Journal Entry for Obsolete Inventory
Obsolete Inventory is the amount of inventory that passes the best quality and it will be hard to sell to the customer.
Inventory refers to the items that company sells to generate profit. This can be anything from products that are for sale to supplies and materials that are needed for production. The inventory includes raw material, working in process, and finished goods that are ready to sell to customers. These items will be recorded as the inventory which is the current assets on balance sheet.
The purpose of inventory management is to ensure that a company has the right amount of inventory on hand at all times. Too little inventory can lead to lost sales and unhappy customers, while too much inventory can tie up valuable resources and result in excess costs. There are many different ways to keep track of inventory, but one of the most important things is to have a system in place that works for your company. This might involve using software to track inventory levels, or it could be as simple as keeping a physical count of what is on hand.
With a large size of inventory, company will be facing high inventory cost as well. One of them is the inventory obsolete. The company will try its best to minimize the inventory obsolete cost as it is the cost that does not provide any benefit to the customers or company.
The inventory will remain on the company balance sheet for quite some time before reaching the expired date and becoming obsolete. By that time, we are sure about the total amount of obsolete inventory which should record as expense (cost). However, based on the accrual basis, the expense should be allocated over time rather than recorded in only one specific period. So it comes to accounting for obsolete inventory.
It requires the company to make estimates on inventory obsoletes and record expenses on every accounting period. They should not wait until the actual inventory is obsolete.
Journal Entry for Obsolete Inventory
The company purchases inventory and records them on the balance sheet. It will be recorded as the current assets.
At the same time, the company knows that some of the inventory will not be sold and go obsolete. So the company has to record the expense base on the estimation. Management estimates the obsolete inventory base on the historical data and nature of product.
The journal entry is debiting inventory obsolete expenses and credit allowance for inventory obsolete.
| Account | Debit | Credit |
|---|---|---|
| Inventory obsolete | $$$ | |
| Allowance for inventory obsolete | $$$ |
The inventory obsolete is the cost that will present on the income statement, it will reduce the company profit during the period. The allowance for inventory obsolete is the contra account of the inventory, it will reduce the inventory amount on balance sheet.
When the actual inventory goes obsolete, the company has to quantify them in the dollar value and make the adjustment. By this time, the obsolete inventory will be disposed, so it should be removed from the balance sheet. The company has to remove the inventory and reverse the allowance for obsolete inventory. The transaction will not impact the expense account on income statement as the company has already estimated and recorded the expense.
The journal entry is debiting allowance for obsolete inventory and credit inventory.
| Account | Debit | Credit |
|---|---|---|
| Allowance for inventory obsolete | $$$ | |
| Inventory | $$$ |
The transaction will not impact the income statement as well as the net balance of inventory. Inventory is presented as the net balance which is the combination of inventory cost and allowance for obsolete. So when this journal reduces both accounts, it will not impact the total amount.
Example
ABC is a retail store that sells a variety of daily consumption products. Based on the company experience, 5% of the inventory will be obsolete. The company policy is to record the inventory obsolete of 5% at the end of the accounting period.
At the end of the year, the inventory balance is $ 800,000.
After the year-end closing, the company has quantified that inventory of $ 5,000 is obsolete, so they destroy them immediately.
Please prepare the journal entry for inventory obsolete.
At the end of the year, company has to record the inventory obsolete which equals 5% of the total inventory. We assume that the company does not has any provision in the past, so they have to record the inventory obsolete for the total inventory.
The journal entry is debiting inventory obsolete $ 40,000 ($800,000 * 5%) and credit allowance for inventory obsolete $ 40,000.
| Account | Debit | Credit |
|---|---|---|
| Inventory obsolete | 40,000 | |
| Allowance for inventory obsolete | 40,000 |
The company has to record the inventory of obsolete $ 40,000 on income statement. The inventory net balance will reduce by $ 40,000 as the allowance for inventory obsolete is the contra account of inventory.
During the next year, company has quantified the actual inventory obsolete and get rid of them. They have to remove them from the financial statement. But they can’t record them as expenses again as they already record at the year-end.
The journal entry is debiting allowance for obsolete inventory $ 5,000 and credit inventory $ 5,000.
| Account | Debit | Credit |
|---|---|---|
| Allowance for inventory obsolete | 5,000 | |
| Inventory | 5,000 |