What is 'Obsolete Inventory'

Obsolete inventory is a term that refers to inventory that is at the end of its product life cycle. This inventory has not been sold or used for a long period of time and is not expected to be sold in the future. This type of inventory has to be written down and can cause large losses for a company.

Obsolete inventory is also referred to as dead inventory or excess inventory.

BREAKING DOWN 'Obsolete Inventory'

Inventory refers to the goods and materials in a company’s stock that are ready to be sold. It is one of the most important assets of business operation, as it accounts for a huge percentage of a company’s revenues. If the inventory is held for too long, the goods may reach the end of their product life and become obsolete.

Obsolete inventory is inventory that a company still has on hand after it should have been sold. When inventory can’t be sold in the markets, it declines significantly in value and could be deemed useless to the company. To recognize the fall in value, obsolete inventory must be written down or written off in the financial statements in accordance with Generally Accepted Accounting Principles (GAAP). A write-down occurs if the market value of the inventory falls below the cost reported on the financial statements. A write-off involves completely taking the inventory off the books when it is identified to have no value and, thus, can’t be sold.

GAAP requires companies to establish an inventory reserve account for obsolete inventory on their balance sheets and expense their obsolete inventory as they dispose of it, which reduces profits or results in losses. Companies report inventory obsolescence by debiting an expense account and crediting a contra asset account. When an expense account is debited, this points to the fact that the money spent on the inventory, now obsolete, is an expense. A contra asset account gets reported on the balance sheet immediately below the asset account to which it relates, and reduces the net reported value of the asset account. Examples of expense accounts include cost of goods sold, inventory obsolescence accounts and loss on inventory write-down. A contra asset may include allowance for obsolete inventory and obsolete inventory reserve. When the inventory write-down is small, companies typically charge the cost of goods sold account. However, when the write-down is large, it is better to charge the expense to an alternate account.

For example, a company identifies $8,000 worth of obsolete inventory. It then estimates that the inventory can still be sold in the market for $1,500 and proceeds to write down the inventory value. Since the value of inventory has fallen from $8,000 to $1,500, the difference represents the reduction in value that needs to be reported in the accounting journal, that is, $8,000 - $1,500 = $6,500.

Provision for Obsolete Inventory

Account

Debit

Credit

Inventory Obsolescence

6,500

 

Allowance for Obsolete Inventory

 

6,500

The allowance for obsolete inventory account is a reserve that is maintained as a contra asset account so that the original cost of the inventory can be held on the inventory account until disposed of. When the obsolete inventory is finally disposed of, the allowance for obsolete inventory is cleared. For example, if the company disposes of its obsolete inventory by throwing it away, it would not receive the sales value of $1,500. Therefore, in addition to writing off the inventory, the company also needs to recognize an additional expense of $1,500. The allowance for obsolete inventory will be released by creating this journal entry:

Account

Debit

Credit

Allowance for Obsolete Inventory

6,500

 

Inventory Obsolescence

1,500

 

Inventory

 

8,000

The journal entry removes the value of the obsolete inventory both from the allowance for obsolete inventory account and from the inventory account itself.

Alternatively, the company could have disposed of the inventory for some money, say through an auction for $800. In this case, the proceeds of $800 from the auction is $700 less than the market value of $1,500. $700 will be charged to an expense account, and the journal entry will record disposal of the inventory and receipt of $800 in proceeds from the auction:

Account

Debit

Credit

Cash

800

 

Allowance for Obsolete Inventory

6,500

 

Cost of goods sold

700

 

Inventory

 

8,000

The $1,500 net value of the inventory less the $800 proceeds from the sale has created an additional loss on disposal of $700, which is charged to the cost of goods sold account.

A large amount of obsolete inventory is a warning sign for investors: it can be symptomatic of poor products, poor management forecasts of demand and/or poor inventory management. Looking at the amount of obsolete inventory a company creates will give investors an idea of how well the product is selling and how effective the company's inventory process is.

RELATED TERMS
  1. Inventory Reserve

    An inventory reserve is a contra asset account on a company's ...
  2. Inventory Write-Off

    An inventory write-off is an accounting term for the formal recognition ...
  3. Average Inventory

    Average inventory is a calculation that estimates the value or ...
  4. Inventory

    Inventory is the term for merchandise or raw materials on hand.
  5. Inventory Management

    Inventory management is the process of ordering, storing and ...
  6. Periodic Inventory

    The periodic inventory system is a method of inventory valuation ...
Related Articles
  1. Investing

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  2. Investing

    Understanding Periodic vs. Perpetual Inventory

    An overview of the two primary inventory accounting systems.
  3. Investing

    Why it is important to follow crude oil inventories

    Discover what oil inventories are, how they are communicated, and what important insights they provide into the state of the oil market.
  4. Investing

    Key Financial Ratios for Retail Companies

    Using the following liquidity, profitability and debt ratios, an investor can gather deeper knowledge of a retail company's short-term and long-term outlook.
  5. Investing

    Is Sales Growth Weaker Than Inventory Growth?

    Find out why Goldman Sachs Equity Research is concerned about inventory growth, which appears to be outpacing sales growth for many U.S. sectors.
  6. Investing

    Uncovering Oil And Gas Futures

    Find out how to stay on top of data reports that could cause volatility in oil and gas markets.
  7. Investing

    US EIA Oil Inventory Preview

    U.S. Department of Energy crude oil inventory data released later today should provide an indication of what is next for oil prices.
  8. Investing

    Spotting Creative Accounting on the Balance Sheet

    Companies have used creative accounting as a way of manipulating their balance sheets.
  9. Investing

    API Reports 4.08 Million Barrel Inventory Draw, WTI Oil Price Dips On Gasoline Disappointment

    The latest American Petroleum Institute inventory data for the week ending September 29 recorded a headline draw of 4.08 million barrels after an unexpected draw of 0.76 million barrels the previous ...
  10. Investing

    Why LIFO Is Banned Under IFRS (XOM)

    Here's why Last-In-First-Out is banned under IFRS.
RELATED FAQS
  1. Does working capital include inventory?

    Learn about inventory that is part of current assets and working capital, which is the difference between current assets ... Read Answer >>
  2. How to calculate the inventory turnover ratio?

    The inventory turnover ratio is a key measure for evaluating how effective a company's management is at managing inventory ... Read Answer >>
  3. What does a high inventory turnover tell investors about a company?

    Inventory turnover is an important metric for evaluating how efficiently a firm turns its inventory into sales. Read Answer >>
  4. How is the economic order quantity model used in inventory management?

    Understand what types of costs make up total inventory costs, and learn how the economic order quantity model is used to ... Read Answer >>
  5. How does inventory turnover affect the cash conversion cycle (CCC)?

    Learn how a company's inventory turnover affects its cash conversion cycle (CCC). Understand why a higher inventory turnover ... Read Answer >>
  6. How does inventory accounting differ between GAAP and IFRS?

    Learn about inventory costing differences between generally accepted accounting principles (GAAP) and International Financial ... Read Answer >>
Trading Center