Question

L Co. has not been very profitable for the past three years. Additionally, a recently-ousted manager purchased a substantial quantity of inventory earlier this year…inventory whose customer desirability has waned to some extent. As such, the inventory value has declined below its cost and two methods of handling the write-down are being discussed: showing the amount of the write-down ($3,000,000) as a line item loss on the income statement and showing the loss as part of cost of goods sold. Both methods are GAAP.

a. What is the ethical accounting issue in this situation?

b. Considering the qualitative characteristics of accounting as well as basic accounting concepts, discuss pros and cons of using (1) the loss method and (2) the CGS method.

c. What other information might be useful in making the decision as to how the loss will be recognized on the income statement?

d. What method would you choose and why?

Answer 1

a) The ethical accounting issue in this situation is to either disclose the loss of inventory write-down of $ 3,000,000 as the separate line item or to include it in cost of goods sold.

b) The advantages of accounting the inventory write off under the loss method is that the loss appears as a separate line item in the Income statement and hence it can be easily be inferred from the face of the Income statement. The management usually resorts to this method, when the amount involved is substantial and separate disclosure is needed to enable informed decision making.

In this method of accounting, the cost of these inventory, still appears in the cost of goods sold in order to balance the impact of the loss shown separately in the income statement.

The Cost of Goods sold (CGS) method is the usual accounting treatment in inventory write off. In this method, the loss on sale of inventory is included in the cost of goods sold, thus cost of good sold becomes higher.

The main disadvantage of using the CGS method is that significant loss due to inventory write-offs cannot be traced separately from the income statement.

c. The company has been struggling with profits in last 3 years. Also, the inventory’s demand has declined and has fallen below its cost. This is a major event which the various stakeholders’ must be aware off as the amount involved in the write-down is also huge.

d. The accounting under write-off method is preferred because of the reasons that given the circumstances and amount involved, separate disclosure is needed to make a fair disclosures of the loss to the various stakeholder’s involved.