CFA Level 1 – Financial Statement Analysis · CFA
Inventory Write-Down: A Timing Entry, Not a Loss of Value
An inventory write-down reduces the carrying value of inventory because what the company can now recover from it has fallen below what it paid. That much is uncontroversial and it is where most explanations stop.
The part that carries the marks, and the part that matters to anyone reading a set of accounts, is what the write-down does to the shape of reported profit. It does not create a loss. The loss already existed the moment the inventory became worth less than its cost. What the write-down does is move the recognition of that loss forward into the current period, which makes this year look worse and next year look better. An analyst who reads the improvement next year as an operating recovery has misread the accounts.
Key Takeaways
- A write-down recognises a loss that already exists. It shifts profit between periods rather than destroying value, and the two-period total is unchanged.
- There are three measurement rules, not two, because US GAAP treats LIFO and retail method inventory differently from FIFO and average cost.
- Net realisable value is the selling price less costs to complete and costs to sell. Comparing cost with the selling price is the most common error on this reading.
- Under the LIFO rule, market is replacement cost bounded by a ceiling of NRV and a floor of NRV less a normal profit margin.
- Inventory turnover rises after a write-down for purely arithmetic reasons and reads as an efficiency gain if it is not checked.
- IFRS permits reversal up to original cost. US GAAP prohibits it, so the reduced value becomes the new cost basis.
What a write-down is, and what it is not
Inventory is initially carried at cost. If its recoverable value falls below that cost, the carrying value is reduced to the lower figure and the difference is charged against profit. The trigger is usually falling selling prices, obsolescence, physical damage, or demand that has moved away from the product.
Two distinctions are worth fixing before anything else, because both appear in exam questions as traps.
A write-down is not a write-off. A write-down reduces the carrying value of inventory that still has some recoverable value and the inventory stays on the balance sheet at the lower figure. A write-off removes it entirely, because nothing is recoverable. The accounting mechanics are the same; the difference is whether anything remains.
There is also a question of what the comparison is applied to, and it changes the answer. IFRS ordinarily requires the cost and net realisable value test to be applied item by item, permitting groups only where items are so similar or related that they cannot sensibly be evaluated separately. US GAAP is more permissive and allows the comparison at the level of the individual item, a category, or the inventory as a whole, whichever most clearly reflects income. The difference is not cosmetic. Testing item by item forces every loss-making line to be written down on its own, while testing a category lets unrecognised gains on some items absorb losses on others and produces a smaller charge. Two companies applying the same rule at different levels of aggregation will report different numbers on identical stock.
A write-down is not a cash outflow. No money leaves the business when the entry is made. Operating cash flow for the period is unchanged, and under the indirect method the charge is added back to net income in exactly the way depreciation is. What has changed is the point at which an economic loss is admitted, not the cash position.
Three measurement rules, not one
Most summaries of this topic say that IFRS uses the lower of cost and net realisable value while US GAAP uses the lower of cost or market. That was accurate until 2015 and it has been wrong for public companies since 2017, when the FASB simplified the rule for most inventory. There are now three rules, and which one applies depends on the cost formula the company uses.
| Framework and cost formula | Measured at | Reversal if value recovers |
|---|---|---|
| IFRS, any cost formula (IAS 2) | Lower of cost and net realisable value | Permitted, limited to the original write-down, so carrying value never exceeds original cost |
| US GAAP, FIFO or average cost | Lower of cost and net realisable value | Prohibited. The reduced value is the new cost basis |
| US GAAP, LIFO or retail inventory method | Lower of cost or market, where market is replacement cost bounded by a ceiling and a floor | Prohibited |
Note what this table says about comparability. Two companies holding identical inventory that has lost identical value can report different carrying amounts, different write-downs and different subsequent profit, purely because one uses LIFO and the other does not, or because one reports under IFRS and the other under US GAAP. Adjusting for that is exactly the kind of work financial statement analysis exists to do.
IFRS also permits something US GAAP does not: if the net realisable value of previously written down inventory recovers, the write-down is reversed. The reversal is capped at the amount originally written down, so inventory never rises above its original cost, and it is recognised as a reduction in the inventory expense of the period in which it occurs.
Working out net realisable value
Net realisable value is not the selling price. It is the selling price less everything that still has to be spent to achieve that sale.
NRV = estimated selling price − estimated costs of completion − estimated costs necessary to make the sale
the selling price is the one expected in the ordinary course of business, not a distressed or liquidation price
A manufacturer holds partly finished inventory carried at a cost of $480,000. It expects to sell the finished goods for $520,000. Completing them will cost $45,000 and selling them will cost $30,000 in commissions and freight. Is a write-down required, and how large?
