Understanding Inventory Accounting and Evaluation

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This article reviews basic inventory issues that lenders should consider when extending credit to manufacturers, wholesalers, retailers, and other borrowers with inventory. Some of the problems exposed by recent inventory fraud cases are discussed, and a checklist is provided to evaluate a borrower's inventory and accounting disclosures systematically.

Very few bankers prefer loans based on inventory. Nevertheless, inventory provides collateral support for a large percentage of loans, particularly working capital lines of credit. Especially for borrowers who are manufacturers, wholesalers, or retailers, inventory may be the most important asset in their entire operation - regardless of whether the inventory is pledged to support a loan.

Accounting standards require proper financial reporting of inventory for any operation with a stock of goods. Inventories are required to be compiled, measured, and recorded periodically.

The importance of proper inventory accounting has been demonstrated in several recent, highly publicized cases in which inventory manipulation resulted in dramatic changes to reported earnings and cash flow.

Accounting Standards

Accounting Research Bulletin No. 43, published by the Financial Accounting Standards Board, defines inventory as the aggregate of the items of tangible personal property that are:

* Held for resale in the ordinary course of business (finished goods).

* In process of production for sale (work-in-process).

* To be currently consumed either directly or indirectly in the production of goods or services to be available for sale (raw materials and supplies).

Considering these definitions, it is difficult to envision any business that operates without some form of inventory. An analysis of data from RMA's Annual Statement Studies, 1992, reveals that for the 360 industries represented, 68% showed inventory representing at least 20% of total assets. The average for all industries, weighted by the number of companies in each sample, was 26% of total assets. If service industries are excluded, inventory averages 34% of total assets on a weighted basis.

Inventory is important for reasons other than its relative size on the balance sheet. Inventory has a direct effect on accounts payable and plays a key role in the trade cycle of a business. While receivables are the result of sales, inventory is the key determinant of cost of goods sold, which is usually the largest component of costs on the income statement. In most cases, inventory is less liquid than receivables, and inventory valuation is subject to many more accounting options and management decisions than other assets. For these reasons, inventory can become the greatest risk to seasonal loans. For working capital loans, inventory is a key component used to determine a borrowing base, and problems can occur because of unsold or overvalued inventory.

Inventory Complications

Other problems with inventory can arise in the following areas:

* Inventory amounts.

* Accounting methods.

* Compliance with accounting rules.

* Legal title.

* Effect on payables and cash flow.

* Effect on net income.

* Effect on other management decisions.

* Overall quality.

Inventory Amounts

The amount of inventory maintained by a business is determined by a number of factors, including the availability of supplies and the lead times necessary for placing orders, both of which affect the level of raw materials on hand. The length of the manufacturing process, or any process that adds value, determines how much inventory is allocated as work-in-process. Whether goods or services are produced to fill orders or to maintain stock also affects the level of finished goods.

Owing to the characteristics of specific industries, many banks train lenders and credit analysts to draw conclusions based on observed or reported levels of inventory and on their knowledge of the industry and of the borrower's methods of doing business. …