Question

When the shareholders of Ann Taylor Stores, a national retailer of upscale women's clothing, brought suit against company management, the company was accused of misleading investors by hiding the fact that it had accumulated huge amounts of excessive and overvalued inventory. Although the company reported disappointing results, surprising Wall Street, management denied any wrongdoing. The financial press often reports incidents where management uses inventory accounting to manipulate earnings. Discuss important topics and considerations related to inventory accounting. How does inventory accounting influence the financial statements (be specific). How do these topics individually affect shareholders, creditors, managers, and auditors?

Answer 1

Inventory accounting is basically concerned with valuing and accounting for changes in inventory of a business. Inventory being an asset needs to be valued properly to reflect a true picture of the value of a business’ asset. A manufacturing business may have three kinds of inventories – raw materials, work-in-process and finished goods, while a retailer is most likely to carry inventories of finished goods only.

Valuation of inventory can be done using four methods as described below. Businesses chose inventory accounting method most suitable to them (in terms of fair reporting of their business’ value) at the start and may change to a different method later if need arises. For example, a business with perishable commodities or products with an expiration date should use First In First out (FIFO) method in order to avoid obsolescence, spoilage, etc.

1. Fist In First Out (FIFO method) : This method assumes that inventory procured first is sold out first. So, inventory is valued accordingly and generally, when procurement costs rise over time, this method will higher profits since cost of goods sold will be recorded at a lower rate (earlier procurement rates would be cheaper).
2. Last In First Out (LIFO) : Under this method, latest items are assumed to be sold first. So, cost of goods sold is value at the last purchase prices first.
3. Weighted average accounting method : This method averages the cost of inventory procured during the year. When new inventory is purchased, the cost of new inventory purchased is rolled into the cost of existing inventory to determine a new weighted average cost that is readjusted as more inventory is purchased.
4. Specific identification method : Where the items are high-value and average cost would lead to inaccurate results, items’ individual costs are recorded in inventory. This method requires intensive data recording and maintenance to record value for each and every item.

The type of product a business deals in majorly determines the inventory accounting method it adopts. For the business in question, it being an apparel industry player, FIFO is most suited since clothes lose value over time due to changing fashion trends, so the first procured inventory would lose value fast than later procured inventory, so most firms adopt FIFO method.

Effects of inventory accounting on financial statements:

Inventory is an asset for the business and when it is sold it gets incorporated in the cost of goods sold for determining the profit.

1. Effect on income statement: Cost of goods sold = Beginning inventory + Purchases – Ending inventory, and Profit = Revenue – Cost of Goods Sold. If inventory is understated, Cost of Goods Sold will be lower and this will lead to inflated profits.
2. Effects on balance sheet : Since inventory is an asset till it’s sold, understatement of inventory would result in understatement of business’ assets. Further, there will be lesser working capital since working capital = Current assets – Current liabilities.
3. Cash flows : The method of inventory accounting affects the cash flows in the sense that if a business uses FIFO when prices are rising and inventories are also rising, COGS would be low and net income would be higher. As a result, the company would have to pay higher taxes, which would result in lower cash flow for the firm.

Shareholders, creditors, managers and auditors are the various stakeholders of a business interested in the periodic financials statements of the business. The effects of inventory accounting on each of these stakeholders are as under:

1. Shareholders : Proper inventory accounting is necessary for financial statements to reflect true profits earned by the business and ensure no window dressing happens. Shareholders keenly monitor the firm’s profitability numbers for returns on their investment. As explained earlier, understatement of inventory means inflated profits which may not be real.
2. Creditors : Creditors are lenders of the business. Their interest is in the safety of their money lent. They will always be watchful of the sufficiency of assets of the business at all times to repay their debts. Understatement of inventory will result in lower assets reporting.
3. Managers : Managers are people running the business. It is their moral and legal responsibility to provide fair picture of the business to the external stakeholders. Further, proper inventory accounting is beneficial for themselves too since their future planning is based on historical data.
4. Auditors : The auditor’s job is to find out non-compliances, discrepancies, errors by oversight or intentional window dressing and bring it to notice of relevant stakeholders. They basically keep an eye on the business to avoid any financial loss to the stakeholders. Proper or improper inventory accounting at the firm affects the audit report findings.