Question

1. Explain the various methods employed by companies to manipulate the valuation of inventory. Where appropriate provide relevant examples.

Answer 1

The management of companies might engage in earnings management in order to overstate net income and convey a rosy picture to the users of the financial statements by employing several methods of accounting manipulation.

The most common way to overstate profits would be by overstate ending inventory.

Net Income = Gross Profit - Period Expenses

Gross Profit = Sales - Cost of Goods Sold.

Cost of Goods Sold = Beginning Inventory + Purchases / Cost of Goods Manufactured - Ending Inventory

It is clear therefore, that higher the value of ending inventory, lower the cost of goods sold, higher the gross profit, and higher the net income.

Hence ending inventory plays a crucial role in the income statement and the balance sheet of the company. By inflating ending inventory, not only net income would be higher, balance sheet growth can also be achieved.

Ending inventory valuation can be overstated by the following means:

a. Switch from LIFO cost flow assumption to FIFO cost flow assumption. In a rising market, in times of inflation, this would help to increase the value of inventory.

b. Treating period expenses as inventorial cost. This would help in deferring current period expenses to subsequent periods. For example, warehousing cost for ending inventories, supposed to be treated as period expense, if treated as manufacturing overhead, would increase the cost of goods manufactured and consequently the value of unsold stock.

c. Overstating physical counts of inventory is a very way to overstate the cost of inventory.

d. Another common way to report inventory at higher values would be to delay writedown of inventory. For example, you have 1,000 units of closing inventory, of which 500 are defective, and cannot be sold even at cost. That is, the net realizable value for these 500 units is below their cost of acquisition/ manufacture. This situation would warrant an immediate writedown of the inventory. But, the management deliberately does not recognize/record the loss in the reporting period. So inventory goes to the balance sheet at inflated valuation.