Question

We have discussed in Chapter 4 about the “big bath theory”. Inventory write-down is often used as such income shifting technique. Can you give me an example how inventory write-down can manipulate income?

Answer 1

Under the Big Bath thoery, a one-time charge is taken against income in order to reduce assets. Such a write-off reduces the asset balance and results in lower net income for the year.

An inventory write down reduces net income as well as stockholders equity.

It reduces the profit as reported in the income statement, (due to a decrease in the value of closing stock)

It also reduces the total assets value in the balance sheet (as the value of closing stock is also reported in balance sheet). And thus, a lower value of closing stock would reduce the value of stockholders equity.