Obsolete inventory accounting

Obsolete Inventory Accounting Overview

A materials review board should be used to locate obsolete inventory items. This group reviews inventory usage reports or physically examines the inventory to determine which items should be disposed of. You then review the findings of this group to determine the most likely disposition price of the obsolete items, subtract this projected amount from the book value of the obsolete items, and set aside the difference as a reserve. As the company later disposes of the items, or the estimated amounts to be received from disposition change, adjust the reserve account to reflect these events.

An alternative approach is to create a reserve based on the historical rate of obsolescence. This approach is easier to derive, but is less accurate.

The following issues are associated with the accounting for obsolete inventory:

  • Timing. You can improperly alter a company’s reported financial results by altering the timing of the actual dispositions. As an example, if a supervisor knows that he can receive a higher-than-estimated price on the disposition of obsolete inventory, then he can either accelerate or delay the sale in order to shift gains into whichever reporting period needs the extra profit.
  • Expense recognition. Management may be reluctant to suddenly drop a large expense reserve into the financial statements, preferring instead to recognize small incremental amounts which make inventory obsolescence appear to be a minor problem. Since GAAP mandates immediate recognition of any obsolescence as soon as it is detected, you may have a struggle enforcing immediate recognition over the objections of management.
  • Timely reviews. Inventory obsolescence is a minor issue as long as management reviews inventory on a regular basis, so that the incremental amount of obsolescence detected is small in any given period. However, if management does not conduct a review for a long time, this allows obsolete inventory to build up to quite impressive proportions, along with an equally impressive amount of expense recognition. To avoid this issue, conduct frequent obsolescence reviews, and maintain a reserve based on historical or expected obsolescence, even if the specific inventory items have not yet been identified.

Obsolete Inventory Accounting Example

Milagro Corporation has $100,000 of excess home coffee roasters it cannot sell. However, it believes there is a market for the roasters through a reseller in China, but only at a sale price of $20,000. Accordingly, the controller recognizes a reserve of $80,000 with the following journal entry:

  Debit Credit
Cost of goods sold 80,000  
     Reserve for obsolete inventory   80,000

After finalizing the arrangement with the Chinese reseller, the actual sale price is only $19,000, so the controller completes the transaction with the following entry, recognizing an additional $1,000 of expense:

  Debit Credit
Reserve for obsolete inventory   80,000  
Cost of goods sold 1,000  
     Inventory   81,000

As another example, Milagro Corporation sets aside an obsolescence reserve of $25,000 for obsolete roasters. However, in January the purchasing manager knows that the resale price for obsolete roasters has plummeted, so the real reserve should be closer to $35,000, which would call for the immediate recognition of an additional $10,000 of expense. However, since this would result in an overall reported loss in Milagro’s financial results in January, he waits until April, when Milagro has a very profitable month, and completes the sale at that time, thereby incorrectly delaying the additional obsolescence loss until the point of sale.