Inventory Write-Downs: When Stock Is Worth Less Than It Cost

Accounting refuses to carry an asset above what it can realise, so a write-down happens when goods will fetch less than they cost. The new carrying amount is net realisable value, the expected selling price less what it will still cost to sell. The shortfall becomes an expense straight away, in the year the value fell, not in the year the goods finally leave.

Here is what sits underneath that. Every rupee of stock on a balance sheet is a claim that the business will get that rupee back, and usually more, when the goods are sold. Cost is a reasonable estimate of that claim right up to the moment the goods stop being wanted. After that, cost is a number about the past and the balance sheet is supposed to be a statement about the future. The write-down is the correction, and it is deliberately one directional: it will bring a figure down to what the goods will realise and it will never take it up to what they might fetch.

The correction starts with a net realisable valueThe price the goods are expected to sell for, less every cost still to be spent finishing them and selling them. computed with the selling costs properly deducted, and it ends two years later in gross margin. Anjani Stationers Private Limited, an invented stationery business, carries the numbers: a Rs 1,50,000 write-down on a discontinued ruled format that would have moved four lines of its year two accounts, in a case built to show the mechanism and not one that happened.

Why is stock never carried above what it will fetch?

Think about a household that bought a fridge for Rs 32,000 four years ago. If somebody asks what it is worth today, nobody in that household answers Rs 32,000. The household answers with the second hand dealer's offer, the only number that turns into money. Cost is a receipt. Value is an offer. Once the two disagree, an accounting system has to pick one, and for stock it always picks the lower of the two.

The rule is that inventory is carried at the lower of cost and net realisable value, and it runs in one direction only: goods come down to what they will realise, and they never go up above what they cost, however much the market improves. The reason is not squeamishness about optimism. An asset is defined by the future benefit it carries, and goods that will fetch Rs 150 simply do not carry a Rs 200 benefit, whatever the invoice says. So the balance sheet is corrected downwards the moment the evidence appears. Going the other way would mean recording a profit before anything had been sold to anybody, on the strength of a price the business has not yet been offered, and that profit would have to be reversed if the price slipped back before the goods moved.

The asymmetry has a consequence for the shape of reported profit that people rarely say out loud. Bad news about stock arrives in profit early, on an estimate. Good news about stock arrives in profit late, on a sale. Two businesses holding identical paper, one whose paper has fallen in value and one whose paper has risen by the same amount, will not report mirror image results. The first takes a charge this year. The second reports nothing at all until the goods are invoiced. The asymmetry is a feature of the system rather than an accident of it, and it is worth holding on to when two sets of accounts are compared.

How is net realisable value computed?

Net realisable value is not the price on the shelf. Net realisable value is the price on the shelf less everything the business still has to spend to get the goods into a buyer's hands. Those remaining costs are called the costs to sellEverything still to be spent to complete the goods and get them sold: repacking, carriage out, commission to an agent, the discount a clearance sale needs., and they include the cost of completing the goods where the goods are not finished. Skip that deduction and the realisable value of every item is overstated. Every write-down computed from it is then understated.

Work it on one ream. Anjani Stationers thinks a discontinued ruled format can be moved through a clearance sale at Rs 165 a ream. Repacking it into clearance bundles and carrying it to the buyer costs Rs 15 a ream. Net realisable value is therefore Rs 150, not Rs 165, and against a cost of Rs 200 the write-down is Rs 50 a ream rather than the Rs 35 a careless sheet would produce. That is a difference of thirty per cent in the size of the charge, produced by a single missing line, and it is the most common arithmetic error on this whole subject.

Two details are worth fixing while the arithmetic is in view. The first is that net realisable value is specific to the business holding the goods, not to the market in general. Net realisable value is what this business expects to get, net of what this business will have to spend. Two businesses holding identical paper can therefore honestly report different realisable values. The second is that the estimate is made at the reporting date but takes account of what is known afterwards. If a clearance sale in the following month settles at Rs 140, that price is evidence about conditions at the reporting date and it does not get ignored simply because the calendar had turned.

What makes a business look at its stock and mark it down?

A write-down is not something that happens to a business. A write-down is something a business concludes, at a reporting date, after looking. Four conditions do most of the triggering, and each one has its own kind of evidence.

The first is physical damage. Water gets into the godown before the monsoon roof is fixed and two thousand reams swell and warp. The evidence is a stock count with a damage note against it. The second is obsolescenceThe goods are undamaged and perfectly usable, but nobody wants them any more, usually because the design, the specification or the season has moved on.. Nothing is wrong with the goods, and that is what catches people out. A ruled format the schools have stopped ordering is still clean, dry paper. The paper has simply not been asked for in nine months, and the evidence is the order book rather than the stock count. The third is a fall in selling price, where the goods are still wanted but the price has moved below what the business paid. The fourth is a rise in the cost still needed to finish the goods, and it bites hardest on part-finished work. If binding costs have jumped since the paper was cut, the selling price has not moved but the value that can be realised net of that spend has fallen.

