Obsolete Inventory in M&A: Who Bears the Risk at Closing?
Obsolete inventory can reduce Seller proceeds even when the Buyer legally acquires every item at Closing. If the Acquisition Agreement includes inventory in Working Capital and permits an obsolescence reserve to reduce Closing Working Capital, inventory that cannot be sold at its recorded amount can reduce the purchase price dollar for dollar.
Assume the Company reports $260,000 of inventory, including $60,000 of lettuce that will expire within several days. If the lettuce can generate only $5,000 of net proceeds after discounts, freight, and disposal costs, the inventory balance overstates recoverable value by $55,000. If the purchase price changes dollar for dollar with Closing Working Capital, a properly calculated $55,000 reserve can reduce Seller proceeds by $55,000.
The central transaction question is therefore not whether obsolete inventory remains with the Company after Closing. The Acquisition Agreement must determine what inventory counts toward Working Capital, how any reserve is calculated, which accounting rules control, when inventory is measured, and whether the Buyer may recover the same inventory shortfall again through indemnification.
Why Is Obsolete Inventory Usually an Overvalued Asset Rather Than a Liability?
Obsolete inventory is inventory whose recorded amount exceeds the amount the Company can recover through an ordinary sale because of age, deterioration, expiration, reduced demand, excess quantities, discontinued products, or similar conditions. Obsolete inventory generally reduces the value of an asset already included in Working Capital. A separate liability may arise if the Company also must pay storage, transportation, destruction, or disposal costs, and the Acquisition Agreement should prevent the inventory write-down and a separate disposal obligation from capturing the same economic exposure twice.
Does GAAP Determine Inventory Value at Closing?
Historical cost does not establish the amount that should count toward Closing Working Capital. For inventory measured using FIFO or average cost, FASB Accounting Standards Codification Topic 330 generally requires measurement at the lower of cost and net realizable value. Net realizable value is the estimated ordinary-course selling price less reasonably predictable completion, disposal, and transportation costs. Inventory measured using LIFO or the retail inventory method remains subject to the separate lower-of-cost-or-market model.
GAAP does not independently determine the purchase price. GAAP affects the transaction only to the extent the Acquisition Agreement incorporates GAAP into the Working Capital calculation, and the parties may adopt transaction-specific aging rules, reserve formulas, exclusions, historical-practice requirements, or an illustrative Closing calculation.
The Acquisition Agreement should therefore establish an accounting hierarchy. If the express inventory rules, an illustrative calculation, historical accounting practices, and GAAP could produce different reserve amounts, the Acquisition Agreement should state which source controls. In Northern Data AG v. Riot Platforms, Inc., the Delaware Court of Chancery enforced the accounting hierarchy selected in the purchase agreement, requiring GAAP compliance while using the illustrative closing statement to narrow choices when GAAP permitted more than one acceptable treatment. For obsolete inventory, the Acquisition Agreement should likewise determine before Closing whether transaction-specific reserve rules, historical practices, an illustrative calculation, or GAAP controls the inventory reserve.
Does an Asset Sale or Equity Sale Determine Who Bears the Risk?
No. Transaction structure determines what property transfers, but the Acquisition Agreement determines how obsolete inventory affects the economics between Buyer and Seller.
In an equity sale, the Buyer acquires the entity that owns the inventory, so obsolete inventory ordinarily remains inside the acquired Company. The Seller may nevertheless bear the economic cost if the inventory reserve reduces Closing Working Capital or if an inaccurate inventory representation creates a separate contractual claim.
In an asset sale, the Acquisition Agreement may transfer all inventory, only saleable inventory, or specified categories at negotiated values, while excluded inventory remains with the Seller. The Acquisition Agreement should also allocate storage, removal, and disposal responsibility for inventory the Buyer does not acquire.
The federal tax allocation for an applicable asset acquisition is a different calculation. Section 1060 and Form 8594 allocate consideration among transferred asset classes for federal tax purposes, and inventory generally falls within Class IV. The Section 1060 allocation does not determine the contractual amount credited for inventory in Working Capital or who bears an obsolescence reserve under the Acquisition Agreement.
How Can the Inventory Reserve Change Seller Proceeds?
