For companies that sell products, inventory makes up a large portion of their assets. This inventory may include any stock that companies use to manufacture products. It constitutes both raw materials and finished goods. For some companies, any items that are still a part of the production process are also a part of the inventory, known as work in progress.
Companies usually store these materials in warehouses for safekeeping. They do so to prevent any thefts or damage to inventory. Sometimes, however, that may not be possible. Therefore, companies will need to record that inventory in their books at their value. Before understanding the accounting for damaged or destroyed inventory, it is crucial to understand the accounting for inventory.
What is the Accounting for Inventory?
The primary accounting treatment for inventory is at the end of each accounting period. Usually, companies record the sales and purchases made that decrease or increase inventory. However, they do not update the movement in the inventory account. Instead, companies calculate the closing inventory at the end of an accounting period and make adjustments accordingly.
IAS 2 Inventories is the primary accounting standard that provides guidance regarding the accounting treatment for these items. The standard states that companies must record their inventories at cost. However, when the inventory’s net realizable value falls below its initial recognized cost, companies must adjust for it.
In short, the standard states that companies must record inventory at the lower of either its cost or net realizable value. Cost may include any expenditure that companies incur in bringing the product to its present location and condition. Therefore, it consists of the purchase, transportation, import duties costs involved in acquiring raw material.
On top of these, cost also includes any conversion cost put into converting raw materials into finished goods. Apart from these, some other costs may also be a part of the inventory. However, any subsequent costs borne after bringing the goods to their present condition or position are not capitalizable. For example, storage or holding costs are not a part of inventory costs.
Net realizable value, on the other hand, considers the inventory’s sale value. It represents the revenue that a company expects to earn in the future when it sells the goods. Net realizable value also deducts any selling costs that companies may incur when selling the products. Usually, this value is higher than the cost of producing stock. However, in some cases, it may decrease, such as for destroyed inventory.
What is the accounting for destroyed inventory?
In case of destroyed inventory, the net realizable value of the products become nil. If a company can generate any income for the destroyed stock, for example, for wastage, it may be a part of the net realizable value. Mostly, however, that is not the case. Therefore, companies must write the inventory off completely.
When accounting for destroyed inventory, the treatment is similar to that of damaged or obsolete inventory. When a company determines stock as destroyed, it must remove the stock from its financial statements. The accounting treatment is simple as it involved removing assets and recording expenses instead. Therefore, the journal entries for destroyed inventory will be as follows.
| Account Name | Debit | Credit |
|---|---|---|
| InventoryLoss on inventory write off | XXX | |
| Inventory | XXX |
In case of destroyed inventory, the value of the journal entry will be the entire cost of the destroyed items. This treatment affects a company’s income statement and balance sheet at the same time. Firstly, it increases expenses, which is an income statement item. Usually, this expense is a part of a company’s cost of sales. On the other hand, it also decreases a company’s assets through a reduction in inventory balances.
Example
A company, ABC Co., purchased raw material for $10,000. The company incurs $1,000 in bringing this stock to its warehouse. From there, ABC Co. converts the raw material into finished goods, which costs $4,000. Therefore, the total cost of the inventory was $15,000. However, before selling the item, there was a fire on the company premises, which completely destroyed it.
At the reporting date, the destroyed inventory has no sale value. Therefore, the inventory’s net realizable value was nil. However, ABC Co. still recorded the stock at $15,000 in its accounts. Due to the destruction of the asset, ABC Co. must derecognize the inventory item. Instead, it must record a loss for the same amount. The accounting treatment for destroyed inventory will be as follows.
| Account Name | Debit | Credit |
|---|---|---|
| InventoryLoss on inventory write off | $15,000 | |
| Inventory | $15,000 |
Conclusion
Inventory represents any raw materials or finished goods that companies keep for processing or selling. IAS 2 Inventories states that companies must record inventory at lower of its cost or net realizable value. In case of destroyed inventory, the net realizable value will be nil. Therefore, companies must write off the entire value of the inventory in those circumstances.