Leaders should also ask how the company calculates the price assigned to a product when it’s inventoried. Assuming a standard costing system, how often are the standards updated (including labor and overhead applied to inventory cost for work in process and finished goods)?
Another question: Does the company appropriately capitalize in-bound freight and variance accounts into inventory each month?
Initial inventory value includes the cost of the goods and the costs of bringing them in. That should all be capitalized, according to U.S. Generally Accepted Accounting Principles (GAAP), but most companies expense in-bound freight costs. At merger/acquisition time, that creates a complication, prompting the need for a quality of earnings expert to be brought in to translate accounts from the previous practice.
Many companies also haven’t adequately estimated their inventory reserves. What is the policy for slow-moving, excess and/or obsolete inventory? For example, to assure good customer service, a company may keep extra items in stock, but sometimes those stocks are too large and items sit in inventory for long periods. If an item isn’t going to be used for five years, can it really be valued at 100 percent, considering the likelihood of selling the item and the time value of money?
During diligence, a great deal of emphasis will be placed on inventory valuation. Those conducting diligence will dissect the cost-accounting entries (walking through the costing from receipt through assembly to finished goods and the release of inventory at shipment).
Costs that can be inventoried will be analyzed using average inventory turnover to estimate the amount of reported manufacturing expenses that should have been capitalized as inventory at any given balance sheet date.
Experts will take usage reports and quantify how many years of coverage the company has per stock keeping unit (SKU) based on average annual usage. The recorded reserve will be compared to the estimate of the value of inventory that won’t be converted to cash in the near term.
These findings will directly impact quality of earnings and working capital. Non-GAAP accounting for inventory could potentially change earnings before interest, tax, depreciation and amortization as well as the valuation of the company/purchase price — either positively or negatively.
Post transaction close, the findings of the due diligence process can also affect gross profit. Almost all manufacturing business owners look at gross margin as part of their standard operations review; however, many of these unaudited and/or lower middle market companies may not be calculating gross profit correctly. Accounting for inventory in accordance with GAAP can materially change reported gross profits. It’s important to keep these changes in mind when comparing to prior months or budgeting for the future.
Implementing changes from prior practices to GAAP-based accounting for inventory may result in material changes to the net inventory balance recorded on the balance sheet. Whether increasing the balance with additional capitalized costs or decreasing with additional reserves, getting to GAAP is key for both buyers and sellers.