Why Would Inventory Value Increase?

Article written by EricBank

It seems like only awful things can happen to inventory: it breaks, spoils, gets stolen or goes obsolete. Accountants are used to marking down inventory value, but it's rather a rare accounting entry that actually increases the value of inventory. In fact, this is only possible to do this if you use international accounting standards, because GAAP doesn't allow for it.

Inventory Valuation

GAAP requires that when your inventory becomes distressed in some way, you write down the value using LCM: lower of cost or market method. Under LCM, the markdown is required when inventory cost is greater than its market price. The markdown must lower the value to no more than its net realizable value -- the amount that the inventory will garner at auction after subtracting the extra costs necessary to prepare and sell the goods. The minimum value of the inventory is the net realizable value less your regular profit margin.

Write-Downs

GAAP is fussy when it comes to writing down inventory value. Specifically, the rules request you use the allowance method. Under this method, you must estimate the value of the inventory losses you anticipate in the next accounting period. At the start of the period, debit cost of goods sold and credit reserve for lost inventory by the amount of the estimated loss. By recognizing the loss at the beginning of the period, you meet the requirements of the matching principle: book expenses in the period that is responsible for causing them. This handles the case where you don't discover inventory damage or theft until a later period. Otherwise, you'd be booking the expense in an incorrect period. Eventually, you'll discover the theft or damage, at which point you debt the reserve account and credit inventory for the loss amount.

Income

The cost of goods sold increases when you write down inventory. An increase in COGS reduces in gross profit, which is equal to sales revenue minus COGS. Of course, this decreases your taxable income, your tax bill and your net income. This is usually considered a desirable outcome. However, if a company uses employee incentives in an effort to maximize income, and an increase in COGS is the last thing the company wants. "Income management" techniques attempt to minimize COGS and maximize net profit. This creates the temptation to ignore distressed inventory. Shocking but true. It also just might be fraudulent.

Recovery

The written-down inventory can occasionally regain value. Imagine that a consumer safety scare causes a drug producer's inventory value to plummet. However, if the scare proves to be unfounded, the inventory value can experience a price recovery. GAAP forbids you from increasing the value of the inventory, whether or not you've marked it down. International financial reporting standards take the opposite approach: you have to mark up inventory that you wrote down when the price recovers, but only as much as the written-down amount. As more and more U.S. companies begin adopting IFRS, the opportunity to mark-up inventory will spread.