All goods and products have a life and after that life, they become useless. Slow-moving inventory refers to such inventory items that are not used or sold yet and are at the later stages of their life. For example, a medicine has an expiry date 3 years after its production. If the medicine is still in the store of a pharmaceutical company after 2 or 2.5 years, it would be considered as slow-moving inventory. Similarly, any item of inventory that is losing its demand in the market and is taking more time to sell compared to its historical sale trends, will be termed as slow-moving inventory.
What if the medicine is still in the store after 3 years and gets expired? After the expiry date, the medicine cannot be sold and becomes useless. Inventory that loses its value or becomes useless due to one reason or the other is termed as obsolete inventory. Some goods can lose their value if they are old and are considered less useful in the later stages of their lives. Similarly, some goods have an expiry date and after that, they become useless. However, there can be other reasons for obsolescence of inventory. For example, a telephone manufacturing company had an inventory of telephone sets that had an estimated life of 10 years. Due to rapid technological advancements in the cell phone industry, market demand of telephone sets drastically dropped. It means that telephone sets will not be sold or will be sold at a lesser price than the initially expected price. Here, telephone sets inventory has become obsolete due to technological advancements in cell phone industry. Similarly, inventory can become obsolete due to some disaster such as being damaged by fire etc.
Accounting treatment of obsolete inventory
Identification of slow-moving inventory is an alarm for the management to try to sell these slow-moving goods at priority. At the same time, from financial reporting point of view, slow-moving inventory should be evaluated for obsolescence. If any obsolete inventory has been identified, i.e. goods whose market values have dropped below their carrying values, such obsolete inventory must be written down to its market value.
A contra account “provision for obsolete inventory” is used to write down the inventory. Expense is debited in the income statement and credited in the provision for obsolete inventory account. Inventory account’s balance is netted with this contra account’s balance, and net amount is presented in the balance sheet as inventory. By doing so, loss due to inventory obsolescence is recorded in a timely manner as per prudence principle. When that obsolete inventory is disposed, either sold or scrapped, balance of that inventory item is removed from the inventory account and contra account.
Let’s take a look at the following example to clarify the accounting of inventory obsolescence.
At the reporting date, a company has an inventory of certain products that have a cost of $15,000. Due to technological advancements, demand of the product has decreased significantly. However, the company estimates that the obsolete inventory can still be sold for $5,000. In the next accounting period, the company sold the inventory for $3,000.
How should the above transactions be recorded in the books of account of the company?
Following entries will be made to record the inventory obsolescence and disposal of obsolete inventory.