Guidelines for Accounting for Obsolete Inventory
Obsolete inventory is inventory that is no longer of use to sell or to include in the manufacturing process. Such inventory is a drag on the company, for it consumes space, wastes time required to count and manage such inventory, increases the amount of inventory insurance coverage, and may even reduce local property tax on inventory.
Image Credit: Wikimedia Commons
How to Locate Obsolete Inventory
The first step in accounting for obsolete inventory is identifying it.
Items not in use need not necessarily be obsolete inventory. For instance, some items might be required for incorporation in future plans and some items may need retention as difficult-to-obtain possible spares.
The best practice to classify items not in use as obsolete inventory is to constitute a material review board including representatives from accounting, engineering, logistics, production, and any other department that handles inventory to determine inventory no longer needed that may be safely disposed.
Disposal of Obsolete Inventory
The second step in accounting for obsolete inventory is disposal of the items identified as obsolete through various means.
Considering the trade-off between acquiring new spares and the cost of retaining inventory, some obsolete inventory may be classified for retention as possible spares for the future.
Other possible option includes:
- Returning the obsolete item to the original supplier, depending on whether the supplier would accept returns, and if so, the restocking fee charged.
- Selling such items to salvage contractors.
- Donating such items to a nonprofit charity notified under section 501(c)(3) of the Internal Revenue Service tax code, and becoming eligible for tax deduction. Such tax deductions can contribute to a net operating loss carry-forward, carried forward into a different tax-reporting year.
- Throwing away the items as junk to claim depreciation benefits.
Expense Recognition for Obsolete Inventory
General Accepted Accounting Principles (GAAP) mandates writing off the unrecoverable portion of the obsolete inventory immediately upon its identification. The important accounting consideration in this regard is ensuring the proper expense recognition procedure for the obsolete inventory.
The steps in this direction include:
- Identifying the book value of the obsolete items.
- Estimating the most likely disposition value for the items identified as obsolete.
- Subtracting the most likely disposition value from the book value for the specific item.
- Setting aside the resultant difference as reserve.
The actual value obtained on actual disposition of the obsolete item would invariably remain different from the estimated disposition value. The reserve account then requires adjustment to reflect this change.
For instance, a computer dealer having identified obsolete CRT monitors worth $100,000 estimates that selling such items to e-waste recyclers would fetch $25,000. The computer dealer estimates the reserves as $75,000 ($100,000 - $25,000) and makes the following journal entry:
- [Debit]. Cost of goods sold = $75,000
- [Credit]. Reserve for obsolete inventory = $75,000
If on actual sale, the dealer realizes only $23,000, the following adjustments to the journal entry reflect the $2,000 as additional expenditure:
- [Debit]. Reserve for obsolete inventory = $75,000
- [Debit]. Cost of goods sold = $2,000
- [Credit]. Inventory = $77,000
While accounting for allowance for excess and obsolete inventory is a straightforward mechanical process, this process can distort reported financial results.
For instance, if the disposal of inventory fetches higher than the estimated price, then the company results look better than expected when it is not the case. Similarly, when the disposal of inventory fetches a lesser-than-estimated price, company results look better, when in reality nothing has changed.
If the company does not conduct an exercise to identify inventory on a frequent basis, a sudden entry into a large expense reserve alters the financial statements negatively, causing concern for outside investors and creditors.
The key to avoiding such issues is a timely review by the material review board and implementing concepts such as Just-in-Time inventory control to avoid obsolete inventory rather than accounting for obsolete inventory.