Assume a furniture manufacturer carries $400,000 of discontinued finished goods at cost. Recent sales indicate the goods can be sold for $180,000, and the Company expects $30,000 of commissions, freight, and liquidation costs. Net realizable value is therefore $150,000, producing a potential $250,000 inventory write-down.
If the Company recorded no reserve and the Acquisition Agreement includes inventory in Working Capital, a $250,000 Closing reserve can reduce Seller proceeds by $250,000 when the Working Capital adjustment operates dollar for dollar.
The result changes if the Working Capital target already reflects a normalized obsolescence reserve. Assume the target was established using a historical reserve of $100,000 and the Closing reserve is $250,000. All else equal, the reserve change reduces Closing Working Capital by an additional $150,000 relative to the target, not $250,000. The Seller may properly bear the additional $150,000 if pre-Closing deterioration caused the decline. The Buyer should not obtain the same $150,000 reduction merely because the Buyer adopts a more conservative reserve policy after Closing or decides after Closing to discontinue a product line that the Company had continued to sell.
Because inventory reserves require judgment, the Acquisition Agreement should identify the reserve methodology and restrict post-Closing changes inconsistent with the agreed methodology.
What Should the Acquisition Agreement Say About Obsolete Inventory?
The inventory provisions, Working Capital formula, accounting hierarchy, and remedies should be drafted together.
- Define included and excluded inventory. Address expired or near-expiration goods, damaged goods, discontinued products, customer returns, excess quantities, goods beyond a stated aging period, and inventory that cannot be sold in the ordinary course without unusual discounts.
- Establish the reserve methodology. The Acquisition Agreement may use SKU-level aging, expiration dates, trailing sales, forecast demand, historical markdowns, identified disposal costs, or another transaction-specific formula. The methodology should apply consistently when establishing the Working Capital target and calculating Closing Working Capital.
- Specify the measurement date and count procedures. Address goods in transit, consigned goods, returns, damaged goods, cutoff rules for receipts and shipments, and any physical inventory count or observation rights.
- Provide information rights. The Seller should receive the inventory detail reasonably necessary to test the Closing calculation, including SKU reports, aging schedules, sales history, reserve workpapers, and disposal records relevant to disputed items.
- Prevent duplicate recovery. If a $250,000 inventory reserve already reduces Closing Working Capital, the Buyer should not recover the same $250,000 again under an inventory representation or indemnification claim. A separate indemnification claim may remain appropriate for a different loss, such as concealed spoilage, falsified inventory records, or disposal costs not captured in Working Capital.
How Should Inventory Disputes Be Resolved?
The Acquisition Agreement should distinguish a technical reserve calculation from a contractual breach. An independent accountant may determine whether the agreed aging formula, net realizable value methodology, or reserve calculation was applied correctly. A court or arbitrator should generally decide whether the Buyer changed the agreed methodology, whether inventory was intentionally concealed or misrepresented, or whether the Buyer is seeking duplicate recovery through both Working Capital and indemnification.
The Acquisition Agreement should also identify which party must support a proposed reserve adjustment, what records must be produced, whether the accounting expert is limited to the parties’ submitted positions, and when the final Working Capital payment becomes due.
Conclusion
Obsolete inventory can reduce Seller proceeds because the Acquisition Agreement determines how much inventory value counts toward Closing Working Capital. The Buyer should not pay full Working Capital value for inventory that cannot generate the expected cash, while the Seller should not lose purchase price because the Buyer changes reserve methodology or operating strategy after Closing.
The Acquisition Agreement should define which inventory counts, establish the reserve methodology and accounting hierarchy, apply the same methodology to the Working Capital target and Closing calculation, provide access to supporting records, and prohibit duplicate recovery. A completed inventory example in the Acquisition Agreement can show exactly how an obsolescence reserve changes Seller proceeds before the parties reach Closing.
By Joseph R. Luna
Primary Authorities
FASB Accounting Standards Codification Topic 330, Inventory.
FASB Accounting Standards Update No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory.
26 U.S.C. § 1060.
Treas. Reg. § 1.1060-1.
Internal Revenue Service, Form 8594 and Instructions for Applicable Asset Acquisitions.
Northern Data AG v. Riot Platforms, Inc., C.A. No. 2023-0650-LWW (Del. Ch. June 2, 2025).