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href="#ulink_1395b830-827f-56b5-9a3b-a2e5764bd3a1">TABLE 3-7 Journal Entry 7: Recording an Allowance for Obsolete Inventory

Account	Debit	Credit
Inventory obsolescence	$100
Allowance for obsolete inventory		$100

As Journal Entry 7 shows, to record the obsolescence of a $100 inventory item, you first debit an expense account called something like “Inventory obsolescence” for $100. Then you credit a contra-asset account named something like “Allowance for obsolete inventory” for $100. As I mention in the discussion of accounts receivable, a contra-asset account gets reported on the balance sheet immediately below the asset account to which it relates. The contra-asset account, with its negative credit balance, reduces the net reported value of the asset account. If the inventory account balance is $3,100, and you have an allowance for an obsolete inventory contra-asset account of $100, the net inventory balance shows up as $3,000. In other words, the contra-asset account gets subtracted from the related asset account.

      

QuickBooks requires you to record Journal Entry 7 yourself by using the Make General Journal Entries command. You can find out more about these types of entries in Book 4, Chapter 1.

      Disposing of obsolete inventory

When you ultimately do dispose of obsolete inventory, you record a journal entry like the one shown in Table 3-8. This journal entry debits the contra-asset account for $100 and credits inventory for $100. In other words, this journal entry removes the value of the obsolete inventory from both the allowance for obsolete inventory account and the inventory account itself. You record this journal entry when you actually, physically dispose of the inventory — when you pay the junk hauler to haul away the inventory, for example, or when you toss the inventory into the large trash bin behind your office or factory.

TABLE 3-8 Journal Entry 8: Recording Disposal of Inventory

Account	Debit	Credit
Allowance for obsolete inventory	$100
Inventory		$100

      

In general, one thing you should do every year for tax accounting reasons is deal with your obsolete inventory. The tax rules generally state that you can’t write off obsolete inventory unless you actually dispose of it for income purposes. Typically, however, you can write down inventory to its liquidation value. Such a write-down works the same way as a write-down for obsolete inventory. A write-down can be a little tricky if you’ve never done it before, however, so you may want to confer with your tax adviser.

One more really important point about recording disposal of obsolete inventory: Within QuickBooks, you record inventory disposal by adjusting the physical item count of the inventory items. I describe how adjusting the physical inventory accounts works in Book 3, Chapter 3. So even though I won’t go down that path here, you should know that you don’t actually enter a journal entry like the one shown in Journal Entry 8. You adjust the inventory accounts for the obsolete inventory. This adjustment automatically reduces the inventory account balance. When QuickBooks asks you which account to debit, you specify the allowance for obsolete inventory account.

      Dealing with inventory shrinkage

      The other chronic inventory headache that many business owners and business managers have to deal with is inventory shrinkage. It’s very likely, sometimes for the most innocent reasons, that your inventory records overstate the quantity counts of items. When this happens, you must adjust your records. Essentially, you want to reduce both the dollar value of your inventory and the quantity counts of your inventory items.

      WHY NOT JUST CREDIT THE ASSET ACCOUNT?

      If you’re really getting into this double-entry bookkeeping, you may wonder why you don’t just credit the inventory account in the case of something like obsolete inventory. Wouldn’t that save you time and trouble? Well, yes and no.

      Simply crediting the inventory account does make sense. Such an approach saves you the task of having to set up a goofy contra-asset account. Accountants, however, have concluded over the centuries that it makes sense to keep a record of your obsolete inventory as long as you own it. There are a bunch of reasons for this approach, but one reason is that you want to know what inventory you need to get rid of or dispose of.

      It’s not necessary to set up some sort of separate system for keeping track of obsolete inventory. By using the contra-asset account, you can continue to store information about your inventory in the accounting system without making the balance sheet information and income statement information incorrect.

      This logic applies to other contra-asset accounts too. Earlier in this chapter, I describe how to set up a contra-asset account for uncollectible accounts receivable. The business about wanting to have some record of your uncollectible accounts receivable — perhaps so that you know you don’t want to deal with those customers again — means that you may as well keep this information in the accounting system. A contra-asset account allows you to do so and at the same time not have uncollectible receivables present to overstate your accounts receivable balance.

Table 3-9 shows the journal entry that QuickBooks makes for you to record this event. This journal entry debits an appropriate expense account — in Journal Entry 9, I call the expense account “Shrinkage expense” — for $100. A journal entry also needs to credit the inventory account for $100.

TABLE 3-9 Journal Entry 9: Recording Inventory Shrinkage

Account	Debit	Credit
Shrinkage expense	$100
Inventory		$100

      Within QuickBooks, as I’ve mentioned, you don’t actually record a formal journal entry like the one shown here. You use something called a physical count worksheet to adjust the quantities of your inventory item counts to whatever they actually are. When you make this adjustment, QuickBooks automatically credits the inventory account balance and adjusts the quantity counts. QuickBooks also requires you to supply the expense account that it should debit for the shrinkage.

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