Inventory Management: How to Optimize Your Inventory Levels

Introduction 

Inventory refers to the production materials and finished goods held by an accounting entity (IRS, 2017). It forms an important position in the balance sheet. Nevertheless, in instances where they are lost or damaged, it affects the income statement. It implies that such inventory is no longer available for sale. The focus of this presentation is a case study on treatment of inventory write-offs in regards with the provisions of the accepted accounting principles and the provisions of the Internal Revenue Service. 

Facts 

The client presented in this study is a movable home manufacturer. In his books of accounts, there is obsolete and damaged inventory amounting to $1 million. In the balance sheet the inventory is carried at $1 million. Some of the items included in the inventory include sections of manufactured homes that were exposed to bad weather and hence should be dumped. The client wrote down the inventory within a two years period. Both of the inventory damage deductions were made in form 1120 

Issues 

A number of issues that creates a need for more research into the case are whether the inventory write-downs are allowed to such organizations for tax purposes. It is worth noting that under the Internal Revenue Service, making deductions that are not allowed exposes the organization to potential penalties from the Internal Revenue Service. The Internal Revenue Service has very clear guidelines on how various elements of the income statement should be treated for tax purposes. When the inventory is poorly entered, the client is likely to incur huge penalties from the Internal Revenue Service. On the other hand, when the clients end up overcharging taxes, it would be a loss to his income or business. The need for adherence with the IRS tax computation guidelines is thus high, it not only ensures that tax is computed correctly but also helps in increasing the value of financial statements to their end users (IRS, 2017). 

The second issue is whether if the treatment of the inventory was not the right one under the IRS, which is the right approach that the organization should have taken in the handling of such inventory. It would indicate the corrective measure that should have been taken in the process (IRS, 2017). 

The third issue is in regards to accounting practice. Whenever a transaction is made, there are clear approaches that should be assumed in the recording of the transaction. There is a need to assess whether the way that the client recorded the losses was the right approach to the treatment of accounting data or not. If the right approach were not employed, it would be important to record the books of accounts to reflect the right accounting procedures that should have been assumed in the process (IAS, 2017). 

Law and analyses 

The Internal Revenue Service allows accounting entities to write off inventory that has been damaged. When the loss occurs as a result of theft, fire and floods among others, individuals are expected to claim the same for tax deduction purposes. To determine the level of inventory, individuals are expected to adopt methods of write off that are allowed by the IRC section 47. 

When it comes to the writing off inventories when they are damaged or go obsolete, the accepted accounting principles provide bases on how to do it. Accounting entities focus on selling inventories at a gain from the purchase price. This gain may not be realized unless such inventory is sold and in the right condition. The extent to which accounting entities discloses losses from the inventory write-offs is dependent on the level of such inventory as compared to the net income. The organization may establish a contra account where such account is debited with the amount of write-off and the inventory account credit. The write-off involves the crediting of inventories charged against the cost of sales. Accounting entities are not expected to split a write off across time as this would indicate that there are expected future gains from the same. Consequently, in this particular study, the client was not supposed to write off inventory the way he did it but rather, should have written it off once (IRS, 2017). 

When obsolete products are written off, it is important to adjust the resulting volume of inventory. The two main alternative methods that should be employed in the recognition of inventory write-off is as indicated in the diagram below 

Method 1 

Method 2 

In write-off of inventories, companies may use the perpetual inventory system in the write-off. Under this method, they are expected to track sales and purchases as well as inventory transfers to identify the right level of inventory. The amount of damaged inventory ends up reducing the overall cost of closing inventory held by the accounting entity. Through periodic assessments of inventory, the entities are in a position to identify scrap as well as damaged inventory. 

The Internal Revenue Service (IRS) provides guidelines on how inventory write-offs should be recognized by accounting entities for tax purposes in IRC section 47. Organizations are expected to factor in the cost of inventory in Schedule C, where the cost of damaged inventory is factored in the overall cost of goods sold. It is thus not deducted directly as an inventory loss from the income statement but rather used to adjust the cost of goods sold. By increasing the amount of cost of goods sold, the gross income reduces. This equally translates to a decline in the level of tax obligation and hence the seller is exempted from paying tax on inventories that were damaged and hence not sold. In this particular case, the seller did not utilise this method in recognition of inventory. Rather, he employed other inventory management methods. The client treated the write off as a loss, and hence such a loss would be deducted from the net income to arrive at the level of comprehensive income. The right procedure was thus not followed by the client in the treatment of such inventory. A more objective approach ought to have been taken in the process ((IAS, 2017). 

