Inventory Depreciation - Accounting for Value Loss
Inventory depreciation is an essential concept in accounting that addresses the reduction in the value of goods held in stock over time. Various factors, including obsolescence, damage, or shifts in market demand, sometimes lead to inventory not retaining its original worth.
Understanding what inventory depreciation is, when and why it occurs, and how to account for it is critical to maintain financial transparency and remain compliant. Consult a professional for the fairest and most tax-favorable outcome for your small business.
Inventory Depreciation Explained
Inventory depreciation (or, more accurately, inventory value loss or write-down) refers to the loss of value of inventory over time. "Depreciation" is a misnomer in this case, as inventory doesn't depreciate like fixed assets.
Inventory write-down isn’t calculated by the allocation of cost over an item’s useful life, as regular depreciation is. Rather, it’s a way to calculate a decline in inventory value when it can no longer be sold at its original cost.
Businesses must account for the value their inventory loses in order to present accurate financial statements. This is important, as financial statements reflect the true value of the company’s inventory. Exaggerating the value of your assets could inflate stock prices and paint an inaccurate picture of how the business is going.
There are various established ways to present inventory loss value. The accounting standards and the calculation method your company chooses will influence how inventory depreciation is reflected in your financial statements. These write-downs ultimately reduce net income and asset values, which impact key financial ratios used by investors and lenders.
An expert in small business accounting will advise you on the most appropriate approach for your company and how to report losses while remaining compliant.
Inventory Value Loss Examples
There are several reasons a company's inventory could lose value, some of which occur more frequently in certain industries. These include:
Physical Depreciation
Physical depreciation due to wear and tear or spoilage is a common challenge for businesses handling perishable food items or medicines that pass their expiry date before they are sold. Fragile items, such as furniture or large appliances, also experience physical depreciation as they're at high risk of damage from dust accumulation, moisture, light exposure, and scratches in the store.
Obsolescence
Companies that sell items that quickly go out of fashion or are frequently replaced by a newer, better version are at risk of value loss. Fashion and tech brands are particularly exposed to obsolescence. Companies producing seasonal goods, for example, holiday food or decorations, are also at a high risk.
Market Depreciation
Certain inventory items lose value if there's a surplus on the market. A high influx of agricultural goods when a certain item is in season is an example of when its value is at risk of going down.
How to Calculate Inventory Value
The method used to calculate inventory value and depreciation is highly influential in how inventory depreciation works in your business. Be aware that under U.S. Generally Accepted Accounting Principles (GAAP), inventory must be recorded at the lower of original cost or market value.
Standard Costing Method
The standard costing method involves assigning a fixed, standard cost to your inventory items instead of using their actual purchase price or production costs. Value loss in inventory is then recorded as a write-down. This method is commonly used by manufacturing businesses with high-volume production processes.
How to Calculate Inventory Depreciation Using Standard Costing
Let's imagine a small manufacturing company in Jacksonville, Florida, that makes components for the automotive industry. Calculating a standard cost per unit is based on the expected production costs per unit, including materials, labor, and overhead. After calculating this total:
Multiply the number of units stored in inventory by the standard cost per unit. (e.g., $50 standard cost x 100 units = $5,000 inventory value)
Calculate the net realizable value (NRV) by subtracting the selling costs from the estimated selling price. (e.g., If NRV per unit is $45, total NRV = $4,500.)
The difference between the NRV and the standard costs is your inventory depreciation. In this case, the standard cost is ($5,000 - $4,500). The total inventory depreciation is $500.
This loss must then be recorded as an inventory write-down.
Specific Identification Method
The specific identification method tracks each item in inventory with its actual cost rather than an estimated cost. This makes it more suitable for high-value products like luxury goods, cars, or high-ticket equipment than the standard costing method.
How to Calculate Inventory Depreciation Using Specific Identification
Follow the same steps as in the standard costing method to calculate inventory depreciation using this method, but use each item's actual value rather than its standard cost. This method requires more detailed tracking, as each item must be individually valued.
