Obsolete Inventory Allowance

In our example on inventory write downs, an Allowance for obsolete inventory account is created when the value of inventory has to be reduced due to obsolescence.

The Allowance for obsolete inventory account is in effect a reserve for expected future inventory write offs. It is maintained as a contra asset account, so that the original cost of the inventory can be held on the Inventory account until disposed of.

When the obsolete inventory is finally disposed of, the allowance for obsolete inventory is cleared.

As an example, suppose a business has a product in inventory which cost 1,000, and has decided that due to a decline in the market for the product, its value is now estimated to be worth 700.

Allowance for Obsolete Inventory Journal Entry

The value of the inventory has fallen from 1,000 to 700, and the reduction in value which needs to be reflected in the accounting records is 1,000 – 700 = 300.

The allowance for obsolete inventory is created by the following journal entry:

Provision for Obsolete Inventory Journal Entry
Account Debit Credit
Loss on inventory write down 300
Allowance for obsolete inventory 300
Total 300 300

The journal entry creates the allowance for obsolete inventory of 300.

Release of the Allowance for Obsolete Inventory

If the business now disposes of the obsolete inventory for 600 in cash, then this Allowance for obsolete inventory can be released by creating the following journal.

Release of the Allowance for Obsolete Inventory
Account Debit Credit
Inventory 1,000
Allowance for obsolete inventory 300
Cash 600
Cost of goods sold 100
Total 1,000 1,000

As the inventory has been disposed of, the inventory and the allowance for obsolete inventory accounts have now been cleared.

The net value of the inventory 1,000 – 300 = 700 less the proceeds from the sale 600, has created an additional loss on disposal of 100, which has been charged to the cost of goods sold account.

The Accounting Equation

The Accounting Equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities of the business This is true at any time and applies to each transaction. For this transaction the Accounting equation is shown in the following table.

Allowance for Obsolete Inventory – Accounting Equation
Assets = Liabilities + Owners Equity
Cash – Inventory + Allowance = None + Reserves
600 – 1,000 + 300 = 0 + – 100

In this case the asset of cash has increased by 600,  inventory has been decreased by a 1,000, the contra Allowance for obsolete inventory account has been reduced by 300, and the profit and loss has been charged with the 100 as cost of goods sold. The charge to the profit and loss reduces the profit which reduces the reserves and therefore the owners equity in the business.

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