Key Concepts
Normally, a business sells goods at a price above their cost to earn a gross profit. However, if the net realisable value (NRV) — the price the business expects to receive from selling the goods — falls below the cost of inventory, the business faces a potential loss.
According to the prudence theory, inventory is valued at the lower of cost and net realisable value (NRV). The prudence theory states that the accounting treatment chosen should be the one that least overstates assets and profits, and least understates liabilities and losses. So when the cost of inventory is higher than its NRV, the business must reduce the inventory value and record the potential loss as an impairment loss — even though the inventory has not yet been sold — to ensure that current assets and profit are not overstated.
When NRV < cost, the business must:
- Reduce the inventory value from cost down to NRV.
- Record the difference as an impairment loss on inventory (an expense).
To manage the risk of loss caused by damaged goods, a business may also make an insurance claim to seek compensation.
Journal entries:
| Transaction | Debit | Credit |
|---|---|---|
| Record impairment loss | Impairment loss on inventory (+expense) | Inventory (−asset) |
| Record insurance claim for damaged goods | Insurance claim receivable (+asset) | Impairment loss on inventory (−expense) |
Effects if impairment loss is NOT recorded:
- Impairment loss on inventory is understated → profit for the period is overstated (expense and profit move in opposite directions).
- Gross profit is not affected. Impairment loss is an other expense, shown below the gross profit line in the Statement of Financial Performance — it is not part of cost of sales. So failing to record it lowers profit for the period only, not gross profit.
- Inventory on the Statement of Financial Position is overstated (current assets are overstated).
Prudence: never overstate. If NRV < Cost, write cost down to NRV and record the difference as an expense. Dr Impairment loss on inventory / Cr Inventory. After the write-down, inventory is shown at NRV on the Statement of Financial Position — not at cost.
Impairment loss on inventory = Cost − NRV = $5,200 − $3,400 = $1,800
| Date | Particulars | Dr ($) | Cr ($) |
|---|---|---|---|
| 20X9 | |||
| 30 Nov | Impairment loss on inventory | 1,800 | |
| Inventory | 1,800 |
Statement of Financial Performance for the month ended 30 November 20X9 (extract)
| $ | |
|---|---|
| Less: Other expenses | |
| Impairment loss on inventory | 1,800 |
Statement of Financial Position as at 30 November 20X9 (extract)
| $ | |
|---|---|
| Current assets | |
| Inventory | 3,400 |
(Inventory is shown at NRV of $3,400, not original cost of $5,200.)
On 31 December 20X5, Saffron Trading had an ending inventory valued at $8,000. A flood damaged some of the goods, and the NRV of the ending inventory fell to $6,200. Saffron Trading holds an insurance policy for goods damage, and the insurer agreed to pay a claim covering 60% of the loss on the damaged goods.
Impairment loss on inventory = Cost − NRV = $8,000 − $6,200 = $1,800
Insurance claim = 60% × $1,800 = $1,080
| Date | Particulars | Dr ($) | Cr ($) |
|---|---|---|---|
| 20X5 | |||
| 31 Dec | Impairment loss on inventory | 1,800 | |
| Inventory | 1,800 | ||
| 31 Dec | Insurance claim receivable | 1,080 | |
| Impairment loss on inventory | 1,080 |
Net impairment loss = $1,800 − $1,080 = $720
Statement of Financial Performance for the year ended 31 December 20X5 (extract)
| $ | |
|---|---|
| Less: Other expenses | |
| Impairment loss on inventory | 720 |
Only the net $720 remains as an expense — the $1,080 claim has offset the rest.
Statement of Financial Position as at 31 December 20X5 (extract)
| $ | |
|---|---|
| Current assets | |
| Inventory | 6,200 |
| Insurance claim receivable | 1,080 |
(Contrast with a full claim: had the insurer paid the whole $1,800, the impairment expense would be fully cancelled and no impairment loss on inventory would appear on the Statement of Financial Performance.)
Wrong direction of the impairment journal entry. The entry is Dr Impairment loss on inventory / Cr Inventory. Impairment loss is an expense — the business has incurred a loss — so it is debited; inventory's value has dropped, so it is credited. Reversing this would increase inventory value instead of reducing it.
Showing inventory at cost on the Statement of Financial Position after impairment. After recording the impairment loss, inventory must be shown at NRV ($3,400), not at the original cost ($5,200).
Confusing the effect on profit. Impairment loss is an expense. When expense increases, profit decreases. If the impairment is not recorded, expense is understated and profit is overstated.