A retailer determines that its entire $40M inventory balance is obsolete and writes it down to $0. The write-down is tax-deductible. The company had pre-tax income of $60M before the write-down. Tax rate 25%. Walk through the three-statement impact of the write-down. Later in the year, the company unexpectedly sells half of these written-off units for $15M cash (net of selling costs). Walk through the income statement impact of that sale.

Initial write-down:

• IS: Inventory write-down increases COGS by $40M. Pre-tax income: $60M - $40M = $20M. Tax expense: $20M × 25% = $5M (down $10M from $15M originally). Net income down $30M ($40M × (1 - 0.25)).
• CF: Net income down $30M; add back non-cash write-down $40M. CFO increases by $10M (the tax shield).
• BS: Inventory -$40M; Cash +$10M (from tax savings); Retained earnings -$30M. Balanced.

Subsequent sale: Half the written-off inventory (book value $0) is sold for $15M. Revenue $15M, COGS $0, so gross profit $15M. Pre-tax income increases by $15M. Tax: $15M × 25% = $3.75M. Net income increases by $11.25M. Cash flow: net income up $11.25M, no non-cash add-back (inventory already written off), so CFO increases by $11.25M (the $15M cash received less $3.75M cash tax).

Follow-up pressure:

• How would the initial write-down flow through the statements if the tax deduction were only allowed when the inventory is physically disposed of (i.e., at sale), not at the write-down date?
• If the company had a valuation allowance and could not recognize a tax benefit on the write-down, how would the cash flow impact differ?
• Does the later sale affect your assessment of whether the original write-down was appropriate? How might an auditor view the reversal?