Financial Accounting: In an Economic Context

THE LOWER-OF-COST-OR-MARKET RULE AND HIDDEN RESERVES

The lower-of-cost-or-market rule is often criticized because it treats inventory price changes inconsistently. Price decreases, based on difficult-to-determine market values, are recognized immediately, while price increases are not recognized until the inventory is sold in an objective and verifiable transaction. This conservative, but inconsistent, treatment can create “hidden reserves” that managers can use to manipulate income.

Consider a company that is just about to complete a very good year. Reported earnings are expected to be so high that management is seeking to reduce income and perhaps move some of the earnings to future periods that may be less successful. One way to execute this “income smoothing” strategy is to write down inventory in the current year and sell it in a future period. Suppose, for example, that management chooses to write down an inventory item with an original cost of $10 to its subjectively determined market value of $8. A $2 loss is immediately recognized, reducing the current year's net income. Assume further that during the following year, the inventory item is sold for $12, giving rise to a book gain that increases that year's net income by $4 ($12 - $8). Note that by writing down the inventory in the first year, management was able to transfer $2 of net income from the first to the second year. A “hidden reserve” was created by the write-down, which was realized in a subsequent period.

Certainly, ...