Excess inventory levels and elevated interest rates are compelling industrials companies to think strategically about their supply chain processes, workforce practices, and capital expenditures. Understanding the accounting ramifications—such as revenue recognition, cost estimates, and subsequent measurement of inventories—is crucial not only to overcoming these marketplace challenges but also to finding opportunities to improve operations.

“Better data also means better decisions in your accounting estimates and your judgements and all decisions across every operation and C-suite,” says Ryan McGurk, RSM partner, and the firm’s industrials audit policy leader.

McGurk joined Jeremy Zwart, RSM’s industrials industry audit leader, and Mike Lundberg, RSM’s industry audit policy leader, for a nine-minute discussion about the latest business issues and accounting implications facing industrials companies. Below is a transcript of the discussion, edited for clarity and length.

They covered the following topics, with the corresponding timestamp noted for your convenience:

• Economic factors affecting industrials companies (0:59)
  
• Accounting issues resulting from excess inventory and higher interest rates (2:12)
• Steps industrials companies might take to position themselves for success (3:32)
• How IT infrastructure and digital applications might help companies build resilience and even improve operations (7:46)

Mike Lundberg: What's the latest in industrials?

Jeremy Zwart: We all know the supply chain shut down in 2020 and 2021, resulting in low inventory levels and unfilled orders in 2021. During 2022, the global supply chains came back online at various times, with quickly rising prices for products and logistics. But by the end of 2022, global supply chains, for the most part, had caught back up to the backlogged demand.

ML: I remember those $20,000 to $30,000 container prices. Now that COVID is kind of behind us, does that mean we're all back to normal?

JZ: Well, not quite. At the same time, our clients started to see orders softening in the second half of 2022 and early 2023. We're also seeing sales orders being delayed or deferred out into 2023 and even beyond into '24.

That's resulting in swelling inventory levels and causing storage and warehouse issues at our clients. While at the same time, everybody's working capital interest rates have nearly doubled or more in the last couple of years.

ML: It sounds like it's going to take us a little bit to work through all of this.

Ryan, given all the challenges that Jeremy noted, what are some of the audit- and accounting-related topics or issues that our industrials clients are facing this year?

Ryan McGurk: Jeremy touched on a number of things there, certainly in between the lines as well. Any manufacturer that's listening to this certainly understands a lot of that leads to excess inventory on hand. There's a lot of continued inflationary pressures, as well as pricing concerns on contracts with customer orders that have been delayed.

So, first of all, the cost of capitalized inventory components continues to rise. We're talking materials, freight, labor, overhead—they're all increasing. So if an entity is unable to pass these higher costs to their customers, then they need to really start thinking about: Is the carrying amount of their inventory recoverable?

There are a lot of estimation and significant judgments that go into those management estimates. So for inventory provisions, it's critical to fully analyze and understand the composition of the inventory during the year, as well as the forecasting of production and demand in the coming fiscal years.

An entity's subsequent measurement of the inventory should assure that the losses of inventory are not inappropriately deferred and should be consistently applied.

ML: Okay, interesting. So, what should companies be thinking about?

RM: Entities should continue to think about how they can leverage their own internal data, as well as their external market data, to more reasonably estimate their raw material needs, production levels, and sales forecast, as these and many of them will impact the inventory provision estimates and policies.

Some entities may be considering increasing sales incentives to move excess inventory, and this has implications related to variable considerations, which may be an area that certain manufacturers haven't considered in the past under their recognition policies.

And then in addition, contract manufacturers should think about their revenue streams. If their projects or custom orders are being delayed by customers, the entity's original cost estimates on the contract may have changed, as we mentioned, due to some factors like inflation, increasing overhead costs, etc. So they'll need to carefully consider or revisit the estimated cost budgets when using an input method and recognizing revenue on a cost-to-cost basis.

ML: Well, it's amazing how quickly we went from empty warehouses to full warehouses. And again, just as we work through the peaks and valleys of this process, hopefully, we'll be returning to normal here shortly.

Jeremy, you mentioned earlier some opportunities for our industrials clients this year. Let's explore that a little bit. How are you seeing companies respond to this, manage these peaks and valleys a little bit, and plot a path forward for '23 and '24?

JZ: While our industrials clients have certainly faced a lot of challenges, they also have a lot of really unique opportunities in front of them right now. I think the opportunity to reimagine and re-leverage their supply chains going forward is really a once in a—I don't want to say once in a lifetime—but certainly once in a recent era for them to think about.

In the last few years, they've likely found new and alternative suppliers. Maybe they're considering re-shoring or near-shoring portions of their supply chains. And they've likely invested, or at least realized that they need to invest, in their technology tools to improve their connectivity with their suppliers and customers.

It's really important for industrials clients to understand which customers and products generate the highest margins, and just as importantly, those customers and products that generate negative margins and headaches. They really need to have timely and accurate data to make the best business decisions in light of the continued labor shortages and increasing cost of working capital.

ML: Thanks, Jeremy. It seems like everybody's having to sort of reprioritize what they do, revisit their strategy, like you talked about, identifying products that are contributing to margin, maybe some products or lines that aren't contributing as much as they should, as they prioritize the precious resources that they have.

What else are we seeing companies do to help prepare themselves for '24 and '25?

JZ: Following on the conversation points I brought up around that slowing demand and that deferral, I think our clients are facing a struggle. It's the opposite end of the struggle they had the last three or four years of trying to find enough qualified labor and get them trained up.

Now they've got this workforce in place, but now they don't have the orders in the production schedule to keep everybody busy. So our clients need to be really proactive and be smart and think about what's really the end goal of keeping these quality, trained people employed.

We are seeing clients doing rolling layoffs, maybe shorten production weeks down to three or four days. You look at the calendar—maybe taking a week or two extra around the holiday breaks, and stuff like that, to help manage the time. We're just seeing clients get really creative to keep those trained resources busy in the production cycle.

RM: I think it's important that the clients have that long-term strategic view too, in terms of what are they doing to harvest the data within their organization and driving data-driven decisions. Because there's a lot of data our clients have that they either can't access, or they can't access and manage it to make appropriate decisions.

So there's opportunity to invest in capital, to enhance the IT architecture at our clients so they can make better data-driven decisions and eventually transform to the factory of the future, where there's a lot more IT involved and the volatility in the labor market might not have as big of an impact.

And that goes beyond just the ability to produce and deliver to their customers, which is ultimately their goal. But better data also means better decisions in your accounting estimates and your judgements and all decisions across every operation and C-suite.