Inventory Gets Written Down Long Before Anyone Admits It Is Unsellable
Stock is carried at cost until cost exceeds what it can be sold for. Deciding when that moment arrived is a judgement, and delaying it keeps profit on the books that was never there.
The Rule
Inventory is carried at the lower of cost and what it can actually be sold for, net of the costs of selling it. When the realisable amount falls below cost, the difference is written off immediately.
The principle is conservative on purpose. An asset should not sit on a balance sheet at a value the market will not pay.
Inventory is the only major asset that can become worthless while remaining physically perfect. A warehouse of last season's stock has not decayed. It has simply stopped being wanted.
Why It Goes Bad
| Cause | Typical industry | Speed |
|---|---|---|
| Technological obsolescence | Electronics, components | Fast, a new generation ends the old one |
| Fashion and seasonality | Apparel, toys | Fast, tied to a calendar |
| Expiry | Food, pharmaceuticals | Predictable, dated |
| Demand forecast error | Any | Slow, discovered gradually |
The last row is the dangerous one, because there is no event that forces recognition. Nothing expires and no new model launches. The stock simply sells more slowly than planned, and each quarter it is possible to believe demand will recover.
The Discretion
Companies estimate obsolescence with reserve policies, typically aging inventory into buckets and reserving a rising percentage as stock gets older.
Every part of that is a choice. How the buckets are defined, what percentage attaches to each, and whether the policy is applied mechanically or overridden by management judgement about specific lines.
Loosening any of those raises reported profit immediately, because a smaller reserve means a smaller expense. The change appears in accounting policy language that most readers skip.
The Signal Worth Watching
The single most useful check is inventory growth against revenue growth.
Inventory rising materially faster than sales means goods are accumulating rather than moving. It can be deliberate, ahead of a launch or to buffer a supply risk, and companies say so when it is. Unexplained, it usually means demand came in below the plan the purchasing was built on.
Inventory days, meaning how long stock sits before selling, makes the same point in a way that is comparable across periods and competitors.
Why the Write Down Arrives Late
Recognising it means admitting that money spent building or buying the stock will not be recovered, and frequently that a demand forecast was wrong.
There is also a mechanical incentive. Writing down inventory reduces the cost of goods sold on any subsequent sale of that stock, because the goods now carry a lower cost. So a large write down depresses profit today and flatters gross margin later, when the written down goods sell at prices above their new carrying value.
A company reporting unusually strong gross margin in the periods after a big inventory charge may be selling through goods that were already expensed.
Where It Is Disclosed
The inventory note breaks the balance down into raw materials, work in progress and finished goods, and usually discloses the reserve and its movement.
Finished goods rising as a share of the total is more concerning than raw materials rising, because finished goods are the least flexible. Raw materials can still be directed to whatever customers actually want. A completed product in the wrong configuration cannot.
The Bottom Line
Inventory is carried at the lower of cost and realisable value, so stock that cannot be sold at cost must be written down, and the timing of that admission is discretionary. Watch inventory growing faster than revenue and finished goods rising as a share of the total, since both precede the charge. And treat strong gross margins immediately after a large write down with care, because the cost was already taken.