Problem - The Effect of Inventory Misstatements

In its recent action against Microsoft, the Securities and Exchange Commission (SEC) charged that the software company had understated its income for certain periods between 1994 and 1998. According to the SEC, overstated reserves for obsolete inventory were one of the primary causes of these understatements. The action was settled on June 3, 2002, after Microsoft, without admitting or denying the charges, agreed to the SEC's order that it "cease and desist from committing accounting violations and other violations of federal securities laws"

Inventory misstatements are common, and they can have a significant impact on financial statements. For merchandising and manufacturing firms, inventory is typically the largest current asset. On the income statement of these firms, revenue from the sale of inventory is usually the largest number, and the cost of goods sold, which arises from the sale of inventory, is usually the single largest expense. Inventory misstatements on the balance sheet lead to understated or overstated income on the income statement.

Properly valuing and recognizing inventory as an asset when it is purchased or produced and as an expense when it is sold is critical to creating financial statements that fairly represent a company's financial position and operating results. However, even after inventory is recognized as an asset, adjustments may have to be made. Recall from Chapter 6 of the text that companies must apply the lower-of-cost-or-market (LCM) rule to unsold inventory at the end of an accounting period and recognize market declines if necessary.

Microsoft appears to have overestimated obsolete inventory and decreases in market value and overstated the related inventory reserves, thereby understating income. In many other cases involving misstatements of inventory valuation, income has been overstated. For example, Gerber Scientific reportedly overstated income by not writing down inventory as required, 2 and Atlantic and Pacific (A&P), the large grocery store chain, recently restated its financial statements partially because of overstatements of inventory.3

Inventory misstatements can occur in a number of ways. The need to exercise judgment in valuing and recognizing inventory and to choose among cost flow assumptions creates opportunities for misstatements. While many inventory misstatements are unintentional, many others are not. The latter have figured in a number of revenue fraud cases.

Special care must be taken to safeguard inventory through internal controls, and diligence must be exercised in measuring and recording inventory values. Accountants and auditors have to be sensitive to the possibility of misstatements and strive to avoid or detect them.

Notes

1. Securities and Exchange Commission, "SEC Settles Accounting Charges Against Microsoft," Press Release No. 2002-80, June 3, 2002, Rebecca Buckman, "Microsoft, SEC Settle Probe into Earnings Misstatements," The Wall Street Journal, June 4, 2002.

2. PR Newswire, "Gerber Scientific, Inc. Securities Purchasers Represented by Schatz & Nobel in Class Action Lawsuit." May 9, 2002. 3. Dow Jones Business News, "A&P Restates Results for Past 3 Years amid Accounting Adjustment," July 5, 2002.

Questions

1. What may motivate a company to overstate inventory write-downs? How does overestimating reserves for inventory obsolescence affect the net book value of inventory?

2. Errors in recognizing inventory purchases in the correct year typically reverse in two years. Suppose a company defers recognition of a purchase. How would this affect financial statements in the year of error? What may motivate a company to defer recognition of inventory purchases?

3. Under what circumstances is inventory written down consistent with the LCM rule?

4. Why is it important to record inventory at lower of cost or market? What accounting convention is most applicable to the LCM rule?

5. Errors in applying the LCM rule are one possible cause of inventory misstatements. What are some others? Why are intentional misstatements common?