Markdowns

What Are Markdowns?

Markdowns, in the context of Financial Accounting, represent a reduction in the recorded value of inventory on a company's balance sheet. This adjustment is typically made when the net realizable value (NRV) or market value of the inventory falls below its original cost. The purpose of recording markdowns is to ensure that a company's assets are not overstated, adhering to conservative accounting principles such as the Lower of Cost or Market (LCM) rule, which dictates that inventory should be valued at the lower of its historical cost or its current market value. Markdowns directly impact a company's gross profit and, consequently, its income statement, reflecting a decrease in the asset's worth.

History and Origin

The concept of valuing inventory at the lower of cost or market (LCM) has long been a cornerstone of accounting. This principle, which underpins the practice of markdowns, gained prominence to ensure financial statements present a conservative and realistic view of a company's assets. Historically, accounting standards evolved to prevent the overstatement of inventory, especially in dynamic markets where product values can decline rapidly due to obsolescence, damage, or shifts in demand. U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) both incorporate rules requiring inventory impairment when its carrying amount exceeds its net realizable value. For instance, the U.S. Securities and Exchange Commission (SEC) provides staff guidance emphasizing that once inventory is written down, a new cost basis is established and is not subsequently written back up in future periods, reinforcing the conservative nature of markdowns.⁵

Key Takeaways

• Markdowns reduce the book value of inventory to reflect a decline in its market value or net realizable value.
• They are a critical application of conservative accounting principles, ensuring assets are not overstated on the balance sheet.
• Markdowns directly impact the cost of goods sold, reducing reported gross profit and taxable income.
• The primary drivers for markdowns include obsolescence, damage, changes in fashion or technology, and decreased market demand.
• Proper application of markdowns is mandated by accounting standards like GAAP and IFRS to provide a fair representation of a company's financial position.

Formula and Calculation

Markdowns are not typically calculated using a single, universal formula in the way a financial ratio might be. Instead, they represent the difference between the original cost of the inventory and its current net realizable value (NRV) or replacement cost, depending on the specific accounting standard and cost flow assumption applied (e.g., FIFO, LIFO, or weighted-average).

The core principle for calculating a markdown is to determine the amount by which the recorded cost exceeds the recoverable amount. This is often guided by the Lower of Cost or Market (LCM) or Lower of Cost or Net Realizable Value (LCNRV) rules.

The markdown amount for an individual inventory item or a group of items can be expressed as:

Where:

• Original Cost is the initial cost of acquiring or producing the inventory.
• Current Market Value refers to the current replacement cost, and is subject to specific ceilings and floors under GAAP's LCM rule.
• Net Realizable Value (NRV) is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal. This is the standard under IFRS and often under GAAP when using the LCNRV rule for inventory valued using FIFO or weighted-average methods.

This adjustment is then usually recorded as an increase to Cost of Goods Sold on the income statement, or sometimes directly to a separate loss account.

Interpreting Markdowns

Interpreting markdowns involves understanding their impact on a company's financial health and operational efficiency. A significant level of markdowns can signal several underlying issues within a business. Firstly, it may indicate poor supply chain management or flawed purchasing decisions, where too much inventory was acquired or products that are no longer in demand were stocked. Secondly, substantial markdowns can point to competitive pressures, technological obsolescence, or shifts in consumer preferences that have diminished the market value of goods.

From a financial perspective, higher markdowns lead to reduced profitability as they increase the cost of goods sold. This impacts key financial ratios such as gross profit margin and inventory turnover. While markdowns are necessary to present an accurate financial picture, consistently large markdowns can be a red flag for investors, suggesting inefficiencies or an inability to accurately forecast demand. Conversely, a company with consistently low markdowns might demonstrate effective inventory control and a strong understanding of its market.

Hypothetical Example

Consider "GadgetCo," a retail electronics company that purchased 1,000 units of a new smart speaker at a cost of $100 per unit, totaling $100,000 in inventory. Shortly after, a competitor releases a more advanced speaker at a lower price point, causing demand for GadgetCo's speaker to plummet.

GadgetCo's management determines that to sell the remaining 1,000 units, they must reduce the selling price significantly. The estimated net realizable value (NRV) of each speaker is now $70.

To apply the markdown, GadgetCo calculates:

• Original Cost per unit: $100
• Net Realizable Value per unit: $70
• Markdown per unit: $100 - $70 = $30

Total markdown for the 1,000 units: $30 x 1,000 = $30,000.

GadgetCo would then record a $30,000 markdown, typically increasing their Cost of Goods Sold by this amount, which reduces their reported gross profit for the period. This adjustment ensures the inventory is reported on the balance sheet at its new, lower value of $70,000.

