Inventory Losses and Write-Downs

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Posted by Bob on April 27, 19100 at 04:07:33:

Graham and Dodd's Security Analysis, The Classic 1934 Edition, 1996 reprint, McGraw-Hill, Chapter XXXII Extraordinary Losses and Other Special Items in the Income Account, pp. 364-371, discusses nonrecurrent losses. The key distinction here is between normal and abnormal, ordinary and extraordinary, recurring and nonrecurring business conditions.

The primary issue is the quality of earnings or managed earnings. So-called manufactured earnings include a "whole set of practices which constitute perhaps the most vicious type of accounting manipulation."

The mark-to-market-value principle is conservative when used judiciously. Generally accepted accounting principles (GAAP) include various write-offs of assets to the income account. The D,D and A account for depreciation, depletion and amortization is the most common. Also, there may be different reserves for expected losses, such as Allowance for Doubtful Accounts as a contra account offsetting accounts receivable, or Reserve for Leasehold Impairment as a contra account offsetting leases in mineral exploration. GAAP also allow for direct write-offs to the capital surplus account under extraordinary conditions of loss. The question is, Which of the two treatments of accounting for inventory loss in a particular circumstance would be the better guide to future results?

For example, if a company routinely loses fresh inventory due to a short shelf-life or time-sensitive material, it makes sense to charge-off the expected amount of recurring loss each year to the income account. But if that same company has one warehouse only for finished goods inventory, and it is destroyed by force majeure, say an earthquake or a 100-year flood, then it makes sense to write-off the nonrecurring loss directly to the capital surplus account.

Investors might be misled if such an extraordinary loss was charged to the income account as would be done in ordinary conditions. Earthquakes and 100-year floods are not predictable annual company events, but inventory spoilage can be a highly predictable continuing loss.

The method of accounting for inventory losses and similar write-downs is an indication of how conservative or aggressive the management is, and whether the company managers are stockholder-oriented.

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