Topic: Asset Valuation/Write-Downs
Characters: Ron, Inventory Control Clerk; Penny, Controller Art, Company President Rhonda, Sales Manager
Penny is the first Controller ever hired at a medium-sized farm machinery company. The firm has reacquired tractors and other parts and equipment from farmers who filed for bankruptcy or were seriously behind in their monthly payments during a recent two-year downturn in the economy. In addition, the firm has acquired some miscellaneous inventory from competitors experiencing the same misfortune.
One of Penny’s initial goals is to determine how accurately the inventory on the books reflects its fair market value. As she walks with Ron, the inventory control clerk, through all the equipment and inventory pallets, she notices that numerous parts and machines look rusty and dusty. Ron informs her that while only about a third of these items are repossessions, most are from overruns or the recession; “many have been sitting on these skids for years.” As Penny inquires further, it appears that this problem is extensive, and that this inventory moves slowly. When the inventory does sell, it is at a significant discount. Rhonda, the Sales Manager, indicates that these are really tough times to sell this stuff, especially because most of the “slow movers” are large-ticket items. In fact, Rhonda feels sorry for her sales staff since they have been forced by the company president to push these items with only 2 percent more in commission.
Finally, Penny approaches Art, the Company President, about this problem and asks what he intends for her to do about the dilemma. Art informs her that he believes that many of these items are salable given appropriate marketing and the right economic conditions. Besides, some of his major customers owe him a few favors. Art also indicates that now is not the right time for the company to take a hit from inventory revaluation.
During the ensuing months, Penny did not see much movement from these stacks. She again approached Art and asked how he would address this issue when the audit came. Art reiterated his former response regarding product salability and stressed actual sales across all product lines to the auditors. He asked Penny not to point out this problem to the auditors and finally said, “just see if they notice it. And if they start nosing around in it, I hope you’ll be able to show them that some of these items are turning over.” Penny interpreted Art as saying she should help falsify records if it looked like the auditors were discovering the slow movers. Penny didn’t know what she would do next.
Author: Curtis Jay Bonk, Ph.D., CPA, Assistant Professor of Education Psychology, West Virginia University.
Co-author: Mary M. Bonk, CPA, Director of Financial Analysis, West Virginia University Hospitals, Inc.
What Are the Relevant Facts?
- The company has purchased and repossessed farm equipment that it will have difficulty reselling.
- Much of this inventory is overvalued and turns over slowly.
- It is a difficult task to try to unload this inventory profitably.
- Art does not want to write-down a significant portion of this inventory, even though it has been on the books for years. Moreover, Art has implied that he wants Penny to help him hide the problem from the auditors.
- Penny is attempting to straighten out the books.
What Are the Ethical Issues?
- Should Penny put through a market value adjustment for the inventory in spite of Art’s comments?
- Should Penny compute what the write-down would be, just for Art’s information?
- To what extent can she expect Rhonda and Ron’s support?
- How is fair market value determined during recessionary times?
- Does Penny have a responsibility to take formal action?
- Is it ethical for Penny to mislead auditors if it is to the company’s long-term advantage?
Who Are the Primary Stakeholders?
- Sales staff
- Shipping and Receiving personnel
What Are the Possible Alternatives?
- An inventory control system could be established to flag inventory when it is “x” number of days old.
- Sales staff could be paid significantly more commission for selling these items.
- Penny can price out the inventory at full cost, while hoping that the auditors do not uncover this problem.
- Penny can attempt to compromise with Art and the auditors by writing off a modest though incomplete portion of the inventory this year and saving the major adjustments for the next year.
- Penny can talk to the auditors when they arrive.
- Penny could talk to Art and ask him specifically what he wants her to do and if he wants her to lie. She could also express her concerns about these practices.
- Penny can follow Art’s request as she has interpreted it.
What Are the Ethics of the Alternatives?
- Would better checks on the inventory (such as a computerized inventory control) necessarily pinpoint when items lose their market value?
- Why should the sales staff benefit with higher commissions from slow-moving items and not the rest of the firm who are also going out of their way to get rid of the stuff?
- Would Art’s practices be justifiable if one or two hard-to-sell items were sold each quarter?
- Can Art justify his practices based on overall need for the firm to appear healthy to customers?
- Does Penny have an obligation to disclose her company’s questionable practices to outside entities?
- Does Art have a right to expect loyalty from his employees?
What Are the Practical Constraints?
- At some point, excess inventory will be seen as taking up too much space and will be dumped.
- There is always some inventory that moves more slowly than others.
- It is difficult to expect the president to “take a hit” or write down significant amounts of assets in one year, especially during an economic downturn.
- The auditors will check the large-ticket items and find that they are not turning over quick enough.
- Penny cannot press Art on this issue since she is a new employee.
What Actions Should Be Taken?
- What actions should Penny take?
- Which alternatives would you choose if you were in her shoes and why?