Balance sheets should provide an accurate snapshot of your company’s net worth. But if the financial statements contain bloated asset values, you may mistakenly believe your business’s outlook is rosy when, in fact, the company is headed for a fall. One common cause of this balance sheet deception is not accounting for obsolete inventory.
Let’s say you’re in the business of selling computers. In the technology field, today’s state-of-the-art equipment quickly becomes tomorrow’s dinosaurs. If your warehouse is stocked with computers manufactured five years ago, that inventory may need to be sold or written off. Or, perhaps you sell appliances and a competitor across town is offering discounted prices on similar products. In these scenarios, inventory obsolescence may come into play.
Here are a few ways your business can account for obsolete inventory:
- Write-downs. If you can’t sell inventory for as much as you paid for it, the market value has dropped below its cost. Generally accepted accounting principles require inventory to be presented on the balance sheet at the lower of cost or market price. You may need to “write down” (reduce) inventory values to better reflect economic reality.
- Reserve accounts. Setting up a “reserve for obsolescence” account that’s periodically adjusted can help you monitor inventory values. This reserve is offset against the inventory account on the balance sheet, making it easy to identify inventory that’s considered subject to obsolescence.
- Write-offs. Despite your best efforts, inventory values may fall beyond recovery. To ensure the company’s records remain accurate, you may need to “write off” (reduce to zero value) obsolete inventory from your asset register and recognize the expense in a corresponding entry. Although net profits may suffer in the short term, overstated asset values tend to skew financial ratios that bankers, managers, and auditors use to assess the financial health of your business.
Proper inventory accounting can keep your company on the right track.