- NRV = 520,000 − 45,000 − 30,000 = $445,000.
- Compare with cost: $480,000 against $445,000. Cost is higher.
- The inventory is written down to $445,000.
- The charge against profit is 480,000 − 445,000 = $35,000.
Answer: a write-down of $35,000, and the balance sheet now carries the inventory at $445,000. Note that the selling price of $520,000 comfortably exceeds the $480,000 cost. A candidate who compares cost with the selling price rather than with NRV concludes no write-down is needed, which is the single most common error on this reading.
That result holds under IFRS and under US GAAP for a company using FIFO or average cost. A company using LIFO has a second rule to apply first.
The LIFO exception and the market window
For inventory measured under LIFO or the retail inventory method, US GAAP still compares cost with market, and market means replacement cost. Replacement cost is not used unconstrained, though. It is bounded above by net realisable value and below by net realisable value less a normal profit margin.
The floor exists to stop a company writing inventory down so far that the eventual sale reports an artificially high margin. The ceiling exists to stop it carrying inventory above what the sale will actually realise. Between them they force the reported figure into a band that neither flatters this year nor flatters next year.
Take the same inventory: cost $480,000, selling price $520,000, completion $45,000, selling costs $30,000, so NRV is $445,000. The company uses LIFO, and its normal profit margin on this product is 8% of the selling price. Replacement cost is $430,000.
- Ceiling = NRV = $445,000.
- Normal profit margin = 8% × 520,000 = $41,600.
- Floor = NRV − normal profit margin = 445,000 − 41,600 = $403,400.
- Replacement cost of $430,000 lies between the floor and the ceiling, so market = $430,000.
- Cost of $480,000 exceeds market, so the inventory is carried at $430,000 and the charge is $50,000.
Answer: a write-down of $50,000, against $35,000 for the identical inventory under IFRS or under US GAAP with FIFO. Same goods, same loss of value, two different reported numbers and two different carrying amounts, decided entirely by the cost formula.
Where the charge lands in the statements
On the income statement the write-down is an expense of the period. Under IFRS it is normally recognised within cost of sales, and it is presented separately when the amount is material enough that burying it would mislead. Gross profit falls, operating profit falls, and net income falls by the after-tax amount.
On the balance sheet inventory falls, so current assets and total assets fall, and retained earnings fall by the same after-tax amount, which reduces equity. The entry balances without touching cash or liabilities.
On the cash flow statement nothing happens. Operating cash flow is unaffected, because no cash moved. Under the indirect method the charge appears as an add-back to net income, offset by the smaller increase, or larger decrease, in inventory in working capital.
A write-down is a timing entry, not a value-destroying one. The economic loss happened when the market moved against the inventory. The accounting entry decides which period reports it. This is why the same event produces a worse current year and a better following year, and why a company under pressure to reset expectations has an incentive to write down generously.
What it does to the ratios, this year and next
The ratio effects split cleanly into the period of the write-down and the period in which the written down inventory is sold, and several of them reverse between the two. This is where most of the analytical value sits.
| Item | Period of the write-down | Period the inventory is sold |
|---|---|---|
| Cost of sales | Higher | Lower, because the carrying value is lower |
| Gross margin and net profit margin | Lower | Higher |
| Inventory and total assets | Lower | Lower until sold |
| Current ratio and quick ratio | Current ratio lower. Quick ratio unchanged, since inventory is excluded | Restored as the sale converts inventory to receivables or cash |
| Inventory turnover | Higher, from a higher numerator and a lower denominator | Higher |
| Days of inventory on hand | Lower | Lower |
| Debt to equity | Higher, since equity falls | Recovers as the higher margin rebuilds retained earnings |
| Return on assets | Ambiguous. Both numerator and denominator fall | Higher |
| Operating cash flow | Unchanged | Unchanged by the write-down itself |
Two rows deserve comment. Inventory turnover rising looks like an efficiency improvement and is not one, because it is produced arithmetically by a larger cost of sales divided by a smaller average inventory. An analyst who screens on turnover without checking for write-downs will rank a company higher for having lost money on its stock.
And the reversal of profitability in the following period is the entire point of the topic.
Continue the IFRS case. The inventory costing $480,000 is written down to $445,000 at the end of Year 1. During Year 2 it is completed and sold for exactly the expected $520,000, with completion costs of $45,000 and selling costs of $30,000. Compare the two-year picture with and without the write-down.
- With the write-down, Year 1 reports a charge of $35,000, so pre-tax profit from this inventory is −$35,000.
