In brief, the proper expense recognition procedure for obsolete inventory is to determine the most likely disposition value for the targeted items, subtract this value from the book value of the obsolete inventory, and set aside the difference as a reserve. As the obsolete inventory is actually disposed of or estimates in the disposition values change, adjust the reserve account to reflect these alterations.
Example: a review of the Lie Computer Company’s inventory reveals that it has $100,000 of laptop computer hard drives that it cannot sell. However, it believes there is a market for the drives through a reseller in Antarctica, but only at a sale price of $20,000. Accordingly, the Lie’s controller recognizes a reserve of $80,000 with the following journal entry:
[Debit]. Cost of goods sold = $80,000
[Credit]. Reserve for obsolete inventory = $80,000
After finalizing arrangements with the Antarctica reseller, the actual sale price is only $19,000, so the controller completes the transaction with the following entry to recognize an additional $1,000 of expense:
Sounds like a simple, mechanical process, doesn’t it? It is not!.
The first problem is that one can improperly alter a company’s reported financial results just by altering the timing of actual dispositions. For example, if a manager knows he can receive a higher-than-estimated price when selling old inventory, he can accelerate or delay the sale in order to drop some gains into a reporting period where the extra results are needed. This is unlikely to be a significant problem if the reserve is small, but it is a substantial risk if the reverse is the case. For example, the Lie Computer Company has set aside an obsolescence reserve of $25,000 for laptop computer fans. However, in January, the purchasing manager knows that the resale price for fans 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, because this would result in an overall loss in Lie’s financial results in January, he waits until April, when Lie has a profitable month, and completes the sale at that time, thereby delaying the additional obsolescence loss until the point of sale.
A second problem is the reluctance of management to suddenly drop a large expense reserve into the financial statements, which may disturb outside investors and creditors. Managers have a tendency instead to recognize small incremental amounts, thereby making it look as though obsolescence is a minor problem. There is no ready solution to this problem, because GAAP clearly mandates that all obsolete inventory be written off at once. It is a rare accountant who does not enter into a battle with management over this issue at some point during his or her career.
A third problem is the shear size of expense recognition if there has been a long time period between obsolescence reviews. A review usually occurs at the end of the fiscal year, when this type of inventory is supposed to be investigated and written off, usually in conjunction with the auditor’s review or the physical inventory count (or both). If this write-off has not occurred in previous years, the cumulative amount can be startling [which can result in the departure of the materials manager and/or the controller on the grounds that they should have known about the problem].
There are three ways to keep a large write-off from occurring:
- First, conduct frequent obsolescence reviews to keep large write-offs from building up: Create an obsolescence expense reserve as part of the annual budget, and encourage the MRB to use it all. Under this approach, one can usually count on the warehouse manager to throw out the maximum possible amount of stock on the first day when the new budget takes effect.
- Implement some of the approaches described in the next section to prevent inventory from becoming obsolete.
- A final expense recognition issue is that senior management simply may not believe the MRB when they arrive at an extremely high obsolescence reserve, and management may reject the recommended expense recognition. Their presumed knowledge of the business will not allow them to consider that a large part of the inventory is no longer usable. If this is the case, consider bringing in consultants to conduct an independent evaluation of the inventory. Senior managers may need this second opinion before they will authorize a large obsolescence reserve.