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 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:
| 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 inventory for 600 in cash then this allowance for obsolete inventory can be released by creating the following journal.
| Account | Debit | Credit |
|---|---|---|
| Inventory | 1,000 | |
| Allowance for obsolete inventory | 300 | |
| Cash | 600 | |
| Cost of sales | 100 | |
| Total | 1,000 | 1,000 |
As the inventory has been disposed of, the inventory and the allowance 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 sales 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.
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 income statement has been debited with the 100 as cost of sales. The debit to the income statement reduces the net income which in turn reduces the retained earnings and therefore the owners equity in the business.
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