What if due diligence shows the inventory is actually obsolete?

Obsolete stock is a diligence finding that touches the numbers directly: the inventory on the balance sheet may be worth less than it shows, and the earnings may be overstated if the write-down was never taken. BDC’s diligence article lists sluggish inventory turnover or any obsolescence among the things you and your accountant should look for, and inventory aging among the records to request.

Confirm what you found

Ask for the inventory aging report and the inventory list, which BDC lists among the documents to examine, and compare them to a physical count. Ask whether the items can still be sold in the ordinary way, and at what price. If the stock is specialized, consider an independent appraiser. Check your findings with the seller, who may explain the stock or already have a plan for it.

How the tax rules value inventory

Subsection 10(1) of the Income Tax Act says that, for a business that is not an adventure or concern in the nature of trade, property in an inventory is valued at year end at cost or fair market value, whichever is lower, or in a prescribed manner. The CRA’s guidance for sole proprietorships and partnerships says you can value individual items at cost or FMV, whichever is less, or value all inventory at FMV, and that you should use the same method as in past years. It measures FMV by either the replacement price or the amount you would get if you sold the item. So ask your accountant whether the seller’s statements applied that rule to the items you found.

What to raise before closing

Several responses are possible, and the right one depends on the amounts and on your lawyer’s advice. You can ask the seller to correct the statements and rerun the earnings, to exclude the items from the purchase, to adjust the price after a joint count, or to give an indemnity covering the stock. BDC suggests an indemnity agreement from the seller for unforeseen liability for a period after the sale. Whatever you agree, put it in the purchase agreement in writing. See what to do if you find a problem during due diligence.