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One year after the Great Recession, companies the world over are still picking up the pieces. Thousands of them are facing increasing inventories due to significant decreased year-to-date 2009 sales, making inventory a significant risk on balance sheets.

Impairments
Over the last year, some companies took drastic measures to survive, including modifying business plans and eliminating less profitable revenue streams. Consequently, many have discontinued less profitable business segments, resulting in reduced value and/or worthless inventory. Inventories associated with these less-profitable segments must be written down to their net realizable values (selling price less reasonable costs of disposal), which, in certain circumstances, could be pennies on the dollar. The result could be significant charges to a company’s income statement, and if certain criteria are met, the exit from the activities must be accounted for as discontinued operations under U.S. Generally Accepted Accounting Principles (GAAP).

Scrutinizing Inventory
Companies, especially those with restrictive debt covenants, have been forced to scrutinize the inventory on their balance sheets and provide larger allowances for inventory deemed slow moving or obsolete. This forces companies to continuously monitor inventory turns and provide detailed evidence that they can sell the inventory in the next year. Decreased demand and economic uncertainty leave many with little evidence of future sales volume.

Fixed Manufacturing Overhead
Due to significantly reduced demand, some companies have experienced decreased production levels. When production falls below an expected range, manufacturers must evaluate whether production is less than normal capacity, which is the range of production expected over a number of periods, taking into account loss from planned maintenance. If production falls below normal capacity, U.S. GAAP prohibits increasing the amount of fixed costs allocated to each unit produced. Instead, companies must expense excess fixed costs in the period incurred.

Deflation and Inventory Valuation
The Consumer Price Index (CPI) is a leading indicator of pricing and cost-of-living trends in the U.S. According to the Department of Labor, the CPI decreased 1.3 percent for the 12-month period ending September 30, 2009. The deflation we are experiencing will affect a company’s balance sheet and income statement differently, depending on the method the company uses to value its inventory.

Two common methods companies use to value inventory are the first-in first-out (FIFO) method and the last-in first-out (LIFO) method. FIFO operates under the assumption that the first product that is placed into inventory is also the first sold. LIFO, commonly used by department stores and food retailers, assumes instead that the last unit to reach inventory is the first sold.

During a period of decreasing prices, each of these methods produces a different result on a company’s finances. A company using FIFO to determine the cost of inventory will likely see a lower income before taxes and lower inventory on its balance sheet, which is good news regarding taxes. A company using LIFO to value its inventory can most likely expect the exact opposite this year, higher income before taxes and a higher inventory on its balance sheet.

Purchase Commitments
Companies that locked into prices prior to the economic downturn could find themselves accounting for loss contracts this year. Companies that made commitments to purchase quantities of raw materials or finished goods prior to the downturn must now assess whether those prices are unfavorable in the current market. If a company can now purchase the contracted items for less, it must accrue the entire loss during the current period, per U.S. GAAP.

Lessons Learned
One thing we’ve learned is that planning is crucial to inventory management. Companies need to invest additional time to prepare sales forecasts based on the environment, not necessarily on historical experience. Strong forecasts will enable companies to manage inventory levels but, more importantly, forecasts will yield improved cash flow. While it may be nearly impossible to prepare a forecast without looking back, companies should review recent results, for example, the past quarter instead of the past year. In addition, comparing industry trends and averages to its own situation as a sanity check is a great way to make sure a company is on the right track.

Joseph C. DiFalco, CPA, is an audit manager at Amper, Politziner & Mattia, LLP. He is a member of the New Jersey Society of CPAs. DiFalco can be reached at difalco@amper.com or 732-287-1000.