of the write-down is typically determined by the company's assessment of the market value of the inventory, based on market research, sales trends, industry reports, and other relevant data.
There are accounting standards and principles, such as the Generally Accepted Accounting Principles (GAAP), to guide companies on this.
Factors that can cause an inventory’s value to depreciate include:
Effective inventory management can help to prevent this (and is explored later in this article).
By accurately recording the change in value helps organizations maintain precise records, make important business decisions, and fully understand their financial position.
Write-downs can contribute to lower tax liabilities, but it may also cause a drop in reported net income, which reduces shareholder equity and retained earnings – effectively lowering the value of the business.
The difference between a write-off and a write-down is a matter of degree. A write-down reduces the value of an asset to offset a loss or expense. It becomes a write-off when the entire balance of the asset is eliminated and removed from the books altogether.
The decision to write down or write off an asset is usually made by the company's management based on assessments by auditors, accountants, financial analysts, or tax professionals.
The accounting treatment for write-downs captures the decrease in the inventory's market value relative to its recorded value on the balance sheet.
First, the accountant ascertains the scale of the inventory’s reduction.
Ultimately, an inventory write-down will reduce the value of the inventory for the period. This has implications for both the balance sheet and the income statement of a business.
An inventory write-down has several effects on a company's financial statements, including the balance sheet, current assets, and equity:
Reduced net income leads to a decrease in retained earnings, which is a component of shareholders' equity on the balance sheet. The result: the company's profitability is negatively impacted by the write-down.
Similarly, an inventory write-down has an impact on a company's income statement. By increasing the COGS, it can impair profitability:
There are also several effects on other financial ratios which are used to interpret a company's financial health.
Write-downs are sometimes regarded as warning signs for commercial and financial issues within a company, such as declining market demand or poor inventory management. Frequent or significant write-downs are likely to raise concerns about the quality of the company's financial reporting and its ability to value its assets accurately.
Investors and creditors typically view a company with a history of inventory write-downs as riskier, which can affect its creditworthiness and stock valuation.
The key metrics are:
[COGS / Average inventory]
This metric measures how often a company´s inventory is sold and replaced and is considered a crucial indicator in how effectively a company manages its inventory. The reduced value of inventory leads to an increase in the inventory turnover ratio, which may be interpreted as a sign of reduced inventory quality.
[Current assets / Current liabilities]
The current ratio measures a company´s short-term liquidity and is seen as an indicator of its ability to meet its financial obligations. A reduction in a company´s current assets – those assets it can sell to turn into cash – can lower a company’s current ratio potentially causing alarm bells to ring about its financial security.
[Net income / Total assets]
The return on assets reflects a company´s ability to generate profit from its inventory. An inventory write-down results in a lower net income thus reducing the ROA indicating that a company is less effective at generating profit relative to its assets.
[Net income / Shareholders' equity]
The reduced ROE may signal to investors that the company is becoming less profitable in relation to the equity invested and as a result is less attractive to investors.
Inventory write-downs are subject to specific disclosure and reporting requirements in financial statements.
These requirements are often governed by accounting standards, such as the Generally Accepted Accounting Principles (GAAP) in the US or the International Financial Reporting Standards (IFRS) in many other countries.
The nature and amount of the write-down will be recorded in footnotes to financial statements. Similarly, a clear record of the write-down must appear in income statements and other reporting to key stakeholders.
In the Management's Discussion and Analysis (MD&A) section of financial statements, companies may need to discuss the risks associated with inventory write-downs and how they affect their financial position and prospects.
Compliance with these disclosure and reporting requirements is critical for providing stakeholders, including investors, creditors, and regulators, with a clear understanding of a company's financial performance.
Failure to meet these requirements can result in regulatory penalties and a loss of trust from investors and other stakeholders.
There are certain conditions in which reversals of inventory write-downs can be made. These typically occur where the conditions that led to the initial write down no longer exist and there has subsequently been an increase in the inventory’s market value.
The reversal of write-downs is very limited under GAAP rules but is permissible by IFRS where a reversal is permitted as long as a value difference is identified in the period in which it occurs. The reversal is also limited to the amount of the original write-down.
There are a number of inventory management best practices and risk mitigation strategies that can help a business with write-down protection.
These include:
Inventory write-downs are an essential tool for directors, investors, creditors, and regulators to understand businesses.
They affect financial statements and ratios and are also regulated by compliance and reporting rules.
There are many practical strategies that can decrease the need to write-down inventory that will also help improve a business’s financial health and reputation.
Looking for tax tips? Find them here.
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