How inventory is managed – whether LIFO or FIFO – impacts inventory valuation. LIFO typically represents the more conservative valuation, particularly in an inflationary environment because recognized costs are relatively higher. However, LIFO also results in relatively lower inventory valuations.
Value investors should understand inventory valuation policy, normally disclosed in Note 1, particularly where an accounting policy is changing or has been changed. If a company switches from LIFO to FIFO, watch out.
Expense stretch
Expenses, or indirect costs, are easier to stretch because there are more different kinds of them, and typically little detail is given on the consolidated statements. Fortunately, this area has received considerable scrutiny, especially options and amortization expenses, so it is less of an arena for abuse than in the past.
OptionsCompensating employees with stock options became much more in vogue toward the end of the 20th century. Why? To recruit and retain better employees without consuming precious cash or diluting earnings. Investors got very upset about it because not only were companies inflating earnings by not recognizing option expenses, but many a corporate staffer was getting fantastically wealthy on the resulting awards.
For a long time, accounting rules required only disclosure – not incorporation into actual statements. So option grants and their theoretical expense were noted somewhere deep in the statements, but not in the results themselves. Finally in 2004, that changed: The Financial Accounting Standards Board implemented a revised Statement 123, requiring expensing and prescribing a formula for valuing the options. So now, options can still be abused by greedy or irresponsible management teams, but at least investors will see the results more clearly.
R&D and marketing costs
A few companies have been caught deferring certain R&D and marketing costs into the future by capitalizing them: recording them as an asset when incurred, rather than an expense, and then depreciating or amortizing the asset over future years. Accounting rules are fairly firm, but not rock solid, around the notion that most R&D expenses should be incurred as they arise due to the uncertain nature of their outcome. Theres no way to tell upfront whether an R&D effort will turn into a marketable product. However, where R&D is significant as a proportion of total product expense, as with software, portions are allowed to be capitalized.
