GAAP and Inventory

May 07, 2015

We were recently called in to consult with an accounting firm on a costing issue involving one of their manufacturing client’s. This firm is located out West and had a manufacturing client in the magnitude of $100 million a year in sales that had recently gone through a sale to an outside strategic buyer.

This manufacture had their books audited by the accounting firm for the last 10 years and had relied on those statements based on Generally Accepted Accounting Principles (GAAP) for financing and to be the foundation for computing the selling price for this sale to the strategic buyer. The reason we were called in to consult with the accounting firm had to do with the buyers post sale review of the carrying values of inventory. Apparently, the purchase agreement included a portion related to the purchase of inventory at cost by the buyer.

In this case, the buyer had sent in a team to review the assets acquired for the purposes of determining if asset values at the end of year were computed correctly. One of their major focuses was on the very large inventory of finished goods and work in process. This team raised issues concerning the carrying values of the inventory and was asserting that the inventory was overvalued by $5 million; and therefore, the purchase price should be reduced by the same amount. Needless to say, the sellers were concerned that a significant portion of the purchase price would disappear and never be paid because the inventory supposedly maintained in accordance with GAAP were not appropriately valued and were at risk to be a reduction to the purchase price.

In this case, the partner on the account was interested in discussing all the issues surrounding how they had valued the inventory. The methods that they used over a number of years hadn’t changed but they were concerned that perhaps an adjustment would be required.

We also discussed how the buyers’ accountants have computed the inventory values and what possible discrepancies might be uncovered in their methods that would indicate they were not in accordance with GAAP.

The discussion continued for quite a period of time with many relevant factors being discussed that both supported and failed to support the sellers case. Similar facts were discussed related to the case that the buyers are putting forward. At the end of the conversation, we offered to help further if this did lead to a large adjustment or perhaps litigation but the contract did include a provision for mediation should a problem like this arise and be unable to be resolved by the buyer and the seller.

I am sure the sellers accountant was particularly distressed by this potential adjustment after having completed audits for ten previous years where GAAP basis of accounting was the method of stating those financial statements.

I can only imagine what the seller will say to his accountants about their participation in an adjustment like this should the buyers accountants be right about the failure to comply with GAAP on the audited financial statements.

We frequently hear that businesses that are profitable don’t need to invest any resources in their costing because the rate of return on investment associated with improving their costing is very low particularly as it relates to profitable companies. It is only after an event like this occurs that it reaffirms the benefits of maintaining good costing information during the life cycle of the company.

Categories: Cost Accounting