Because the test is applied at every reporting date and not only when something visibly goes wrong, a write-down is a recurring judgement rather than an event. That matters for how one is read. A business that reports a write-down has not necessarily had a disaster; it has completed an assessment and found a shortfall in one part of its stock. A business that reports none has either found no shortfall or has not looked hard, and the accounts alone will not always say which. The place to look is the note on inventories and the accounting policy that sits with it, where the basis of the assessment is described.

Why is the test applied item by item rather than on the whole shelf?

One question decides how much of a write-down ever gets reported. Anjani Stationers closes year two holding 14,000 reams, all carried at Rs 200. If the total cost of Rs 28,00,000 were compared with the total realisable value of the whole holding, would a shortfall appear at all?

Split into the three groups a stock note would show, the same 14,000 reams look quite different. Eight thousand reams of the current ruled hundred sheet format have a realisable value of Rs 240, Rs 40 of headroom a ream. Three thousand reams of a graph ruled format sit at Rs 205, Rs 5 of headroom. Three thousand reams of the discontinued format sit at Rs 150, a shortfall of Rs 50. Added up as one pot, the headroom is Rs 3,35,000 and the shortfall is Rs 1,50,000, so the total realisable value comfortably exceeds the total cost and a netted test reports nothing whatever.

The rule is applied item by itemEach item of stock, or each group of similar items, is tested against its own realisable value. A surplus on one item is never used to cancel a shortfall on another., or to groups of similar items, precisely so that a surplus on the paper that is selling cannot be used to cancel a shortfall on the paper that is not. The reason is straightforward once the netted answer's actual claim is stated. Netting says the discontinued format is fine because the current format is doing well, and that is a statement about the current format rather than about the discontinued one. Nobody is going to buy the discontinued reams at Rs 200 on the strength of what the graph ruled reams fetch. Grouping is allowed where items genuinely belong together, similar purpose, similar market, made and sold in the same line, but it is not a licence to pool everything in the godown into a single number and report the comfortable answer.

Where does the charge land in the statement of profit and loss?

The statement of profit and loss is where a write-down becomes hard to see. A reader half expects a line saying write-down of inventories, sitting on its own, easy to add back. No such line usually appears.

A write-down reduces closing inventory. Closing inventory is a subtraction inside the cost figure, so cutting it raises cost by exactly the same amount. In an Indian statement of profit and loss the effect surfaces inside cost of materials consumed, or inside the changes in inventories line, depending on which stage of stock was written down. Either way it goes above the gross line, into cost, and it comes straight out of gross profit. A write-down therefore shows up as a lower gross margin and not as a separate expense, so a reader watching only the margin percentage will see the effect and will never see the cause.

The mechanics run on the identity that governs stock accounting throughout. Opening stock plus purchases less closing stock equals the cost consumed. Opening and purchases are settled facts; they are invoices that already exist. So the only free term is the closing figure, and every rupee taken off it is a rupee added to cost. The cut to closing stock is the whole of the write-down's route into profit, and it is why no journal entry is needed that says anything as helpful as write-down. The cause is disclosed instead, in the note on inventories, where the amount recognised as an expense in the period and any write-down included in it are described. The inventory note is where the number appears, and it is the reason an analyst reads that note before reading the margin.

What would a write-down have done to Anjani Stationers in year two?

Suppose, only to see the machinery work, that 3,000 of the closing 14,000 reams were a ruled format the schools had stopped ordering, that a clearance sale would fetch Rs 165 a ream, and that repacking and carriage would take Rs 15 of that. Net realisable value is Rs 150 against a carrying amountThe figure at which an asset currently sits on the balance sheet, after every adjustment made to it so far. of Rs 200, so the write-down is Rs 50 a ream on 3,000 reams, Rs 1,50,000 in total.

Now watch the four lines that would move together. Closing inventory would fall from Rs 28,00,000 to Rs 26,50,000. The identity forces cost of materials consumed up from Rs 1,48,50,000 to Rs 1,50,00,000. Gross profit on unchanged revenue of Rs 2,70,00,000 would fall from Rs 1,21,50,000 to Rs 1,20,00,000. And gross margin, the figure this whole cost sequence turns on, would read 44.4 per cent instead of 45.0 per cent. One judgement about three thousand reams of unwanted paper, worth Rs 1,50,000, moves the headline margin by roughly six tenths of a percentage point. Six tenths of a point is quite enough for somebody to write a paragraph about competitive pressure that has nothing to do with what happened.

Why does one write-down touch two years of profit?

The two year effect is the part almost everybody misses, and it is the reason a write-down is worth understanding rather than merely recognising.

Take the same 3,000 reams. In the year of the write-down they are still sitting in the godown, and the charge of Rs 1,50,000 hits that year's profit on nothing more than an estimate. In the following year the clearance sale happens and the reams go out at Rs 165 each, Rs 4,95,000 of revenue. But the cost that leaves with them is no longer Rs 200 a ream; it is the reduced carrying amount of Rs 150. So the batch reports Rs 4,50,000 of cost, Rs 45,000 of gross profit, and a gross margin of 9.1 per cent.

