Year-end Considerations for Wholesalers and Manufacturers

There are many reasons to keep a handle on your inventory every day of the year. The primary reason, of course, is to maintain adequate inventory levels in order to provide great customer service – that is why you are in business. What special considerations should your company be making now that year end is rapidly approaching? There are many financial and tax reasons for taking a closer look at your company's inventory to determine what can be done to improve the financial picture of the company at year end. Below is a discussion of inventory related as well as other financial statement and tax considerations for year-end planning.

Inventory Physical Counts
The obvious thing that probably comes to mind is the year-end physical inventory count. But, if your company has a cycle counting system in place that is being done throughout the year and it is working, there is no need to do a full physical inventory count at year end – regardless of the level of financial statement reporting desired. Cycle counting is a method of counting a company's entire inventory throughout the year based on predetermined criteria. Typically, a set number of inventory items are counted on a daily basis – before the warehouse opens­ – by warehouse personnel. Companies that employ a method of cycle counting typically have an accuracy level of greater than 95%. Full year-end physical inventories are often cumbersome and end up taking a large amount of time.

Inventory Cut-off
Be aware of recording sales and purchases in the correct period. For sales that occur just before year end, the inventory should be shipped out of the warehouse and the sale recorded. For purchases, items that are received into the warehouse subsequent to year end should ordinarily be excluded from inventory. If the purchase terms of the inventory were FOB Shipping Point, then title will have transferred to the purchaser upon the supplier delivering the goods to the common carrier. Therefore, it should be included in the inventory balance at year end.


Inventory Valuation
This is the never-ending question from financial statement users – “How much is that inventory really worth?” This question is a very valid one as your company's inventory probably is a key factor in how much money your company can borrow from the bank. Inventory should be valued at the lower of cost or market. Now is the time, if you haven't looked at it for a while, to look at certain items or entire inventory lines and determine if they are valued correctly. Ask how much that item or group of items could be bought for in the open market. Is it cheaper than what you have it for on your books? Then it is time to write that inventory down. Additionally, look at items that potentially have no value at all. Those are the items that haven't moved in the warehouse for as long as you can remember and have about an inch of dust on top of them. If these types of items have any value on the company's books, they definitely need to be reevaluated and probably written off. Writing down inventory may be needed to more accurately portray the company's financial position. Additionally, the company will benefit from a tax deduction for the write-down. Generally, tax law allows for a write-down of inventory to what the goods could sell for on the open market.

Cash
Plan transactions at the close of the year that will ensure a positive cash balance.


Accounts Receivable
Receivables should be reviewed carefully to determine if collection is reasonable. Financial statement users typically discount balances with an aging in excess of 60 or 90 days. Consider accelerating collections of such receivables at the close of the year.


Capitalization Policy
Review expense accounts such as “Office Supplies” or “Repairs and Maintenance” for items that should more appropriately be capitalized. A capitalization policy is helpful to assist with the determination of what is expensed and what is capitalized as fixed assets.


Debt
Be sure to purchase long-term assets with long-term liabilities. If your company uses debt to fund the purchase of inventory, that debt should be in the form of a line of credit. This line of credit should be limited to funding daily operations, like the purchase of inventory, and not for the purchase of any long-term assets. A company's financial ratios could significantly be affected if this matching doesn't occur.


Guarantees and Other Agreements
Review guarantees and buy-sell agreements to ensure they do not have to be recorded under any new Financial Accounting Standards Board rules.


State Operations
If your company has operations in multiple states, now is the time to be looking at your inventory levels in each state. When filing a non-resident return for most states, income is apportioned based on a three-factor formula which includes: revenues, payroll and property. Property includes a few different things like rent expense, fixed assets, and inventory kept in that state. Determine where inventory is going to be at year end to help reduce your income tax liability by moving that inventory to a state that doesn't have income taxes.

Additionally, if company operations have ceased in a particular state, review the steps necessary to terminate state filing and reporting requirements.

Section 179 and Bonus Depreciation
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, the IRC Section 179 deduction has increased from $25,000 to $100,000 of tangible personal property. Limitations still exist for the annual expensing amount allowed based on the qualifying amount of property placed in service during the year. But, this limitation has increased from $200,000 to $400,000. Additionally, software now qualifies for the Section 179 deduction. These increased deduction provisions are for tax years beginning after 2002 and before 2006.

In addition to these deductions related to Section 179 expensing, there has been an increase and extension to the 30% bonus first-year depreciation. You first heard about 30% bonus depreciation with the Job Creation and Worker Assistance Act of 2002 which allowed for an additional deduction of depreciation the first year a qualified asset was placed in service of 30% as long as the property was acquired after September 10, 2001 and before September 11, 2004 and it had to be placed in service before 2005. You are able to take this bonus depreciation on most new tangible personal property and qualifying land improvements. With the new Act in 2003, this bonus depreciation is now 50% of the qualified assets placed in service after May 5, 2003 and before 2005. If you are not as concerned with deductions in the current year, taxpayers can elect on a class-by-class basis to claim the 30% rather than the 50% or can also elect not to claim the first-year bonus depreciation at all.

If you are contemplating placing an asset in service after the first of the year, consider moving that time frame up to before the end of this year. The financial statement impact will be small as the income statement will only reflect about one month of depreciation. The benefit is the potential for a large tax deduction on qualifying property for placing the assets in service in this current year.

IRC 263A
Internal Revenue Code Section 263A requires that certain overhead costs that are related to inventory be capitalized into inventory. This section of the IRC applies to all manufacturers and those resellers with average annual gross receipts for the last three years in excess of $10 million. If you are subject to this provision of the IRC, look at ways to reduce the impact of the 263A adjustment by reducing the amount of inventory the company is carrying at the end of the year. If you are a reseller who hasn't yet been required to do a 263A calculation because your sales are below the minimum level, look at where your sales are going to end up at year end. If company sales this year averaged with the sales for the last two years are going to be in excess of $10 million, decide if it is possible to defer sales into 2004 to keep the company under the $10 million threshold.

Related Party Accruals
Look at items that are due to a related party at year end. Most commonly these items are wages, interest expense and rent. There is generally no tax deduction for items until they are paid, but these amounts are expensed on the company's financial statement.

Donated Inventory
A C Corporation can donate inventory to a qualified organization under Internal Revenue Code Section 501(c)(3) and receive a deduction of two times the basis in the inventory. This deduction is limited to 10% of the C Corporation's taxable income for the year. To the extent contributions exceed this 10% limit, the excess can be carried forward and deducted for five years.

The Overall Picture

When evaluating all of these year-end planning items, you must consider your bank borrowing and other credit agreements. There could be restrictive covenants in your borrowing agreements that could be adversely affected by focusing on only one or two of the planning opportunities listed. You must be in tune to all of the users of your financial statements in order to achieve the balance of having a strong equity position, maintaining working capital, meeting banking covenants and maximizing profits while minimizing taxable income.

Jennifer Raybon , CPA
Inventory Group Leader