Mattel Inc., a manufacturer of toys, failed to write off obsolete inventory, thereby overstating inventory and improperly deferred tooling costs, both of which understated cost of goods sold and overstated income.

“ Excess” inventory was identified by comparing types of toys ( wheels, general toys, dolls, and games), parts, and raw materials with the forecasted sales or usage; lower of cost or market (LCM) determinations then were made to calculate the obsolescence write- off. Obsolescence was expected and the target for the year was $ 700,000. The first comparison computer run showed $ 21 million “excess” inventory! The company “adjusted” the forecast by increasing the quantities of expected sales for many toy lines. (Forty percent of items had forecasted sales more than their actual recent sales.) Another “adjustment” was to forecast toy closeout sales not at reduced prices but at regular prices. In addition, certain parts were labeled “interchangeable” without the normal reference to a new toy product. These adjustments to the forecast reduced the excess inventory exposed to LCM valuation and write- off.

The cost of setting up machines, preparing dies, and other preparations for manufacture are tooling costs. They benefit the lifetime run of the toy manufactured. The company capitalized them as prepaid expenses and amortized them in the ratio of current- year sales to expected product lifetime sales (much like a natural resource depletion calculation). To lower the amortization cost, the company transferred unamortized tooling costs from toys with low forecasted sales to ones with high forecasted sales. This caused the year’s amortization ratio to be lower, the calculated cost write- off lower, and the cost of goods sold lower than it should have been.

The computerized forecast runs of expected usage of interchangeable parts provided a space for a reference to the code number of the new toy where the part would be used. Some of these references contained the code number of the part itself, not a new toy. In other cases, the forecast of toy sales and parts usage contained the quantity on hand, not a forecast number.

In the tooling cost detailed records, unamortized cost was classified by lines of toys (similar to classifying asset cost by asset name or description). Unamortized balances were carried forward to the next year. The company changed the classifications shown at the prior year- end to other toy lines that had no balances or different balances. In other words, the balances of unamortized cost at the end of the prior year did not match the beginning balances of the current year except for the total prepaid expense amount.

For lack of obsolescence write- offs, inventory was overstated at $ 4 million. The company recorded a $ 700,000 obsolescence write- off. It should have been about $ 4.7 million, as later determined. The tooling cost manipulations overstated the prepaid expense by $ 3.6 million.

The company reported net income (after taxes) of $ 12.1 million in the year before the manipulations took place. If pretax income were in the $ 20 to $ 28 million range in the year of the misstatements, the obsolescence and tooling misstatements alone amounted to about 32 percent income overstatement.