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RM Role in Accounting.

A risk manager stumbled across something that he thought was wrong. Worse yet, he thought the problem might have an adverse effect on his company's business income insurance.

About half the company's locations valued its inventory using the first-in first-out (FIFO) accounting method, while the other half used last-in first-out valuation (LIFO).

The risk manager worried that the differences would somehow result in short-changing the company in the event of a business income loss.

The risk manager had a point, in a way. A company should use accounting conventions consistently, and the choice of accounting conventions for valuing inventory does affect the amount an insured can recover under business income insurance. The risk manager also overlooked the effect inventory valuation conventions have on the choice of a retention, especially if the company has set its retention as a multiple of daily earnings. The question the risk manager needed to answer is whether or not the choice of accounting conventions for valuing inventory is part of a risk manager's responsibility.

For those whose accounting is a little rusty, let's review how accounting conventions for valuing inventory work and how they affect reported earnings. The first thing to remember is that accountants keep track of historical costs. They have to match every asset the company owns to the price the company paid for that asset. In a world of changing prices, that creates a need for rules to determine the price of assets held in inventory. FIFO resolves that dilemma by assuming that the first asset put into inventory is the first asset used.

LIFO adopts the reverse methodology, assuming that the last asset the company purchased is the first it uses. That affects reported earnings because the price of assets removed from inventory for production or sales becomes an expense deducted from gross sales to arrive at net profit in the income statement.

FIFO produces a more current inventory valuation, but a less current cost of goods sold or cost of sales. LIFO delivers a more current figure for cost of goods sold or cost of sales, but a less current inventory valuation.

In a world of rising prices, FIFO produces a lower cost of goods sold or cost of sales and a lower inventory valuation. The result is higher reported earnings but a lower inventory valuation. LIFO has the reverse effect, generating higher cost of goods sold or cost of sales, and lower inventory values. Because business income insurance protects against loss of earnings, the choice of FIFO or LIFO definitely has an effect on how much a business can recover if a loss disrupts its operations.

That choice, however, is not the risk manager's concern. There are a wealth of reasons for a company to choose FIFO or LIFO to value its inventory and measure its costs. Accountants have never considered the effect on business income insurance one of them.

The risk manager's concern is to protect the company's assets and earnings from loss, and that does not require influencing the way a company calculates its reported earnings. If the chief financial officer, the board of directors, and the shareholders are content with the way a company calculates and reports its earnings, who is the risk manager to say they're wrong? Properly designed business income insurance will protect the earnings the insured would have reported, and that's all there is to that aspect of the risk manager's job.

There's one other thing to consider. A company that reports higher earnings needs higher limits for its business income insurance, and that means paying a higher premium. In an ideal world with perfect knowledge, the additional premium will precisely offset the extra recovery reporting higher earnings will produce. That leads us to the conclusion that a company's choice of FIFO or LIFO has no effect on potential recovery from business income insurance--at least no effect that a risk manager can predict with an acceptable degree of accuracy.

Joseph F Mangan is a consultant in Scotch Plains, N.J.
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Copyright 2000 Gale, Cengage Learning. All rights reserved.

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Publication:Risk & Insurance
Date:Nov 1, 2000
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