Financial Reporting and Analysis 【Reading 29】Sample company, capacity, following, 2012

kim226

Diabelli Inc. is a manufacturing company that is operating at normal capacity levels. Which of the following inventory costs is most likely to be recognized as an expense on Diabelli’s financial statements when the inventory is sold?

A) Administrative overhead.

B) Allocation of fixed production overhead.

C) Selling cost.

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Assuming normal capacity levels, allocation of fixed production overhead is a product cost that is capitalized as part of inventory. Thus, this cost will not be recognized as an expense until the inventory is sold (it becomes part of COGS for that period). Administrative overhead and selling costs are period costs that must be expensed in the period incurred.

terpsichorefan

thanks for sharing

kim226

United Corporation and Intrepid Company are similar firms operating in the same industry. United follows U.S. Generally Accepted Accounting Principles and Intrepid follows International Financial Reporting Standards. At the end of last year, Intrepid had a higher inventory turnover ratio than United. Are the following plausible explanations for the difference?
Explanation #1 – United accounts for its inventory using the first-in, first-out method and Intrepid uses the last-in, first-out method.
Explanation #2 – United recognized an upward valuation of inventory that had been previously written down. Intrepid does not revalue its inventory upward.

Explanation #1

Explanation #2

A) No Yes

B) No No

C) Yes No

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While the LIFO firm will typically report lower average inventory (higher inventory turnover), Intrepid cannot be a LIFO firm because LIFO is not permitted under IFRS. An upward revaluation of inventory would lower the inventory turnover ratio; however, United cannot revalue its inventory upward because it follows U.S. GAAP. U.S. GAAP prohibits upward inventory revaluations (except in very limited circumstances which are beyond the scope of the Level I exam).

kim226

When analyzing profitability ratios, which inventory accounting method is preferred?

A) Weighted average.

B) First in, first out (FIFO).

C) Last in, first out (LIFO).

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Using LIFO cost of goods sold (COGS) gives a more accurate measure of future earnings because the LIFO COGS is more representative of the current cost of product sold as compared to using FIFO therefore net income will be more accurately represented.

kim226

The inventory turnover ratio and the number of days in inventory are least likely used to evaluate the:

A) effectiveness of a firm’s inventory management.

B) age of a firm’s inventory.

C) stability of a firm’s inventory levels.

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Neither metric is directly relevant in evaluating the stability of a firm’s inventory levels. Determining stability would presumably require other information such as purchase and sales levels, for example. The inventory turnover ratio and the number of days in inventory can be used to evaluate the relative age of a firm’s inventory as well as the effectiveness of a firm’s inventory management.

kim226

Which of the following ratio levels would suggest that a company is holding obsolete inventory?

A) Low inventory value compared to cost of goods sold.

B) Low inventory turnover ratio.

C) Low number of days in inventory.

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Low inventory turnover (high number of days in inventory) may be a sign of slow-moving or obsolete inventory, especially when coupled with low or declining revenue growth compared to the industry. Low inventory value compared to cost of goods sold, however, implies a high inventory turnover ratio. This suggests much less risk of obsolescence.

kim226

Which of the following statements about inventory presentation and disclosures is most accurate?

A) IFRS permits reversals of inventory writedowns but the firm must disclose the circumstances of the reversal in its financial statements.

B) An analyst must determine which inventory cost method was used by examining the firm’s current and historical inventory values.

C) Changing from FIFO to LIFO is a change in accounting principle that must be applied retrospectively.

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IFRS requires a firm that reverses an inventory writedown to discuss the circumstances that led to the reversal. Both IFRS and U.S. GAAP require firms to disclose the inventory cost flow method they use. While a change to LIFO from another inventory cost method is a change in accounting principle, under U.S. GAAP this change is not applied retrospectively. The carrying value of inventory is considered to be the first LIFO layer.

kim226

Judah Inc. prepares its financial statements under IFRS. On December 31, 20X8, Judah has inventory of manufactured goods with a cost of $720,000. The estimated selling cost of that inventory is $50,000 and its market value is $740,000. By January 31, 20X9, none of the inventory has been sold but its market value has increased to $810,000. Selling costs remain the same. Which of the following entries is most likely permissible under IFRS?

A) Write down inventory by $30,000 on December 31, 20X8 and write up inventory by $30,000 on January 31, 20X9.

B) Write down inventory by $30,000 on December 31, 20X8 and write up inventory by $70,000 on January 31, 20X9.

C) Make no adjustments to the valuation of inventory on either date.

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IFRS rules require inventory to be valued at the lower of cost or net realizable value (NRV). NRV is calculated as estimated sales price less estimated selling costs. At December 31, 20X8, NRV = $740,000 − $50,000 = $690,000. Since cost is $720,000, then the lower of cost or NRV is $690,000 and a $30,000 writedown is required.
At January 31, 20X9, NRV = $810,000 − $50,000 = $760,000. Under IFRS, when inventory recovers in value after being written down, it may be “written up” and a gain recognized in the income statement. The amount of such gain, however, is limited to the amount previously recognized as a loss. Under IFRS it is not permissible to report inventory on the balance sheet at an amount that exceeds original cost, except in the case of some agricultural and mineral products. Since cost is $720,000, the lower of cost of NRV is $720,000.

kim226

Using the lower of cost or market principle under U.S. GAAP, if the market value of inventory falls below its historical cost, the minimum value at which the inventory can be reported in the financial statements is the:

A) net realizable value.

B) net realizable value minus selling costs.

C) market price minus selling costs minus normal profit margin.

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When inventory is written down to market, the replacement cost of the inventory is its market value, but the “market value” must fall between net realizable value (NRV) and NRV less normal profit margin. NRV is the market price of the inventory less selling costs. Therefore the minimum value is the market price minus selling costs minus normal profit margin.

kim226

Barber Inc. sells DVD recorders. On October 14, it purchased a large number of recorders at a cost of $90 each. Due to an oversupply of recorders remaining in the marketplace due to lower than anticipated demand during the Christmas season, the selling price at December 31 is $80 and the replacement cost is $73. The normal profit margin is 5 percent of the selling price and the selling costs are $2 per recorder.

Under U.S. GAAP, what is the value of the recorders on December 31?

A) $74.

B) $73.

C) $78.

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Under U.S. GAAP, market is equal to the replacement cost subject to replacement cost being within a specific range. The upper bound is net realizable value (NRV), which is equal to selling price ($80) less selling costs ($2) for an NRV of $78. The lower bound is NRV ($78) less normal profit (5% of selling price = $4) for a net amount of $74. Since replacement cost ($73) is less than NRV minus normal profit ($74), then market equals NRV minus normal profit ($74). As well, we have to use the lower of cost ($90) or market ($74) principle so the recorders should be recorded at the lower amount of $74.