Vigilant investors are always on the lookout for a company engaged in "financial shenanigans," or the manipulation of earnings to make things look better then the actual performance. Because inventory has an effect on profits, adjustment of inventories is one area that financial analysts look to for signs of earnings manipulation. If this is the case, the company suffers a decline in its stock price. In the opinion of investors, management of the company can no longer be trusted.
How Inventory Affects Profitability
Inventory is what a company has available for sale. Therefore, inventory valuation is paramount for businesses. On a company's income statement, the line item "cost of goods sold" contains the amount of inventory a company sold during the period. The formula for COGS is beginning inventory plus new inventory purchases minus ending inventory. The company deducts COGS from sales to figure out its gross profit. After taking into account its growth profit, the company subtracts all other operating expenses to calculate net income. If a company overestimates COGS, this results in lower net income. On the other hand, if a company underestimates COGS, this produces higher profits all else being equal.
A company can value its inventory using several methods. The two most popular methods are "last in, first out" and "first in, first out." LIFO assumes that new inventory purchases are the first to sell rather than older inventory. FIFO assumes the first inventory purchases sell first. In a period of rising prices, LIFO produces a more accurate value for COGS, but an unrealistic picture for ending inventory on the balance sheet, as older inventory may be obsolete. Higher COGS under LIFO result in lower net income. In contrast, FIFO produces a lower COGS and higher net income. On the balance sheet, FIFO produces a more accurate value for ending inventory.
Once a company chooses an inventory valuation method for accounting purposes, such as FIFO, it is uncommon for it to switch to LIFO in another period. However, there is one exception. Tax rules allow a company to use FIFO accounting to report its financial results but use LIFO for tax reporting purposes to reduce tax liability. Remember, FIFO produces a higher net income. If a company uses FIFO, then it must report a LIFO reserve, which is essentially is the difference between the LIFO and FIFO methods. There are legitimate adjustments a company should make if it discovers an inventory accounting error. Depending on the nature of the error, this may have a material affect on net income. In such a case, the company must restate its financial results.
Inventory and Stock Price
Net income is an important consideration for how investors value companies. Because inventory has an impact on profitability, investors watch changes or adjustments to inventory and the company's reasoning behind it. If it is a legitimate error, investors may not punish the company by selling its shares. However, even a legitimate inventory adjustment may garner the ire of investors that may dump the shares because of lack of trust in management. In addition, investors may sell the shares if they believe the company's inventory is obsolete. Financial analysts like to compare a company's accounting methods with that of its peers. If all companies within the sector use LIFO to report results and one company uses FIFO, then this may signal that management is not following industry practice, which may be enough cause to devalue the stock.
Case Study: Blockbuster Inc.
For years, Blockbuster operated a chain of video stores throughout the country. However, with the increasing popularity of DVDs, Blockbuster found its huge videotape inventory quickly becoming worthless. The company had to take several write-downs of its videotape library over several years. It's stock price suffered as a result. For example, in September 2001, Blockbuster announced a $400 million charge to write-off its videotape inventory. The company's stock price fell 8.2 percent on the day of the announcement. In September 2010, Blockbuster filed for Chapter 11 bankruptcy protection to reorganize its business amid competitive pressure from Netflix Inc. the online videostreaming and mail-in DVD rental service.