Every manufacturer deals with unsalable inventory or inventory whose fair market value as fallen below cost. It can take the form of defective products, obsolete products, a surplus of finished goods, or simply inventory that’s gotten old. Every product that rolls off your production line has a chance to depreciate over time.
No matter the circumstances, unsalable inventory brings with it a litany of hidden costs. Furthermore, the inventory remains on the books and generally won’t be written off until the item is sold or disposed. Most manufacturers continue to maintain the inventory on the books at historical cost plus cost of production where applicable.
However, tax regulations may allow for inventory write-downs to occur in certain circumstances even if it’s not sold or disposed.
Unsalable inventory isn’t a blanket term for “inventory you didn’t sell.” Rather, it’s inventory that producers can’t sell at fair market value.
According to IRS Regulation 1.471-2, subsection C, this inventory is defined as, “unsalable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes, including second-hand goods taken in exchange.”
The larger the percentage of unsalable inventory, the greater the drain on your profits. An inventory write-down eliminates these amounts on your balance sheet.
The first step in determining the value of a write-down is to identify the amount of unsalable inventory. The key is to identify those old products that are considered unsalable by reviewing your inventory listing. These are generally items for which you may be setting up inventory reserves or have not moved in a significant period of time. You must exclude any finished products currently being offered at their original price or a price above historical cost.
Unsalable inventory items should be valued at bona fide selling prices minus the direct cost of disposition. However, there’s a difference between general finished goods and raw or unfinished goods. Manufacturers need to be cognizant of both.
Write-downs for unsalable inventory should occur in the fiscal year that the inventory becomes unsalable. This also applies to businesses liquidating inventories in preparation to declare bankruptcy.
Writing down unsalable inventory is a way for you to speed up a tax deduction that might otherwise weigh down your balance sheet. A write-down lowers your total liability by reducing taxable income.
While inventory write-downs serve an important purpose, however, you shouldn’t rely on them to absolve huge losses year after year. If you’re constantly left with large amounts of unsalable inventory, you need to investigate why this keeps happening. Otherwise, it’ll catch up to you in the form of crunched cash flows and losses produced.
Also, be mindful that an inventory write-down is not the same as a write-off. Determining the value of a write-down is imperative for proper accounting and shouldn’t be confused with a write-off, which marks a total loss on the balance sheet. Finally, remember that once inventory has been written down, it can’t be written back up!
Want more information? The manufacturing CPAs at James Moore can help you properly utilize write-downs to help with your unsalable inventory.
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