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? (1 pt.)

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. (3 pts.)

c. What other information might be useful in making the decision as to how the loss will be recognized on the income statement? (2 pts.)

d. What method would you choose and why? (1 pt.)

Answer 1

Part a:

Ethical accounting issue in this case is to ensure proper accounting treatment to record the write down of inventories. The accounting treatment must ensure proper and correct disclosure of financial performance of the company in the income statements. Hence, the write-down of $3,000,000 in the value of inventory must be included in the books of accounts in such a way to ensure true and correct picture of financial performance of the company in its financial statements.

Part b:

(1): Loss method:

Pros:

1. The net effect on the financial performance of the company will be clearly explained.
2. The actual financial performance will be reflected in the profit and loss account.

Cons:

1. The actual impact on the value of inventory will not be reflected.
2. The closing inventory will not be restated in actual value.

(2):

Pros:

1. The cost of goods sold will be higher.
2. The company will try to achieve higher profit with the use of this method.

Cons:

1. The cost of goods sold will be higher than the actual cost incurred o the goods.
2. Lower gross margin of the company.

Part c:

The following information will be helpful:

1. The market value of unwanted inventory.
2. The net realizable value expected from the inventory.
3. The reason for the inventory to be unwanted.

Part d:

The inventory value shall be adjusted to reduce the value of inventory to net realisable value in case the cost of the inventory is higher than net realisable value. This will reduce the profit of the company to the extent the inventory is overvalued and accordingly, the write off of $3,000,000 shall be adjusted.