# What Is Obsolete Inventory, and How Do You Account for It?

## What Is Obsolete Inventory?

Obsolete inventory is a term that refers to [inventory](https://www.investopedia.com/terms/i/inventory.asp) that is at the end of its [product life cycle](https://www.investopedia.com/terms/p/product-life-cycle.asp). 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 or written-off and can cause large losses for a company.

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

### Key Takeaways

*   Obsolete inventory is inventory at the end of its product life cycle that needs to be either written-down or written-off the company's books.
*   Obsolete inventory is written-down by debiting expenses and crediting a contra asset account, such as allowance for obsolete inventory.
*   The contra asset account is netted against the full inventory asset account to arrive at the current market value or book value.
*   When obsolete inventory is disposed of, both the related amount in the inventory asset account and the contra asset account are removed in the disposal journal entry.

## Understanding Obsolete Inventory

Inventory refers to the goods and materials in a company’s possession that are ready to be sold. It is one of the most important assets of a business operation, as it accounts for a huge percentage of a sales company’s revenues.

In the past, if the inventory was held for too long, the goods may have reached the end of their product life and become obsolete. Currently, with technology, the state of abundance, and customers' high expectations, the product life cycle has become shorter and inventory becomes obsolete much faster.

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](https://www.investopedia.com/terms/g/gaap.asp) (GAAP).

A [write-down](https://www.investopedia.com/terms/w/writedown.asp) occurs if the market value of the inventory falls below the cost reported on the financial statements. A [write-off](https://www.investopedia.com/terms/i/inventory-write-off.asp) involves completely taking the inventory off the books when it is identified to have no value and, thus, cannot be sold.

## Risks Associated With Obsolete Inventory

There are a number of reasons why a company doesn't want to hang onto obsolete inventory. Below is a list of some of those reasons, and each company that does carry obsolete inventory may not necessarily experience each downside.

*   **Tied-Up Capital:** Obsolete inventory represents a significant amount of capital that is stuck in products that are no longer selling. This capital cannot generate any return and prevents the company from investing in other areas that could drive growth. This is sometimes referred to as [opportunity cost](https://www.investopedia.com/terms/o/opportunitycost.asp).
*   **Storage Costs:** Maintaining obsolete inventory involves ongoing costs for warehousing, utilities, insurance, and labor. This article does not go into the accounting for these costs, though companies often have to recognize expenses tied to carrying old inventory.
*   **Operational Risk:** Companies that hang onto too much inventory run the risk of that inventory being stolen. Though obsolete inventory may not hold as much value, a company stuck with products still has to protect, insure, and monitor the inventory.
*   **Financial Reporting Impact:** Accounting standards necessitate that obsolete inventory be written down or written off, reflecting its reduced value on financial statements. This can lower the company’s net income and can negatively affect [financial ratios](https://www.investopedia.com/financial-ratios-4689817), in addition to creating more work for the administrative group to track. Let's take a look at this more in-depth in the next section.

## Accounting for Obsolete Inventory

GAAP requires companies to establish an [inventory reserve](https://www.investopedia.com/terms/i/inventoryreserve.asp) account for obsolete inventory on their [balance sheets](https://www.investopedia.com/terms/b/balancesheet.asp) 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](https://www.investopedia.com/terms/c/contraaccount.asp).

When an expense account is debited, this identifies that the money spent on the inventory, now obsolete, is an expense. A contra asset account is reported on the balance sheet immediately below the asset account to which it relates, and it reduces the net reported value of the asset account.

Examples of expense accounts include [cost of goods sold](https://www.investopedia.com/terms/c/cogs.asp), inventory obsolescence accounts, and loss on inventory write-down. A contra asset account may include an allowance for obsolete inventory and an 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.

## Financial Statement Impacts of Obsolete Inventory

Some of this has been discussed in the prior section; still, let's dig into the specific financial statement implications of booking the entries discussed above (and in more depth below.

First, when inventory becomes obsolete, it must be written down or written off. This adjustment is recognized as a loss on the income statement, directly reducing net income. The write-down or write-off is recorded as an expense, meaning the loss is recognized in the current period.

Second, the balance sheet is affected as the value of inventory under current assets decreases. The write-down reduces the carrying amount of inventory to its [net realizable value](https://www.investopedia.com/terms/n/nrv.asp) which impacts the total asset value reported. This reduction in assets can affect various financial ratios such as the current ratio and inventory turnover ratio. This can be really important to companies that must meet debt covenants or other reporting metrics for obligations. The decline in inventory value also reduces the overall book value of the company.

Third, the impact extends to the statement of cash flows, specifically in the operating activities section. While the write-down of inventory does not directly affect cash flow, the reduced net income decreases the cash generated from operations when using the indirect method. Plus, if the company decides to dispose of the obsolete inventory at a lower price, any cash received will be less than originally anticipated, further affecting cash flows from operating activities.

## Example of Obsolete Inventory

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.

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 it is disposed of. When the obsolete inventory is finally disposed of, both the inventory asset and 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](https://www.investopedia.com/terms/a/adjusting-journal-entry.asp):

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 [book value](https://www.investopedia.com/terms/b/bookvalue.asp) of $1,500. The amount of $700 will be charged to an expense account, and the journal entry will record the disposal of the inventory and receipt of $800 in proceeds from the auction:

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](https://www.investopedia.com/terms/d/demand.asp), 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.

## How Do Companies Determine Inventory Obsolescence?

Companies determine inventory obsolescence through regular reviews and analysis of inventory turnover, sales trends, and product lifecycle. Items that have not moved within a certain period, usually based on historical sales data, are flagged for potential obsolescence.

## What Are the Financial Implications of Obsolete Inventory?

Obsolete inventory ties up capital, increases storage costs, and requires write-downs or write-offs, which reduce net income. It also affects financial ratios and can impact the company’s overall financial health and borrowing capacity.

## What Is the Process for Writing Down Obsolete Inventory?

The process involves evaluating the inventory's market value, determining the extent of the obsolescence, and recording a journal entry to reduce the inventory value and recognize an expense on the income statement. The inventory value can be reduced by using an allowance account.

## How Does Obsolete Inventory Affect the Income Statement?

Obsolete inventory affects the income statement by increasing expenses, either through cost of goods sold or a specific inventory obsolescence account. This reduces net income for the period.

## How Does Obsolete Inventory Affect Financial Ratios?

Obsolete inventory reduces total current assets, which can weaken liquidity ratios like the current ratio and quick ratio. It also affects inventory turnover ratios, indicating lower efficiency in inventory management.

## The Bottom Line

Accurately tracking, valuing, and managing inventory ensures financial statements reflect its true economic value. This involves recognizing and addressing inventory obsolescence, applying necessary write-downs or write-offs, and implementing practices to avoid future obsolescence. If a company does have to write down or write off some of its inventory, it's important to remember the entries may impact key financial metrics or financial ratios.