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Excess and Obsolete Inventory: Calculating the E&O Reserve
Last updated: October 9, 2026 · Independent guide · We do not sell rankings or coverage.
Excess and obsolete inventory is stock you hold beyond what you can use or sell in a reasonable period (excess), or stock you can no longer sell at a normal price at all (obsolete). Under US GAAP you record an E&O reserve that brings its carrying amount down to net realizable value, using item-level data on usage, demand, shelf life and engineering status. For tax purposes the reserve is generally not deductible until the goods are scrapped, sold or offered at a reduced price.
The E&O reserve formula and journal entries
Required reserve per item = (excess or obsolete units) × (unit cost − expected recovery per unit)
Excess units = on-hand units − units needed to cover demand over your policy horizon (for example, 12 months)
Period entry = total required reserve − existing allowance balance
| Account | Debit | Credit | Note |
|---|---|---|---|
| Cost of goods sold (or inventory obsolescence expense) | Increase in reserve | Records the loss in the period you identify it | |
| Allowance for excess and obsolete inventory (contra-asset) | Increase in reserve | Reduces inventory on the balance sheet | |
| Allowance for excess and obsolete inventory | Reserve on the units disposed | Write-off when the units are scrapped or sold | |
| Cash or scrap receivable | Proceeds, if any | Scrap or liquidation value received | |
| Inventory | Original cost of the units | Removes the units from the perpetual record |
How to identify excess and obsolete stock
A written policy turns item data into reserve categories so the estimate is repeatable each quarter. Four tests cover most manufacturers and distributors.
- Usage versus on-hand. Compare on-hand quantity with trailing 12-month sales or production issues. No movement in 12 months makes an item an obsolete candidate.
- Demand coverage. Divide on-hand quantity by forecast demand to get months of coverage. Units beyond your policy horizon are excess, and non-cancelable open purchase orders add to them.
- Shelf life. Units that will expire before you can consume them at the forecast rate are obsolete, whatever their coverage.
- Engineering and product status. Superseded components and discontinued products usually move straight to obsolete.
A steady cycle counting program gives you the on-hand accuracy the calculation depends on.
Worked example: a quarter-end E&O reserve
Illustration only. The company, items and figures are constructed for this example. A distributor reserves units beyond 12 months of forecast demand down to liquidation value, and obsolete or expiring units down to scrap value. The allowance account holds $14,000 before the review.
| Item | Facts | Test applied | Required reserve |
|---|---|---|---|
| A: bearing kit | 1,000 on hand at $12; 12-month forecast 400; liquidation value $3 | Excess 600 units × ($12 − $3) | $5,400 |
| B: control board | 150 on hand at $80; superseded by an engineering change; scrap value $5 | Obsolete 150 units × ($80 − $5) | $11,250 |
| C: adhesive | 900 on hand at $6; usage 100 per month; 5 months of shelf life left; no scrap value | 900 − 500 usable = 400 units × $6 | $2,400 |
| D: fastener | 2,000 on hand at $4; 12-month forecast 9,000 | Coverage under 3 months | $0 |
| Total | $19,050 |
Step 1: book the adjustment. The required reserve is $19,050 against $14,000 held, so debit cost of goods sold $5,050 and credit the allowance $5,050.
Step 2: write off item B. Next month a recycler pays $750 for the 150 boards. Debit the allowance $11,250, debit cash $750 and credit inventory $12,000. Profit is unaffected because the loss was already recognized.
Step 3: handle a recovery. If a customer later orders 600 bearing kits at full price, you do not reverse the $5,400 because the forecast improved. Each reserved unit ships at its reduced carrying amount, as SAB Topic 5BB expects.
Reserve versus write-off
A reserve recognizes the loss while the units are still on the shelf, once evidence shows net realizable value is below cost. A write-off removes the units when they leave through scrap, donation or liquidation. GAAP requires the loss in the period it occurs, so waiting for disposal puts the expense in the wrong period, while the tax deduction usually follows the write-off.
The rules behind the calculation
ASC 330-10-35: lower of cost and net realizable value
ASC 330-10-35-1B, as amended by ASU 2015-11, requires inventory measured using any method other than LIFO or the retail inventory method to be measured “at the lower of cost and net realizable value,” and states that when net realizable value is lower than cost, the difference “shall be recognized as a loss in earnings in the period in which it occurs” (ASU 2015-11 full text on PwC Viewpoint, July 2015). The FASB glossary defines net realizable value as “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.” LIFO and retail-method inventories stay on lower of cost or market (The CPA Journal, June 26, 2018).
SEC SAB Topic 5BB: the write-down is a new cost basis
In Staff Accounting Bulletin Topic 5BB, the SEC staff states that a write-down of inventory to the lower of cost or market at the close of a fiscal period “creates a new cost basis that subsequently cannot be marked up based on changes in underlying facts and circumstances” (SEC, SAB Codification Topic 5, no date shown). It cites ASC 330-10-35-14, which treats the written-down amount as cost for later periods. An E&O reserve therefore behaves as an item-level cost reduction, relieved only on sale or scrap.
Tax: Thor Power Tool and Treasury Regulation 1.471-2
The tax rules are stricter. Treasury Regulation 1.471-2(f)(1) lists “deducting from the inventory a reserve for price changes, or an estimated depreciation in the value thereof” as a practice that is not in accord with the regulations (eCFR, up to date as of October 6, 2026). Section 1.471-2(c) lets you value goods unsalable at normal prices because of damage, imperfections, shop wear, changes of style, odd or broken lots or similar causes at bona fide selling prices less direct cost of disposition, and raw materials or partly finished goods on a reasonable basis but never below scrap value. A bona fide selling price means an actual offering of the goods during a period ending not later than 30 days after the inventory date. IRS Publication 538 (revised January 2022) restates the rule for goods that cannot be sold at normal prices.
In Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (decided January 16, 1979), Thor wrote excess spare parts down to roughly scrap value while still selling them at original prices. The Supreme Court upheld the IRS disallowance for lack of objective evidence and held that “any presumptive equivalency between tax and financial accounting would be unacceptable” (Cornell Law School LII). Your book reserve is therefore a book-tax difference until the goods are scrapped, sold or offered within the 30-day window.
Common mistakes
- Using a flat percentage of total inventory. A historical charge-off rate, a method AccountingTools describes, cannot be relieved item by item when units ship.
- Reversing the reserve when the forecast improves. SAB Topic 5BB does not allow it.
- Ignoring non-cancelable purchase orders for items already in excess.
- Deducting the reserve on the tax return, contrary to Regulation 1.471-2(f)(1).
- Reserving at standard cost that no longer reflects actual cost. See standard cost vs actual cost.
How to report it
Present inventory net of the allowance and charge the expense to cost of goods sold or an obsolescence line. Keep a quarterly roll-forward of the allowance (opening balance, additions, write-offs, closing balance) and a multi-year schedule of the reserve as a percentage of inventory for your auditors.
For tax, add back the increase in the book reserve and deduct actual write-offs. Thomson Reuters documents a Checkpoint workpaper that splits allowance activity into the deductible portion and the book-tax adjustment (Thomson Reuters, no date shown).
How ERP and accounting systems feed the calculation
ERPs supply the inputs (on-hand, usage, aging, valuation) but leave the reserve policy and journal entry to you.
Microsoft Dynamics 365 Business Central. The Item Age Composition – Value report (5808) shows the age of stock by value “to identify unused or slow moving inventory,” and the Inventory Valuation report reconciles the inventory subledger to the general ledger; US companies use the localized version, report 10139 (Microsoft Learn, April 30, 2026).
SAP S/4HANA. The Slow or Non-Moving Materials app isolates materials with little or no consumption over a set period (SAP Learning, no date shown).
Oracle NetSuite. The Inventory Valuation Detail report lists the transactions that affect inventory value (Oracle NetSuite Help, no date shown). For usage versus on-hand by item, plan on a saved search.
Acumatica. Acumatica partner SWK Technologies documents Dead Stock and Inventory Turnover inquiries filtered by item class, warehouse and days in stock (SWK Technologies, May 6, 2024). Preventing excess is a planning task covered in our guide to inventory replenishment software.
How we researched this
We read ASU 2015-11, SAB Topic 5BB, Treasury Regulation 1.471-2, IRS Publication 538 and the Thor Power Tool opinion, then checked ERP documentation from Microsoft, SAP, Oracle and an Acumatica partner. Sources were checked on October 9, 2026. The worked example uses constructed figures.
Related guides
- Inventory Aging Report: Template, Buckets and E&O Reserve
- ABC Analysis in Inventory: Classify Items and Use Results
- Adjusting Journal Entries: 5 Types, Examples, Automation
Frequently asked questions
What is the difference between excess and obsolete inventory?
Excess inventory still has demand, but more units than you can use within your policy horizon. Obsolete inventory has no demand at a normal price because it is superseded, expired, damaged or discontinued.
Can you reverse an inventory reserve if the stock sells later?
Not when demand improves. SAB Topic 5BB treats a write-down as a new cost basis that cannot be marked back up. The reserve is relieved when the units sell or are scrapped.
Is an obsolete inventory reserve tax deductible?
Generally no. Treasury Regulation 1.471-2(f)(1) disallows it, and the Supreme Court upheld that position in Thor Power Tool. You deduct the loss on scrap or sale, or when you offer subnormal goods at a reduced price within 30 days of the inventory date.
How often should you calculate the E&O reserve?
Every reporting period, usually quarterly. ASC 330-10-35-1B requires the loss in the period it occurs, so an annual-only review risks misplacing the expense.
Sources
- FASB, ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory, full text on PwC Viewpoint (PwC is an audit and advisory firm), July 2015. viewpoint.pwc.com
- Howard B. Levy and Anthony Sarmiento, “Net Realizable Value Is the New Market,” The CPA Journal, June 26, 2018. cpajournal.com
- SEC, Staff Accounting Bulletin Codification, Topic 5BB, Inventory Valuation Allowances, no date shown. sec.gov
- Treasury Regulation 26 CFR 1.471-2, Valuation of inventories, eCFR, up to date as of October 6, 2026. ecfr.gov
- IRS, Publication 538, Accounting Periods and Methods, revised January 2022. irs.gov
- Thor Power Tool Co. v. Commissioner, 439 U.S. 522, decided January 16, 1979, Cornell Law School Legal Information Institute. law.cornell.edu
- AccountingTools, The Reserve for Obsolete Inventory (#225), no date shown. accountingtools.com
- Thomson Reuters (sells Checkpoint tax software), Analysis of Inventory Reserves, no date shown. thomsonreuters.com
- Microsoft, Inventory and warehouse reports in Business Central, April 30, 2026. learn.microsoft.com
- SAP Learning, Using overview apps in physical inventory (SAP S/4HANA Cloud Private Edition), no date shown. learning.sap.com
- Oracle NetSuite Help, Inventory Valuation Detail Report, no date shown. docs.oracle.com
- SWK Technologies (Acumatica partner), How to run inventory turnover and dead stock queries in Acumatica, last modified May 6, 2024. swktech.com
Sherman Hsieh
Independent analysis of enterprise software — ERP, CRM and more
