Danger in book inventories;

              26 HASKINS & SELLS April
The Danger in Book Inventories
TH E R E is perhaps no one item on the
balance sheet with so many ramifica­tions
which are of interest as inventories.
In many industries the inventories are
among the most important assets with
which the business is carried on. Fre­quently
they represent a large portion of
the capital investment. As a consequence
of these facts the value at which the in­ventories
are shown may have a marked
effect on financial condition.
The term inventory signifies stock-taking
and implies that the physical property to
which the title relates has been counted
and listed. Seeing the word inventories
on a balance sheet one is entitled to assume,
unless some qualification appears, that
the values shown are based on a physical
count.
Given this condition, wherein obsolete,
unusable, or unsaleable items have been
either excluded, or priced at not more
than recovery value, the next question
becomes one of valuation. While there
are exceptional cases, like the packing
industry, where sales prices are used con­sistently,
the well-settled valuation prac­tice
is cost or market, whichever was lower
at the date of inventory. Orthodox pro­cedure,
such as the foregoing, would offer
little ground for technical criticism so long
as the books had been adjusted to make
stock records conform with the physical
condition and the adjustments had been
applied to the costs. True, there would
be questions from the standpoint of man­agement
as to relations between inventories
and production requirements, and as to
the proper balance between capital tied
up in inventories and total working capital,
etc., but that aspect is beyond the purview
of this discussion.
What does call for technical concern
and critical consideration is the situation
wherein closings are based on book records
and inventory values derived therefrom
are used for balance sheet purposes. The
ground for concern is found, first, in the
possibility that there may have been wide
divergence between the book records and
the physical stock; second, that cost may
mean cost when purchased and that some
of the stock may have been in hand for
a long time, or a fixed price may have been
used; and, third, that while physical
stocks may have been exhausted several
times since the last physical inventory was
taken, the book records may not have
been adjusted at such times.
Nothing short of an extensive study of
the stock records and prices used in figuring
costs will serve to determine accurately
the fairness of book values used for balance
sheet purposes where physical inventories