10 Inventory

Wear, tear, and obsolescence: impairing inventory to net realizable value

Great work! You have learned about inventory systems and how to value inventory in purchase and sales transactions. Thank you for investing your time to learn about the accounting concepts that support company value creation! Now let’s imagine that a company gets to its fiscal year end and management looks around their inventory storeroom. They see lots of in-tact inventory, but they also find damaged and obsolete inventory. These inventory items can still be sold, but at a reduced price.

There are many causes of damage:

• Maybe inventory was affected by water damage
• There may have been a forklift accident resulting in dropped boxes of inventory
• Or inventory has been in the storeroom for a while and is discoloured by the sun

You can probably think of other ways inventory may be damaged but still sellable.

Obsolescence means that inventory is outdated. This usually happens with technology. Think about an iPhone dealer – when a new iPhone model comes out, the old model is usually sold at a discount. Why? Customers want the newest technology, so the demand for outdated technology declines. The dealer can’t get the same price for an older model.

When assets are damaged or obsolete, companies have to think about whether the affected asset is impaired. Let’s go back to inventory cost and the tables you prepared to calculate asset cost. Impairment happens when the sales price of inventory is less than the cost paid for that asset. In accounting terms, we would say that an asset is held at the lower of cost and net realizable value (NRV), and an asset is impaired if NRV > cost. Seems like a lot, right? Let’s do this step by step.

1. determine the asset’s cost in the accounting system. For inventory, you’ll look at the unit cost from your FIFO or weighted-average costing table.
2. determine the NRV of the damaged or obsolete asset. For inventory, the revised sales price will be your NRV.
3. Is the cost higher than the NRV? If yes, record impairment for the difference. If not, then no adjustment is necessary.

The journal entry to record impairment is:

Looks familiar, doesn’t it! Now let’s work on a problem together.

My Turn

Pine 4 You Ltd. (P4U) sells Christmas trees seasonally in November and December for $150 per tree. It’s now December 31 and P4U has 35 trees remaining in inventory at a unit cost of $80 per tree. The holiday season has passed, but the trees can still be sold to a local wooden furniture manufacturer for $60 per tree.

Required:

Calculate impairment, if any, for P4U at December 31.

1. cost of the trees is $80/tree
2. at December 31, the NRV of the trees is their selling price of $60 per tree
3. Yes, cost is higher than NRV. Impairment is $20 per tree (calc: $80 – $60 = $20). Total impairment for the 35 trees in inventory is $700 (calc: $20 per tree x 35 trees)

P4U will record impairment as:

December 31

Excellent. Now it’s your turn. Follow the three steps to calculate impairment for Granite Top Ltd.