Why Inventory May Need a Write-Down
Inventory is initially measured at its cost, determined using an applicable cost-flow method such as FIFO or weighted-average costing. But the amount paid to acquire or produce inventory is not always recoverable. Goods may become damaged, obsolete, less desirable, or more expensive to finish and sell. If the amount expected to be recovered from selling inventory falls below its recorded cost, the inventory balance may need to be reduced.
This tutorial uses the lower-of-cost-and-net-realizable-value model. It focuses on measuring and recording a decline in value, not on determining inventory cost in the first place. Apply the model to inventory that is subject to it under the relevant accounting framework; for example, U.S. GAAP generally uses lower of cost and net realizable value for inventory not measured using LIFO or the retail inventory method. The applicable framework and inventory measurement method should be identified before applying the rule.
NRV is an estimate of the net amount expected from selling the inventory in the ordinary course of business. It is not simply the quoted selling price: costs still required to finish the product or make the sale must be deducted. Costs already included in inventory cost should not be deducted again as future completion costs.
The comparison is made for the relevant inventory item or appropriate group of similar or related items under the applicable accounting rules. A favorable NRV for one unrelated item should not be used to hide a decline in another. When items can be assessed separately, comparing them separately makes the loss visible.
Calculating and Recording a Write-Down
For an item or appropriate group, compare the recorded cost with NRV. If NRV is lower, the write-down is the difference. If NRV is at least as high as cost, the item remains at cost: the rule does not permit an unrealized increase above cost.
A typical entry debits an inventory write-down loss, often included in cost of goods sold or presented as a separate expense, and credits inventory. Some systems use a valuation allowance instead of crediting the inventory account directly. Either presentation reduces the inventory’s net carrying amount by the same amount. The exact account name and presentation depend on the reporting framework and the entity’s accounting policy.
Worked Example: Write-Downs for Two Inventory Items
A retailer has 120 units of Item A, each with a recorded cost of $18.00. Each unit is expected to sell for $16.50, and the retailer expects selling costs of $0.50 per unit. Item B has 80 units costing $12.00 each; it is expected to sell for $15.00 per unit, with selling costs of $0.60 per unit. Assume no further completion costs. Apply the lower-of-cost-and-NRV model separately to the two items, calculate the write-down, and state the adjusting entry. Ignore income taxes.
Method. Compute per-unit NRV by subtracting completion and selling costs from the estimated selling price, then compare NRV with cost for each item. This avoids the common mistake of using selling price alone or offsetting Item A’s favorable value against Item B’s loss.
Item A. NRV per unit is $16.50 − $0.50 = $16.00. Total cost is 120 × $18.00 = $2,160.00, and total NRV is 120 × $16.00 = $1,920.00. Since NRV is lower, the write-down is $2,160.00 − $1,920.00 = $240.00. Item A is reported at $1,920.00.
Item B. NRV per unit is $15.00 − $0.60 = $14.40. Total cost is 80 × $12.00 = $960.00, and total NRV is 80 × $14.40 = $1,152.00. Since NRV exceeds cost, no write-up is recorded. Item B remains at its cost of $960.00.
Check. Combined recorded cost before adjustment is $2,160.00 + $960.00 = $3,120.00. The required total carrying amount is $1,920.00 + $960.00 = $2,880.00, a reduction of $240.00.
Entry. Debit inventory write-down loss (or cost of goods sold) $240.00 and credit inventory, or an inventory valuation allowance, $240.00. The entry reduces the asset and recognizes the loss in the period of the decline.
Why the Lower-of-Cost Rule Works
The rule prevents inventory from being reported at an amount the business no longer expects to recover through sale. The reasoning follows directly from the measurement objective: cost is the recorded amount invested in the inventory, while NRV estimates the net proceeds expected from selling it. If NRV is below cost, keeping the asset at cost would report more than the expected recoverable amount.
The arithmetic also explains why the loss equals the difference between cost and NRV. When cost exceeds NRV, reducing the carrying amount from cost to NRV requires a reduction of exactly cost minus NRV. When NRV is equal to or greater than cost, the lower amount is cost, so there is no reduction. Thus the write-down cannot be negative, which is why the formula uses the greater of zero and cost minus NRV.
Use the inventory cost already determined under the applicable cost-flow method.
Start with the expected ordinary-course selling price and subtract remaining completion costs and costs necessary to sell.
Apply the lower-of-cost-and-NRV test to each item or permitted group; do not use unrelated gains to conceal an item-level decline.
Recognize the difference as an expense and reduce the inventory carrying amount.
Worked Example: Completion Costs and Unrelated Items
Worked Example: Completion Costs and Unrelated Items
A manufacturer holds 50 units of Product P at a cost of $42.00 per unit. Each unit is expected to sell for $49.00, but it still requires $3.00 of packaging and completion work, and selling costs are $2.00 per unit. The manufacturer also holds 30 units of Product Q at a cost of $70.00 per unit. Each unit of Q is expected to sell for $74.00, requires $2.00 of completion work, and incurs $5.00 of selling costs. Treat P and Q as separate items. Find the total write-down and total inventory carrying amount.
Method. Calculate net NRV after both remaining completion costs and costs necessary to sell. Then compare each product separately with its cost. This avoids the trap of ignoring completion costs or netting a gain on P against a loss on Q.
Product P. NRV per unit is $49.00 − $3.00 − $2.00 = $44.00. Total cost is 50 × $42.00 = $2,100.00. Total NRV is 50 × $44.00 = $2,200.00. NRV is $100.00 above cost, so P remains carried at $2,100.00; no gain is recorded.
