Question

Joe Kang is an owner and audit partner for Han, Kang & Lee, LLC. As the audit on Frost Systems was reaching its concluding stages on January 31, 2016, Kang met with Kate Boller, the CFO, to discuss the inventory measurement of one its highly valued products as of December 31, 2015. Kang told Boller that a write-down of 20 percent had to be made because the net realizable value of the inventory was 20 percent less than the original cost recorded on its books. That meant the earnings for the year would be reduced by $2 million and the client would show a loss for the year. In a heated exchange with Boller, Kang was told to use the January 31, 2016, value, which reflected a full recovery of the market amount. Boller suggested that subsequent values were acceptable under GAAP. Besides, she said, that was the method the previous auditors had used. She went on to explain that the market value for this product was known to be volatile and a smoothing effect was justified in the accounting procedures. Kang was under a great deal of pressure from the other partners of the firm to keep Boller happy. It seems Frost Systems was about to embark on a variety of projects, on which it was considering having the firm provide consulting assistance, advice, and recommendations. The revenue from these arrangements could turn out to be twice the audit fees. Kang called a meeting of the other partners. While the three of them had different points of view on the issue, the final vote was 2-1 to accept the client’s accounting.

Do you think the client’s accounting approach to the market valuation of the inventory was acceptable under GAAP? Include in your discussion a brief explanation of why fair value measurements are difficult.

Answer 1

In this case Joe Kang suggestions were correct as inventories should be shown at net realisable value or book value whichever is less. Book value of inventories are relating to old business cycle which might not be the same in current scenario hence it is necessary to revalue such high valued products. The stand of Boller is not justified for showing inventories at old cost which will lead to misrepresentation of value of stock. The matter relating to inventory valuation has a significant value hence it is not at an acceptable value.

Fair value reporting is by very nature a difficult financial reporting standard, because financial reporting likes to present hard facts and valuation in just about every case will be based on known facts, but it still requires expression of an opinion and not simply reporting a fact. Where there is no established market for the financial item being valued it will be difficlut to derive the fair value and it will need more assumptions which cannot be standerdised in all the companies with same kind of business.