One of the aspects of an analyst is to work as a detective to find out the practices of accounting manipulation to report distort earnings and remove them to get true earnings. As Graham says, majority of the management is honest. But it is a contagious disease to adopt manipulation. Inventory accounting provides a way to present distorted earnings. Companies adopt different techniques to report inventory write-downs. Many a times it is expected the inventory prices to decline in future. It is a part of the business. Though it can be considered an extraordinary event, is it proper to exclude it from operating activity is something management has to decide. Some companies charge such write-down against surplus instead of earnings. In the disastrous year of 1932 majority of companies charged off the write-downs against surplus. But milder inventory losses of 1937-38 were charged against earnings. The extraordinary inventory losses should be considered as a part of operating deficit. This scenario makes it difficult for an analyst to compare companies with different treatment of inventory accounting. It is very misleading to believe in such cases, the earnings ratios statistical manuals. Misleading earnings have determining influence on the market price because market reacts to the figures presented to it without giving a considerable thought to it.
Graham says accounting for inventory losses is frequently complicated by the use of reserve set up before the loss is actually occurred. Such reserves are created as a cushion to absorb future losses. When inventory shrinkage actually occur it is obviously charged against such reserves. It implies that such loss is never reflected in income account. Graham gives example of two companies with different inventory accounting practices. Goodyear charged against earnings of $ 11.5 million during years 1925-28 as a reserve against declining raw material prices. One half of the amount was used to absorb actual losses and remaining was carried forward and later used in 1930. United States Rubber during this period charged a total of $ 20.5 million as a reserve for inventory write-downs. But annual statements presented to share holders excluded this write-down from income and made it appear as special adjustments of surplus. The result of these divergent bases of reporting was reflected in per-share earnings as published in Poor’s manual. The average of highs and lows for this period was 62 and 40 respectively for US Rubber and Goodyear. It would be wise on the part of an analyst to recalculate these figures. For comparison purposes, adjustments must be made to account for different reporting methods. There are three ways to accomplish this-
1) As reported by United States Rubber- exclude losses from income account.
2) As reported by Goodyear- charge earnings to create reserve for future losses.
3) Charge losses against earnings the year in which they occurred.
I believe the third option gives a fair picture of the earnings. One more purpose it serves. Businesses face tough situations often. It is the test of the management to come through from these situations. Inventory write-downs present one such situation. When such losses occur, management has to cut down on other costs to make up. They have to come up with some alternative to increase profits or at least exhibit good performance when others are having tough times. If a management of a company handles this situation well when other players in the industry are struggling, it is a sign of an able management.
Graham says accounting for inventory losses is frequently complicated by the use of reserve set up before the loss is actually occurred. Such reserves are created as a cushion to absorb future losses. When inventory shrinkage actually occur it is obviously charged against such reserves. It implies that such loss is never reflected in income account. Graham gives example of two companies with different inventory accounting practices. Goodyear charged against earnings of $ 11.5 million during years 1925-28 as a reserve against declining raw material prices. One half of the amount was used to absorb actual losses and remaining was carried forward and later used in 1930. United States Rubber during this period charged a total of $ 20.5 million as a reserve for inventory write-downs. But annual statements presented to share holders excluded this write-down from income and made it appear as special adjustments of surplus. The result of these divergent bases of reporting was reflected in per-share earnings as published in Poor’s manual. The average of highs and lows for this period was 62 and 40 respectively for US Rubber and Goodyear. It would be wise on the part of an analyst to recalculate these figures. For comparison purposes, adjustments must be made to account for different reporting methods. There are three ways to accomplish this-
1) As reported by United States Rubber- exclude losses from income account.
2) As reported by Goodyear- charge earnings to create reserve for future losses.
3) Charge losses against earnings the year in which they occurred.
I believe the third option gives a fair picture of the earnings. One more purpose it serves. Businesses face tough situations often. It is the test of the management to come through from these situations. Inventory write-downs present one such situation. When such losses occur, management has to cut down on other costs to make up. They have to come up with some alternative to increase profits or at least exhibit good performance when others are having tough times. If a management of a company handles this situation well when other players in the industry are struggling, it is a sign of an able management.