In some of the noted cases, the market value of the inventory may differ from the book value of such items. For instance, the inventories may lose value resulting to a scenario where the book value is higher than the book value of such assets in such a scenario when the seller opts to value the inventory the value will decline. Nevertheless, not only will the value of obsolete inventory be rated low, but also the closing stock something that will end up reducing the level of taxable income. The right accounting procedures should thus be adopted in the process of valuing inventories if the accounting entity is to arrive at the right profit. ASC 330 requires that inventories be recognised in an accurate manner and all changes in valuation reflected in the financial statements. This approach has the potential of significantly enhancing compliance of accounting reporting with the accepted accounting principles. IAS 2 equally provides guidelines on the recognition of inventories in financial statements. It provides guidelines on the cost of inventories as well as in recognition of expenses including write-downs to the net realizable value. They are also used in the assessment of cost formulas that are used in the assigning of costs. Under IAS, inventories refer to the assets that are held for sale by organizations in the course of doing their business. It also refers to the materials that are purchased for use in the production process. IAS is nevertheless unique in recognition of inventories. It excludes biological assets. It also does not allow recognize the work in progress relating to the construction work. The recognized costs of inventory under this criterion includes the cost of purchasing materials, costs of conversion as well as other costs incurred in the bringing of the inventories to their present location. In such scenarios, the inventory costs should not include storage costs, abnormal waste, selling costs and the interest costs when inventory is purchased, or payment has been deferred. The accounting standard provides for the disclosure of all the information relating to such costs while at the same time, ensuring that the right inventory valuation has been adopted (IAS, 2017). 

In accounting for inventory, standard costs and retail method may be employed in a scenario in the approximation of costs assuming that the costs are approximate the actual costs. For items in the inventory that are not interchangeable, the specific costs of items are associated with the specific costs of such items. For items that are interchangeable, the FIFO method is employed in the assessment of the value of the inventory. Nevertheless, in an accounting entity, it is expected that in a given reporting period a similar method will be employed in the process. It is worth noting that IAS 18 is only employed in the recognition of closing balance of inventory after all the inventory sold has been deducted. For instance, in the above case, in writing of the inventory, the obsolete products should be physically identified, ensuring that sold goods are not double counted as inventory (IRS, 2017). At the same time, it is important to ensure that the reported is recognized in fair value. Under the fair value method to recognition of sales, the organization recognizes the value of the inventory at the current market prices. This is unlike in historical costing where the value of the inventory is based on the price at which they were bought. This implies that such historical costs does not represent current changes in prices in the market (Bragg, 2013). 

Conclusions 

From the first issue, it is evident that inventory write-down is allowed for tax purposes. The implication is that the tax that was computed using the 34% rate is the right one and hence the client is not liable for extra liability. There was no misstatement of the financial liability on the part of the client. 

While the write-off of the amounts is allowed, the write-off method employed in the case was not the right one. For instance, the client is not allowed under schedule C to allocate the inventory for two periods. Rather the amount of loss from obsoleteness should have been allocated only once 

In regards to the accounting treatment, a write-off is supposed to be adjusted on the cost of goods sold. The client should thus not have treated it separately into the write off account but should rather have debited the cost of goods sold and credited inventory. This would have ensured that the right accounting approach according to Generally Accepted Principle has been followed. The Accounting Standard codification 330 provides guidance on ways through which accounting entities should recognize inventories in their financial statements. From the analyses, it is evident that such accounting entity deviated from the provisions of this codification in recognition of inventories. 

References 

Bragg, S. M. (2013). Accounting for inventory . Centennial, CO: Accounting Tools. IAS (2017). Inventories. Retrieved from https://www.iasplus.com/en/standards/ias/ias2 

IRS (2017). Inventories. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/inventory-manufacturing-tax-tips 

IRS (2017). Form 3115, application for change in accounting method. https://www.irs.gov/uac/about-form-3115