Over the course of a recession, corporate inventories tend to accumulate, particularly at companies that were unsuccessful in accurately forecasting the (depressed) level of demand for their products. Accordingly, under generally accepted accounting principles (GAAP) — which normally requires the use of historical cost — a write-down of inventories may be called for to reflect their diminished utility. Further, the existing rule may require the write-down to be recorded at cost or market, whichever is lower.
In general, for financial accounting purposes, the concept of “market” means “replacement cost.” However, market should not exceed “net realizable value” (the estimated selling price minus the direct costs of disposing of the inventory), nor should it be less than the net realizable value reduced by an allowance for a “normal profit margin.”
Of course, a write-down of inventory will have the collateral effect of depressing earnings. This is so because the “cost of goods sold” figure, which appears on the income statement and is used to determine gross profit, essentially is a residual figure. It is calculated by subtracting ending inventory from the sum of the entity’s beginning inventory, plus costs incurred to acquire and manufacture inventory during the period.
That means that the lower the ending inventory balance, the greater the cost of goods sold with the result that earnings will be penalized. Indeed, this reduction in earnings is desirable for tax purposes, and the tax accounting system recognizes the validity of the lower of cost or market approach to valuing inventories. However, to sustain a write-down for tax purposes, the taxpayer must present persuasive evidence that the market value of the inventory items has diminished to a level below its cost. This burden of proof will be particularly difficult to sustain in cases in which the taxpayer retains the items in inventory and does not “scrap” them.
These lessons were learned nearly 30 years ago as a result of the decision rendered by the Supreme Court in a case entitled Thor Power Tool Co. v. Commissioner, 439 US 522 (1979). These lessons are just as relevant today as they were then.
In 1964, and under new management, Thor Power Tool Co. wrote down what it regarded as “excess inventory” to net realizable value in accordance with GAAP. The write-down produced a loss for tax purposes and the ensuing net operating loss (NOL) was carried back by Thor to secure refunds of taxes it had paid in prior years.
At all times, Thor had used the lower of cost or market method of valuing inventories. The write-down was precipitated by the new management’s belief that Thor’s inventory was “overvalued.” In fact, management wrote-off some $2.75 million of obsolete parts and similar items. The Internal Revenue Service had no quarrel with this particular writeoff because Thor promptly got rid of most of those articles.
Excess inventory, comprised primarily of spare parts, was also written down to net realizable value. However, in this case, Thor did not immediately scrap the articles or sell them at reduced prices. In fact, Thor retained the excess items in inventory and continued to sell them at their original prices. Thor charged the writeoff to an inventory contra account and this charge-off decreased closing inventory, increased cost of goods sold, and ultimately produced a loss for the year in which the write-down occurred. The IRS challenged Thor’s entitlement to the write-down and, eventually, the Supreme Court agreed with the IRS’s position.