Cisco Systems is a global provider of networking equipment. In its third quarter 2001 Form 10-Q filed with the US Securities and Exchange Commission (US SEC) on 1 June 2001, the company made the following disclosure:

We recorded a provision for inventory, including purchase commitments, totaling $2.36 billion in the third quarter of fiscal 2001, of which $2.25 billion related to an additional excess inventory charge. Inventory purchases and commitments are based upon future sales forecasts. To mitigate the component supply constraints that have existed in the past, we built inventory levels for certain components with long lead times and entered into certain longer-term commitments for certain components. Due to the sudden and significant decrease in demand for our products, inventory levels exceeded our requirements based on current 12-month sales forecasts. Th is additional excess inventory charge was calculated based on the inventory levels in excess of 12-month demand for each specific product. We do not currently anticipate that the excess inventory subject to this provision will be used at a later date based on our current 12-month demand forecast.

After the inventory charge, Cisco reported approximately $2 billion of inventory on the balance sheet, suggesting that the write-off amounted to approximately half of its inventory. In addition to the obvious concerns raised as to management’s poor performance in anticipating how much inventory was required, many analysts were concerned about how the write-off would affect Cisco’s future reported earnings. If this inventory is sold in a future period, a “gain” could be reported based on a lower cost basis for the inventory. In this case, management indicated that the intent was to scrap the inventory.

When the company subsequently released its annual earnings, the press release stated: 8 Net sales for fiscal 2001 were $22.29 billion, compared with $18.93 billion for fiscal 2000, an increase of 18%. Pro forma net income, which excludes the effects of acquisition charges, payroll tax on stock option exercises, restructuring costs and other special charges, excess inventory charge (benefit), and net gains realized on minority investments, was $3.09 billion or $0.41 per share for fiscal 2001, compared with pro forma net income of $3.91 billion or $0.53 per share for fiscal 2000, decreases of 21% and 23%, respectively.

Actual net loss for fiscal 2001 was $1.01 billion or $0.14 per share, compared with actual net income of $2.67 billion or $0.36 per share for fiscal 2000.

1. What concerns would an analyst likely have about the company’s $2.3 billion write-off of inventory? What is the significance of the company indicating its intent to scrap the written off inventory?

2. What concerns might an analyst have about the company’s earnings press release when the company subsequently released its annual earnings?