For some small businesses, accounting for inventory is a relatively simple thing. You literally count the number of items you have available for sale and tally the results.
For large multinational corporations, inventory is a far more fluid entity and harder to accurately track. Certain industries are even more difficult to track and nebulous to define — for example, what does inventory even mean for a company such as Netflix?
This leaves room for interpretation by corporations and leaves wiggle room for manipulation of inventory if a company is so inclined.
Why would a corporation manipulate its inventory? Generally, it is to make the balance sheet or some other financial metric appear better than it really is.
Consider what inventory actually means. (We’ll stick with simpler manufacturing examples for now.) Inventory is the value of the goods that a company has manufactured but has not yet sold. Inventory in storage is an asset for accounting purposes. Once the inventory is sold, it appears on the income statement under the cost of goods sold (COGS).
A company’s gross profit margin is their net sales income minus COGS. When inventory is overvalued or artificially inflated, the COGS will be underreported as a result. That will result in an inflated gross profit margin, which will propagate through to an inflated net income, and therefore to market fundamentals that are based on income.
Thus, a company that wants to put a positive spin on their fiscal performance prior to an important event, or for the closing of the books for the year, will take any latitude they have to report the inventory and income in a positive manner. An unscrupulous company will flat-out manipulate the values in hopes that future sales blur or obfuscate the inventory manipulation.
The inventory manipulation may not be a simple bold-faced lie on inventory quantities. For example, a company may hide materials or finished goods in inventory that they already know are unusable or unsellable and will be scrapped at a later date.
It is not always straightforward to track the value of inventory. Its value may change as it makes its way through the manufacturing process (from raw material to work-in-process to finished goods) and may also change over time. Consider this on a more global scale, where one company’s finished goods may be another company’s raw material (such as car parts being assembled into a finished vehicle), and you can see why inventory values for GDP calculation purposes are estimates that are often revised.
inventory hoarding was a significant driver behind the GDP numbers at the end of 2013 and in the 2nd quarter of 2014, while 1st quarter 2014’s decrease was driven by reductions in the inventory surplus. If they are correct, there should be a correction in inventory soon, dragging GDP numbers down — but that is still a debatable point.
How can you spot questionable inventory values as you look over a company’s balance sheet? There are a few red flags you can look for that show an inventory buildup, such as inventories that are rising faster than sales or the total assets reported. Turnover of inventory could also be decreasing. A one-month change does not necessarily indicate problems, but a running pattern of any of those factors signals trouble.
Inventories are not a particularly sexy topic, but they are one that you should pay attention to as an investor, especially when the numbers just don’t smell right to you. There may be a very valid reason why.