Practical Applications

Markdowns are prevalent across various industries, reflecting real-world challenges in inventory management and market dynamics. In retail, markdowns are commonly used to clear seasonal merchandise, damaged goods, or slow-moving items to make way for new stock. Fashion retailers, for example, frequently implement markdowns on apparel at the end of a season to manage their inventory levels and optimize holding costs.⁴

In the manufacturing sector, markdowns might occur if a product line becomes obsolete due to technological advancements or if a company overproduces a particular item, leading to excess inventory. For instance, a semiconductor materials supplier recently lowered its full-year sales guidance, citing continued weakness in its business and high customer inventories, implying potential future markdowns for them and their customers to clear stock.³

Tax authorities, such as the Internal Revenue Service (IRS), also recognize markdowns in their regulations for inventory valuation. IRS Publication 538 details various methods for valuing inventory, including the lower of cost or market method, which allows businesses to adjust inventory value for tax purposes when goods cannot be sold at normal prices due to damage, imperfections, or obsolescence.² This ensures that companies' taxable income accurately reflects the true value of their assets. Markdowns, by increasing Cost of Goods Sold, reduce reported profitability and, consequently, a company's tax liability.

Limitations and Criticisms

While markdowns are essential for accurate financial reporting, their application can present certain limitations and become subject to criticism. One common critique revolves around the subjective nature of determining the "market value" or "net realizable value" of inventory. These estimations often rely on management's judgment regarding future sales prices, selling costs, and demand forecasts, which can introduce a degree of bias or error. Overly aggressive markdowns can artificially depress a company's stated asset values and profitability, potentially misleading investors about its underlying performance.

Conversely, a reluctance to take necessary markdowns can lead to an overstatement of assets on the balance sheet, presenting a falsely optimistic view of financial health. This can delay the recognition of losses and may necessitate more substantial write-downs in the future. Furthermore, while markdowns reduce reported gross profit and thus taxable income, companies must comply with stringent regulatory guidelines from bodies like the SEC and IRS to ensure these adjustments are legitimate and consistently applied. The rules, for instance, typically do not allow for the reversal of markdowns if market conditions improve after the initial write-down, establishing a "new cost basis" for the inventory.¹ This one-way street, while conservative, can prevent a company from benefiting financially if the value recovers, locking in the loss permanently from an accounting perspective.

Markdowns vs. Inventory Write-Off

Markdowns and inventory write-off are both accounting adjustments that reduce the reported value of inventory, but they differ in their degree and underlying reasons.

Markdowns are a reduction in the carrying value of inventory to reflect a decline in its market value or net realizable value below its original cost. This typically occurs when the inventory is still considered salable, but its expected selling price has decreased. The markdown adjusts the value of the inventory on the balance sheet and typically increases the cost of goods sold, reflecting the reduced value. The physical inventory still exists and is expected to be sold, albeit at a lower profit.

An inventory write-off, on the other hand, is the complete removal of inventory from a company's books because it is deemed worthless or unsalable. This could be due to severe damage, complete obsolescence, theft, or spoilage. When inventory is written off, it is removed as an asset from the balance sheet entirely, and a corresponding expense or loss is recognized on the income statement. Unlike a markdown, there is no expectation that the written-off inventory will generate future revenue. It is an acknowledgment that the asset has no recoverable value.

The key distinction lies in the recoverability of value: markdowns adjust value expecting some future sale, while write-offs declare the value entirely lost.

FAQs

Why do companies take markdowns?

Companies take markdowns to adjust the value of their inventory on the balance sheet when its market value falls below its original cost. This ensures that financial statements accurately reflect the true, lower value of the assets and adheres to conservative accounting principles like the Lower of Cost or Market rule. Common reasons include obsolescence, damage, or decreased customer demand.

How do markdowns affect a company's financial statements?

Markdowns directly impact a company's income statement and balance sheet. On the income statement, markdowns increase the Cost of Goods Sold, which reduces the reported gross profit and, consequently, net income and profitability. On the balance sheet, the value of inventory (an asset) is reduced to its new, lower carrying amount.

Are markdowns the same as sales discounts?

No, markdowns are not the same as sales discounts. A markdown is an internal accounting adjustment that reduces the recorded value of inventory on a company's books, reflecting a permanent or semi-permanent decline in its worth. A sales discount, conversely, is a temporary price reduction offered to customers, often to incentivize quick payment or increase sales volume, without necessarily implying a reduction in the underlying value of the inventory itself.

Can markdowns be reversed?

Generally, under U.S. Generally Accepted Accounting Principles (GAAP), once an inventory markdown is taken, it creates a new cost basis for that inventory, and the value cannot be subsequently increased if market conditions improve. This is a conservative accounting practice. However, under International Financial Reporting Standards (IFRS), a markdown can be reversed if there is clear evidence that the circumstances that led to the markdown have changed.