Is the company’s auditor the last line of defense to make sure the financial statements accurately reflect the true financial health of the company?  The answer is almost always 100% yes.

 

The real question is: Is the auditor doing their job?  As with most professionals, a great majority of auditors are honest and competent.  While I have witnessed dishonest auditors, they are usually in collusion with either management / ownership.  It’s the incompetent auditors that can be the real problem.

 

Imagine you are an investor in a company with the following:

• Inventory levels between $25 and $30 million
• Auditor has consistently signed off on the inventory reserve of $100K
• Over $5 million of inventory was more than 2 years old (based on purchase date), with over $3.5 million more than 3 years old
• Overall turns were slow, 60% of the inventory had more than 2 years of supply on hand (72% > 1 year supply)

So, was the auditor asleep at the wheel?

 

I think the fair answer would be yes, the auditor was asleep at the wheel.  The company subsequently booked a reserve of almost $5.0 million, wiping out all retained earnings accumulated over nine years.

 

While the final exercise to assess the inventory and establish the reserve was a comprehensive detailed analysis, a basic intellectual curiosity would have highlighted the issue, including:

• Looking at the dust accumulated on top of the boxes (always a good sign of age)
• Paying attention to products / brands no longer offered for sale (in this instance, the company had a catalog to easily assess which product lines were no longer offered)
• Calculating inventory turns at a high level, and then stripping out the impact of the top sellers (if you have some items turning above the average, the others are by definition, below average)

It is not surprising that owners and / or managers are never eager to take a loss.  However, your first loss is usually your best loss.  Unless there is reason to believe an asset will not decline in value, it is not worth holding onto.  Had the company been more aggressive about liquidating these products below cost as they aged beyond one year, the company’s present day liquidity would be dramatically better.