Product Q. NRV per unit is $74.00 − $2.00 − $5.00 = $67.00. Total cost is 30 × $70.00 = $2,100.00. Total NRV is 30 × $67.00 = $2,010.00. The write-down is $2,100.00 − $2,010.00 = $90.00, so Q is carried at $2,010.00.
Total and check. Total cost before adjustment is $2,100.00 + $2,100.00 = $4,200.00. The required carrying amount is $2,100.00 + $2,010.00 = $4,110.00. The difference is $4,200.00 − $4,110.00 = $90.00, equal to Q’s write-down. The adjusting entry is a debit to inventory write-down loss (or cost of goods sold) and a credit to inventory or its valuation allowance, each for $90.00.
Financial Statement Effects and Later Recovery
A write-down reduces inventory, a current asset, and increases expense for the period. With income taxes ignored, the expense reduces net income; lower net income also reduces the equity retained through the period. The entry does not itself change cash or a liability. It recognizes a reduction in the inventory’s carrying amount, not a cash payment.
For example, a $240 write-down reduces inventory by $240 and increases the period’s expense by $240. Before considering taxes or any other transactions, assets and equity each decrease by $240, while liabilities are unchanged. This is consistent with the accounting equation: the reduction in assets is matched by the reduction in equity through the expense.
A later increase in expected recoverable value requires attention to the reporting framework. Under IFRS, a previous write-down is reversed when the circumstances that caused it no longer apply or there is clear evidence of an increase in NRV. The reversal is limited so that the revised carrying amount does not exceed the lower of original cost and the revised NRV. Under U.S. GAAP, a write-down of inventory measured under the lower-of-cost-and-NRV model generally establishes a new cost basis and is not reversed if value later recovers. Follow the applicable framework rather than assuming the two treatments are interchangeable.
Worked Example: A Recovery After a Write-Down
A batch of inventory had an original cost of $400.00. At the prior reporting date, its NRV was $260.00, and it was written down to $260.00. At the next reporting date, the inventory is still on hand and NRV has risen to $350.00. Assume IFRS for part (a), and U.S. GAAP for part (b). Ignore income taxes. Determine the new carrying amount and any recovery entry under each framework.
Method. First identify the prior carrying amount and original cost. Under IFRS, compare revised NRV with the prior carrying amount but cap the reversal at original cost. Under U.S. GAAP, do not reverse the write-down. The common trap is to restore the full original cost even though revised NRV remains below it.
Prior write-down. The original write-down was $400.00 − $260.00 = $140.00. The prior carrying amount is therefore $260.00.
(a) IFRS. The increase in NRV above the prior carrying amount is $350.00 − $260.00 = $90.00. The total amount previously written down was $140.00, so a $90.00 reversal is within the cap. Also, revised NRV of $350.00 is below original cost of $400.00. The new carrying amount is $260.00 + $90.00 = $350.00. Record a $90.00 debit to inventory (or reduction of the related expense) and a $90.00 credit to the reversal of the inventory write-down.
(b) U.S. GAAP. The previous write-down is not reversed under the stated model. Carrying amount remains $260.00 and there is no recovery entry.
Check. Under IFRS, the revised carrying amount equals revised NRV and does not exceed original cost. Under U.S. GAAP, the carrying amount remains at the new basis established by the earlier write-down.
Common Mistakes to Avoid
- Using selling price as NRV. Subtract any estimated completion and selling costs that remain. A sale price of $50 does not imply NRV of $50 if the product still requires $4 of completion and selling costs.
- Writing inventory up when NRV exceeds cost. The lower-of-cost-and-NRV test leaves the item at cost; it does not recognize an unrealized gain above cost.
- Offsetting unrelated items. A favorable comparison for one item does not automatically cancel a write-down required for another item.
- Forgetting the expense and equity effects. A write-down is not just a balance-sheet adjustment; it also recognizes an expense, reducing net income and, before taxes, equity.
- Assuming every framework treats a recovery the same way. IFRS permits a capped reversal when the required conditions are met; U.S. GAAP generally does not reverse the write-down under the model described here.
Check Your Understanding
For each problem, apply the stated lower-of-cost-and-NRV model and use the accounting framework specified where relevant.
- A retailer has 40 identical units costing $25.00 each. Each is expected to sell for $28.00, with selling costs of $4.00 per unit and no completion costs. Find the write-down and ending carrying amount. (Answer: Write-down $40.00; carrying amount $960.00.)
- A distributor has 100 units costing $9.00 each. Expected selling price is $9.00 per unit, completion costs are $0.00, and costs necessary to sell are $0.60 per unit. Find the total write-down and carrying amount. (Answer: Write-down $60.00; carrying amount $840.00.)
- A batch of 25 units costs $32.00 per unit. Each unit is expected to sell for $35.00 and requires $1.00 of completion work and $2.50 of selling costs. Calculate the batch’s NRV and write-down. (Answer: NRV $787.50; write-down $12.50.)
- Item A consists of 10 units costing $15.00 each, with NRV of $16.00 each. Item B consists of 8 units costing $20.00 each, with NRV of $18.00 each. Treat them separately. Find the total write-down and combined carrying amount. (Answer: Write-down $16.00; combined carrying amount $294.00.)
- Inventory originally cost $500.00 and was previously written down to $360.00. It remains on hand, and current NRV is $470.00. Find the carrying amount and recovery, if any, under IFRS and under U.S. GAAP as described above. (Answer: IFRS carrying amount $470.00 with a $110.00 reversal; U.S. GAAP carrying amount $360.00 with no reversal.)