Obsolescence is a notable reduction in the utility of an inventory item or fixed asset. The determination of obsolescence typically results in a write-down of the inventory item or asset to reflect its reduced value. Obsolescence can arise when there are less expensive alternatives in the marketplace, or when customer preferences change.
Obsolescence differs from the ongoing decline in the value of assets that is caused by normal usage, resulting in wear and tear.
Simply stated, inventory or any business asset becomes obsolete when the item is no longer salable or useful. This results in a loss of value to the business holding the item. For example, if your company purchased 100 widgets, sold 25 of them but could not sell the remaining 75 widgets, the remaining widgets would be considered obsolete inventory.
Similarly, if a computer was purchased to run machinery in your factory but the machinery became incompatible with the computer after a required repair, the computer would be considered an obsolete asset if it could not be used elsewhere. That’s because it no longer has value to the business.
A key factor that causes obsolescence is a shift in technology or product design. When new components come to market, older parts become less useful and are usually designed out of a product or the manufacturing process.
Likewise, rapidly changing technology in equipment also causes obsolescence. The push to make equipment better, cheaper and faster can render an asset obsolete in a short period of time – especially when trying to keep up with technology in a competitive marketplace.
Market Driven Obsolescence
Technology is not the only reason for obsolescence. Changes in customer preferences can greatly influence the salability of an item. This is common with fad toys where items can quickly go in or out of favor with children and their parents for any number of reasons. The bottom line is, if you can no longer sell the item, it’s considered obsolete inventory.
Guarding Your Business from Obsolescence
Since holding obsolete inventory or assets of any type can have a financial impact on your business, a prudent business owner should carefully examine their procurement practices. Although buying large lots of inventory may decrease the per-unit cost of the item, it can also put the business at risk if the items are not fully consumed or sold.
In addition, business owners can safeguard capital assets from obsolescence by outfitting their businesses with leased equipment versus purchasing items outright. In this manner, the business is free to upgrade to new technology at the end of each lease or include a lease provision that allows for technology trades.
Accounting Treatment of Obsolete Items
No matter how an item becomes obsolete, there is accounting protocol for stating the impact on financial statements. First, inventory and assets should be periodically reviewed for obsolescence. Once identified as obsolete, items should be segregated on financial statements with a write-down by debiting an income-statement expense account and crediting a balance sheet contra-asset account such as inventory reserve.
Second, the business can later attempt to return or sell the items at a reduced value. If successful, any monies realized from the effort can be used to offset the original reserve entry with a debit to the reserve contra-asset account and a credit to the expense account for the amount of the proceeds – reducing the stated loss to the company.
Last, if the items are discarded because they have no value, the final entry would be a debit to clear the reserve contra-asset account and a credit to inventory when physically removed from the premises.
Tag:Accounting Treatment of Obsolete Items, CAfoundation, CAfoundationaAccounts, CAfoundationClasses, CAfoundationEconomic, CAfoundationFees, CAfoundationLaw, CAfoundationRegistration, commerce, commerceachiever, CommerceAndAccountancy, CommerceBaba, Guarding Your Business from Obsolescence, Market Driven Obsolescence, Obsolescence, Technology-Driven Obsolescence