USA Cost of Goods Sold (Inventory)


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I'm a newbie to both accounting and stock valuations.
Currently I'm reading a book called Security Analysis by Benjamin Graham and the book is extremely old and its difficult to understand because accounting practices have changed since 1934.

To make a long story short the author states that at that time corporations could write down inventory and charge surplus account bypassing the earnings statement. By surplus account im assuming he means Retained Earnings. So the charge to surplus goes unnoticed and the future earnings statement will be inflated since inventory has been written down in the previous period increasing future net earnings by the amount written down. So essential a company would take money out of surplus and show it as income in a future period. From my understanding that's because inventory has been written off and future net earnings increase because the profit margin is higher.

Nowhere in the book does he mention Cost of Goods Sold. So I'm having a hard time visualizing all this without Cost of Goods Sold. The way I understand it is if inventory gets written down, the COGS increase, which decreases net income. But in the earlier days they could bypass the income statement and take it out of retained earnings?

And it appears that today companies try to increase inventory which reduces COGS and therefore increases net income?

So it seems that back in the day, decreasing inventory, increased the net earnings but today increasing inventory, increases net earnings?

Is this paradox because they had no COGS in the income statement?
I'm all confused here.
 
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It's not an actual company. It's all hypothetical exampled from the book Security Analysis.

Here is the example from the book:

"Manufactured Earnings. An examination of the wholesale charges
made against surplus in 1932 by American Machine and Metals, detailed
on page 422, suggests the possibility that excessive provision for losses
may have been made in that year with the intention of benefiting future
income accounts. If the receivables and inventories were written down to an unduly low figure on December 31, 1932, this artificially low “cost
price” would give rise to a correspondingly inflated profit in the following
years. This point may be made clear by the use of hypothetical
figures as follows:
Assume fair value of inventory and receivables on
Dec. 31, 1932 to be . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000
Assume profit for 1933 based on such fair value . . . . . . . . . . . . . . . . . . . . . 200,000
But assume that, by special and excessive charges to surplus,
the inventory and receivables had been written down to. . . . . . . . . . . . 1,600,000
Then the amounts realized therefrom will show a
correspondingly greater profit for 1933, which might
mean reported earnings for 1933 of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000
This would be three times the proper figure.
The foregoing example illustrates a whole set of practices that constitute
perhaps the most vicious type of accounting manipulation. They consist,
in brief, of taking sums out of surplus (or even capital) and then
reporting these same sums as income."


Here is another example how they bypass earnings:


"Reserves for Inventory Losses.
The accounting for inventory losses
is frequently complicated by the use of reserves set up before the loss is
actually realized. These reserves are usually created by a charge to surplus,
on the theory that it is a function of the surplus account to act as
a sort of contingency reserve to absorb unusual future losses. If later the
inventory shrinkage actually takes place, it is naturally charged against
the reserve already created to meet it. The result is that in no year does
the income account reflect the inventory loss, although it is just as much
a hazard of operations as a decline in selling prices. When a company
charges inventory losses to surplus—whether directly or through the
intermediary of a reserve device—the analyst must take this practice
carefully into account, especially in comparing the published results
with those of other companies."

I'm guessing this is illegal now?
That's y I wanted to see if an accountant would know this?
 
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The IASC (which we now know as IASB) came into existence in 1973. Before that, accounting was not as tightly regulated as it is today. So I believe this might be some sort accounting manipulation that accountants developed in order to inflate profits.

This does not make much sense as if you're decreasing inventory you're gonna have to credit inventory. If they're debiting surplus or reserve, its of a credit nature and decreases through a debit entry. So it's beyond me how were they able to increase profits debiting the equity portion of the balance sheet.
 
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Because supposedly by debiting the surplus account directly they didn't show it in the income statement and therefore didn't reduce earnings. That's the whole point is that it was a misleading manipulation of earnings by transferring money from surplus to income for the amount of the write down.

I just wanted to see if any accountants knew when and what law was changed in accounting standards so I can better understand this concept
 
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When inventory is written down (due to a belief that there drop in the value of the asset that is not recoverable CV > FMV), you would usually Dr. Impairment Loss and Cr. Inventory for the difference between the two. Don't the connection with Retained Earnings here.
 

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