First In, First Out Method (FIFO)
The FIFO method is based on the premise that the oldest inventory is sold first. This makes it ideal for industries that produce perishable goods. FIFO is also best for time-sensitive inventory that is at risk of obsolescence.
Calculating inventory depreciation involves assessing if your remaining inventory's NRV is lower than its FIFO cost based on the most recent prices.
How to Calculate Inventory Depreciation Using FIFO
The FIFO method starts by listing your inventory chronologically. The latest acquisitions are then used to calculate ending inventory at FIFO cost.
For example, a business specializing in Christmas candy purchases 100 units at $10. They later purchase another 100 units at $12 each. The business sells 150 of these units, leaving 50 remaining from the $12 batch. This leaves an ending inventory of $600.
The business must then calculate the NRV (what the remaining inventory can be sold for, minus selling costs). The difference between the inventory's FIFO cost and NRV is its total inventory value loss.
Many companies use FIFO as its calculation and implementation are straightforward, and it contributes to a reduction in inventory damage and obsolescence. It's also a great way to bring your inventory value in line with current prices. Research findings support the use of a computerized inventory system rather than a manual one to minimize the impact of human error when following an inventory system like FIFO (page 6 of the document).
Weighted Average Method
The weighted average cost method involves giving the same average cost per unit to all inventory items. It's a good option for businesses that handle large volumes of similarly priced products.
Calculating inventory value loss is then a question of comparing this average cost to the inventory's NRV. Inventory write-downs are recorded when the NRV is lower than the weighted average cost.
How to Calculate Inventory Depreciation Using the Weighted Average Method
Follow these steps to calculate inventory using the weighted average method:
Divide the total cost of the items available for sale by the total number of units available. This gives you the weighted average cost per unit.
Multiply the average cost by the number of units in your inventory to find its value.
Last In, Last Out (LIFO)
The premise behind the LIFO method is that the most recently purchased inventory is sold first. It's most commonly used in industries where inventory prices are rapidly rising. Be aware that LIFO isn't allowed under IFRS. Its use is therefore limited to U.S. businesses under GAAP.
Recording Inventory Depreciation: Basic Principles
The key to accurate record-taking with inventory depreciation is understanding the difference between assets and expenses. Inventory is considered an asset while it's waiting to be sold. This is because it has future value to your business. However, inventory turns into an expense when it's sold or when it becomes unsellable.
The basic principles behind recording inventory depreciation are:
Recording the decrease in value of inventory as an expense on the income statement and as a reduction in the inventory’s asset value on the balance sheet.
The accounting treatment varies depending on the method you use to calculate the loss in value.
Maintaining accurate records is complex, especially in businesses where inventory management is more challenging. The best way to keep on top of your books and ensure accurate records is to work with an expert.
Best Practices to Manage Inventory Depreciation
Managing your inventory effectively is the best way to minimize value loss. Try these best practices to ensure efficient inventory storage:
Regular inventory audits: Modern inventory tracking systems combine barcoding or RFID systems with accounting and sales platforms to offer a holistic overview of your stock and understand demand for different items in real time. Routine physical checks are also effective ways to keep track of your inventory.
Forecast demand effectively: Leverage historical sales data and seasonal or market trends to forecast demand and inform purchasing decisions.
Discount aging inventory: Use sales or discount bundles to get as much value as you can from aging inventory.
Categorize inventory: Categorizing high-value or high-turnover items helps you maintain better control of your stock.
Pro tip: Understanding the tax implications of accounting for inventory write-downs in financial reporting is also a great way to make up for some loss of value. Consult your accountant to implement the most tax-favorable strategies for your business.
Ensure Accurate and Compliant Inventory Reporting
Accurately accounting for inventory value loss ensures your financial statements reflect the true value of your stock. This helps your company avoid overstating asset value and supports wise business decision-making.
Choosing the right write-down method and working with the right professional are the keys to keeping your records compliant while maintaining a financially healthy business. Stay on top of inventory valuation for transparency and long-term success.