- Year 2 reports revenue 520,000, cost of sales 445,000, completion 45,000 and selling costs 30,000, giving exactly $0.
- Without the write-down, Year 1 reports nothing at all from this inventory.
- Year 2 would then report 520,000 − 480,000 − 45,000 − 30,000 = −$35,000.
- Two-year total in both cases: −$35,000.
Answer: the write-down changed nothing about the total outcome and everything about its distribution. It moved the entire $35,000 loss from Year 2 into Year 1. Year 2 then shows a break-even where it would otherwise have shown a loss, and any ratio built on Year 2 profit improves for a reason that has nothing to do with Year 2 trading.
Reversals, and how an analyst should read them
Under IFRS, if net realisable value recovers, the earlier write-down is reversed up to the amount originally taken. Inventory can return to its original cost and no further. The credit reduces the inventory expense of the period in which the recovery occurs, so it flatters that period’s margin. US GAAP prohibits this entirely: the written down amount becomes the new cost basis and a later recovery in value is simply never recognised until the goods are sold.
That asymmetry matters when comparing companies across frameworks. An IFRS reporter whose inventory values recovered will show a margin improvement that a US GAAP reporter in identical circumstances cannot show, and neither company traded any better than the other.
A single write-down in a bad year is ordinary. A pattern is a finding. Write-downs in three consecutive years point to a forecasting process that keeps producing stock the market does not want, or to a product line under sustained competitive pressure. A single very large write-down concentrated in a year that was already poor, particularly one accompanied by a change of management, is the classic shape of a reset: charge everything to a year already written off, and start the next year with a lower cost base and an easier comparison.
The notes are where this work gets done, and they are more informative than the face of the statements. IFRS requires disclosure of the amount of any write-down recognised as an expense in the period, and of the amount of any reversal together with the circumstances that caused it. Read together across several years those two disclosures answer the question the income statement cannot: whether a margin improvement came from trading or from a reversal, and whether this year’s charge is the first one or the fourth.
Neither pattern means the accounting is wrong. Both are permitted, and in most cases both are defensible on the estimates available at the time, because net realisable value is an estimate and estimates have ranges. That is precisely why the analytical work matters. The number in the accounts is correct within the rules; what it means about the business is a separate question, and it is the one the reader is being paid to answer.
The short version
- A write-down recognises a loss that already exists. It shifts profit between periods rather than destroying value, and total profit across the two periods is unchanged.
- There are three measurement rules, not two, because US GAAP treats LIFO and retail method inventory differently from FIFO and average cost.
- Net realisable value is the selling price less costs to complete and costs to sell. Comparing cost with the selling price instead is the most common error on this reading.
- Under the LIFO rule, market is replacement cost bounded by a ceiling of NRV and a floor of NRV less a normal profit margin.
- Inventory turnover rises after a write-down for purely arithmetic reasons, and reads as an efficiency gain if it is not checked.
- IFRS permits reversal up to the original cost. US GAAP prohibits it, so the reduced value becomes the new cost basis.
Frequently Asked Questions
What is the difference between an inventory write-down and a write-off?
A write-down reduces the carrying value of inventory that still has some recoverable value, and the inventory remains on the balance sheet at the lower figure. A write-off removes the inventory entirely because nothing is recoverable. The mechanics are the same and the difference is whether any value remains.
How is net realisable value calculated?
Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale. It is not the selling price itself. Comparing cost with the selling price rather than with NRV is the most common error on this topic, because inventory can require a write-down even when the selling price exceeds cost.
Does US GAAP still use the lower of cost or market?
Only for inventory measured under LIFO or the retail inventory method. For inventory measured under FIFO or average cost, US GAAP has used the lower of cost and net realisable value since the FASB simplified the rule, effective for public companies from 2017. Sources that state a single US GAAP rule for all inventory are out of date.
What are the ceiling and floor in the LIFO rule?
Market means replacement cost, but bounded. The ceiling is net realisable value and the floor is net realisable value less a normal profit margin. A replacement cost above the ceiling is cut to the ceiling, one below the floor is raised to the floor, and one inside is used as it stands. The resulting figure is then compared with cost.
Does a write-down affect cash flow?
No. No cash moves when the entry is made, so operating cash flow is unchanged. Under the indirect method the charge is added back to net income in the same way as depreciation. What changes is the period in which an economic loss is recognised, not the cash position.
Can an inventory write-down be reversed?
Under IFRS yes, if net realisable value recovers. The reversal is limited to the amount originally written down, so carrying value never exceeds original cost, and it is recognised as a reduction in the inventory expense of that period. US GAAP prohibits reversal entirely: the reduced amount becomes the new cost basis.
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