Misadventures in reading a financial statement / absorption costing

When reading financial statements, I pay particular attention to costs that have been capitalized.  Capitalizing costs boosts income in the short-term and is often a sign of aggressive accounting.  I often use the shortcut “Crtl + F” to search for instances of capitalized costs in an annual report.  However, it turns out that I don’t understand accounting rules such as absorption costing for inventory.  Under US GAAP, Canadian GAAP, and IFRS… absorption costing is the only method allowed for valuing inventory.  Companies must capitalize fixed manufacturing overhead (e.g. rent) into inventory.  I wrongly assumed that footnotes describing this practice was a sign of unusually aggressive accounting (it isn’t).

On Tuesday, I attended a stock picking competition where 3 teams of MBA students (the finalists) analyzed an obscure and illiquid Canadian company called Buhler Industries (BUI.TO).  It is from skimming through Buhler’s annual report (page 16 of the annual financial statements on SEDAR) that I erroneously thought that Buhler may have been inappropriately capitalizing overhead costs into inventory.  From talking to others, it turns out that I’m not the only person who didn’t understand that Buhler management was simply following the rules.  I suppose the lesson here is that there are so many unintuitive and/or complex accounting rules that most investors are not aware of all of them.

The implications of capitalizing fixed manufacturing overhead / absorption costing

Capitalizing overhead affects the timing of expenses.  Overhead expenses like rent are recognized when the associated inventory is sold (or written down) rather than when the expense is paid.  The advantage of capitalizing expenses in this way is that it allows for expenses to be recognized at the same time as the associated revenue is recognized.  This is consistent with the matching principle of accounting.  In many cases, this form of accounting closely resembles the economic reality of a business.

One weird aspect of absorption costing is that fixed overhead is spread out over all units produced.  If a manufacturer cuts production in half, then the capitalized overhead per unit produced will double.  The book value of one unit of production will fluctuate based on how many units are produced each year.  This happens even if the product produced is identical from year to year; the book value per unit will fluctuate.

Suppose that a manufacturer holds production steady even when market demand falls.  Under absorption costing, the overhead costs are recognized when the inventory is sold.  Assuming that the inventory takes longer to sell because the manufacturer produced too much, the overhead expenses take longer to be recognized.  The deferral of expense recognition inflates short-term accounting income and deflates future accounting income.  This arguably creates an accounting distortion because the overhead expenses should have been recognized earlier.  A few people argue that absorption costing creates incentives for management to game the system by producing too much inventory.  This allows them to inflate short-term earnings (see “Why the Big Three Put Too Many Cars on the Lot“).  Personally I disagree with that view and don’t think that gaming absorption costing is sensible if management wanted to inflate short-term earnings.  There are better ways of inflating reported earnings without having to run the underlying business poorly.

Abusing capitalized inventory costs

In theory, charlatans can easily abuse this system because there are many subjective determinations as to what is and isn’t fixed manufacturing overhead.  By aggressively (or even fraudulently) classifying costs as overhead, charlatans can inflate earnings.

Arguably, a better way of inflating earnings is to inappropriately capitalize costs into property, plant, and equipment.

  • Costs capitalized into inventory are recognized once that inventory is sold.  For most companies, inventory is sold within a year.
  • Cost capitalized into PP&E are recognized over the estimated useful life of that asset, which is usually in the ballpark of several years.  The boost in earnings would take several years to reverse versus less than a year with capitalized inventory costs.

In terms of detecting fraud, inventory inflation would cause a company’s inventory turns to get progressively worse.  PP&E inflation would cause free cash flow (earnings + D&A – capex) to lag earnings.  Over long periods of time, the PP&E would pile up on the balance sheet and cause return on assets/capital to go down.  A combination of both inventory and PP&E inflation would be even more difficult for investors to detect.  If the inventory is inflated less (because the inflation is spread out over inventory and PP&E), inventory turns will get worse but not unusually so.  Similarly, the PP&E amounts might also seem within the realm of reasonableness.  One insidious aspect of capitalized inventory is that it can be very difficult for investors to detect.  Companies are not required to state the amount of capitalized costs in inventory.  They do not have to ‘show their work’.

Historically, many cases of fraud involving inventory did not rely on inappropriately capitalized costs.  Instead, fraudsters created fake inventory that was recorded on the balance sheet as an asset.  In practice, investors should pay some attention to (A) unusual declines in inventory turns and (B) unusual discrepancies between free cash flow and reported earnings.

*Disclosure:  No position in Buhler Industries.  My current opinion is that their accounting is more conservative than average.  For example, Buhler assumes that software has an estimated useful life of 1 year.

Links

Oregon State University webpage that explains absorption costing.

KPMG paper summarizing the differences between Canadian GAAP and IFRS.

Common Financial Fraud Schemes – A very good 90-page Word document that goes over many historical frauds and common accounting frauds.

Ben Graham Centre’s Internation Stock Picking Competition – This is a stock picking competition where MBA students first competed against their classmates and then other teams from international MBA schools for a shot at winning cash prizes.  In the final round, 3 teams had 1 week to analyze Buhler Industries.

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