The 9.1 per cent reports something worth unpacking. Without the write-down the same sale at Rs 165 against a cost of Rs 200 would have shown a loss of Rs 1,05,000 on the batch, a margin of minus 21.2 per cent. The write-down did not change the total outcome by a rupee; it moved Rs 1,50,000 of it one year earlier, so the first year absorbs a loss it had not yet suffered and the second year reports a profit it did not earn. Add the two years together under either treatment and the answer is the same minus Rs 1,05,000. The reconciliation in both directions is the check that the mechanism is understood rather than half remembered.

Nobody has to intend this for it to happen, and that is the point worth carrying away. The write-down was a correct estimate honestly made under a rule that gave no choice. The flattering margin the following year is a mechanical consequence of it. Which is why a sharp margin recovery is never self-explanatory: the recovery might be operations, or it might be last year's charge coming back to visit.

Three readings from the panel are worth writing down. Push the clearance price up to Rs 215 with 3,000 reams affected and net realisable value reaches Rs 200, the goods are no longer worth less than they cost, and the write-down disappears entirely. Everything above Rs 215 is a flat stretch where the rule simply does not bite. Hold the price at Rs 165 and raise the affected quantity to all 14,000 reams and the write-down becomes Rs 7,00,000. Gross margin would then read 42.4 per cent, more than two and a half points below the published figure. Drag the price down to Rs 100 with all 14,000 affected and the charge reaches Rs 16,10,000 and the margin 39.0 per cent, which is the worst state the panel can produce. Notice what never happens in any state. The rule cannot write anything up, so the marker never moves right of the published 45.0 per cent.

Can a write-down be reversed when the value comes back?

Yes, and this is where inventory behaves differently from most other assets, so it is worth being precise.

If the circumstances that caused the write-down no longer exist, or if the realisable value has clearly recovered because of a change in economic conditions, the earlier write-down is reversed. The stock goes back up and the amount recognised as cost in that period is reduced by the reversal. The reversalPutting back an earlier write-down when the reason for it has gone, limited so that the goods can never end up carried above what they originally cost. is capped at the original cost, so paper written down to Rs 150 can climb back to Rs 200 and no further, however far the market recovers above that. Say a clearance never happened, the schools reinstated that ruled format the next year, and realisable value went to Rs 230. The carrying amount moves from Rs 150 to Rs 200, a reversal of Rs 50 a ream, and the remaining Rs 30 of upside stays where it always stays, invisible until the goods are sold.

The cap is the lower of cost rule wearing different clothes. Nothing can rise above cost. The reversal is not a new permission to write assets up; it is a permission to undo an earlier write-down that turned out to be too pessimistic, and it stops the instant the original cost is back on the books. Other assets do not all work this way. The rules for reversing an impairment on a factory or a machine are set out separately, and the inventory answer does not carry across to them.

What is the difference between a write-down and a write-off?

The two words get used as though they were the same move at different volumes. The two are not. A write-down says the goods are worth less than they cost and moves the carrying amount to that lower figure, leaving something on the balance sheet. A write-offRemoving an item from the balance sheet entirely. The item has no realisable value at all: scrapped, destroyed, or simply beyond use. says the goods are worth nothing at all and removes them completely.

The test that separates them is a single question: is there any value left that somebody would pay for? Paper that swelled in the rain but will still bind into second quality notebooks has value, so it comes down and stays on the books. Paper that rotted in the same rain and is fit only for the scrap dealer at nothing is gone, and it leaves. The difference matters in a way that is easy to miss. A write-down can be reversed if the value comes back. A write-off leaves nothing to revalue, so no change in market conditions can undo it. In practice a write-off of stock is also usually accompanied by physical evidence, a scrapping note or a disposal record, in a way a write-down is not.

Who reads a write-down, and what do they do with it?

Leave the mechanism for a moment. Three quite different people open the inventory note in the same week, and none of them is admiring the arithmetic.

A lender reads a write-down to test whether the stock it has lent against is worth what the borrower says, an analyst reads it to work out how much of a margin movement was operating and how much was an estimate, and Vaidehi Rao reads it to decide what to do with three thousand reams before they get any harder to move. The same number does three different jobs. Take them one at a time. The lender is usually secured on stock, and a facility sized on Rs 28,00,000 of paper behaves differently once part of that paper is admitted to be worth Rs 150 rather than Rs 200 a ream. The lender's follow up question is not the amount but the coverage: how much of the holding is current product with a live order book behind it, and how much has been sitting through two seasons.

The analyst's job is separation. A gross margin that moved from 45.0 per cent to 44.4 per cent might be pricing, might be input cost, or might be an estimate about unwanted stock that has nothing to do with either. The only way to tell is to take the write-down out of the cost line and recompute the margin without it, then compare the two numbers and say which question each one answers. Recomputing is not adjusting the accounts to look better; it is asking what the trading margin was, separately from what the stock judgement was, and then holding both.

Vaidehi Rao is the only one who can still change the outcome, so her use is the most practical of the three. A write-down is a statement that the goods will fetch Rs 150. A write-down is not a plan for actually getting the Rs 150, and paper that stays in the godown another season will not become more wanted. The write-down is therefore a prompt rather than a conclusion: it says a decision about those reams is now overdue, and the accounting has stopped pretending otherwise.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited, Vaidehi Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.