August 20, 2012
As a new hire responsible for analyzing the working papers of additional information request will aid in the analysis. The information requested is the adjusting lower cost of market inventory, capitalizing interest on building construction, recording gain or loss on asset disposal, and adjusting for goodwill. The following is an explanation of why the information is necessary to complete the analysis.
Adjusting Lower Cost of Market
???To ensure the proper matching of expenses and revenues, decreases in the value of inventory due to usage, damage, deterioration, obsolescence, and other factors must be recognized in the accounting period during which the decreases occurs rather than the period during which the merchandise sells??? (John Wiley & sons Inc., 2012, p. 1). How a company values inventory is important for two reasons. First, inventory is a major portion of current assets and has an impact on working capital and the company??™s financial position. Second, valuation has an immediate and major impact on net profits. Because market values fluctuate inventory costs can increase resulting in lower profits. Using the lower of cost or market values is a conservative way to value inventory and is consistent with SFAC No. 2 (qualitative characteristics of accounting information) and SFAC No. 6 (assets and losses definitions). ???That is, when the cost of inventory exceeds its expected benefit, a reduction of the inventory to its market value is a better measure of its expected future benefits??? (Schroeder, 2011, p. 268). To prevent inflated earning of the same period testing is required annually by Generally Accepted Accounting Principles (GAAP) to adjust inventory balances to LMC. If replacement costs are less than historical costs, inventory is adjusted to reflect decrease, and a loss is recorded. If the replacement costs are higher, the inventory remains at historical costs or LMC.
???Net realizable value is then used to calculate the ceiling and the floor on the replacement cost??? (Business Accounting Guides, 2012, p. 1). The net realizable value (NVR) is the selling price minus costs or the ceiling for market and the lower limit or floor is the NVR minus normal profit. If the replacement cost is higher than the ceiling amount is used but if it is lower than the floor it is used for valuation.
The interest incurred during the construction of a new building can be capitalized as long as the interest is incurred to ready the asset for use. The interest is added to the historical cost of the building and depreciated over the life of the asset. ???Qualified assets are defined as (1) assets that are constructed or otherwise produced for an enterprise??™s own use, and (2) assets intended for sale or lease that are constructed or otherwise produced as discrete projects??? (Schroeder, 2011, p. 287). Capitalization begins when expenses begin to occur, however, if there is a delay in construction, interest is not capitalized during this period resulting in a holding cost. Any interest incurred after the asset is ready for use is charged to operations, such as inventories routinely manufactured or repetitively produced in large quantities. Sometimes capitalization of interest is overlooked, causing the value of the asset to be understated. ???Although the capitalization can seem counter intuitive at times, it is required by GAAP and the Internal Revenue Code??? (Patel, CPA, 2010, p. 1).
Assets bought by a company usually become inefficient, obsolete or is at the end of its life cycle, it is necessary to dispose the asset to acquire a replacement. When an asset is sold for less or more than its book value, an adjustment must be made to on the cash flow statement that reflects the gain or loss on the asset. After the sale of an asset the following must be recorded:
* Bring the asset cost and accumulated depreciation to a zero balance
* The amount received from the sale
* Report any differences as a gain or loss.
The asset is removed from the account balance and gains or losses are reported on the income statements as disposal of non-current assets. The disposed asset will be reported in the cash flow statement under investing activities, and the gain will be deducted or the loss added to income from operations.
Goodwill is the premium that a company pays for an acquisition, the difference between the fair value of the asset and the ending cost of acquiring the asset. Examples of goodwill are trademarks, patents, client lists, or reputation of quality of service. Goodwill is treated as an intangible asset, listed on the balance sheet, and tested for impairment annually. If a source of goodwill becomes obsolete, the company can write down to the amount of the goodwill to reflect the impairment. For example, if the market value falls below book value impairment should be written down. On the other hand, if the goodwill exceeds market capitalization, expect impairment in the future. Companies carrying goodwill usually have valid reasons but management should explain assumptions when dealing with goodwill. Goodwill impairments do not involve the exchange of cash, it does, ???however, affect its GAAP earning, and charges have been known to decimate companies??™ income statements at times??? (Jones, 2009, p. 2). Sometimes a company has debt tied to goodwill or intangible assets and if the value of the goodwill decreases the financial institution may freeze the company??™s borrowing capacity. Two ways to deal with goodwill, including the goodwill or treating as nonexistent.
The main reason for the information request is to be sure that working papers are reasonably free of misstatement and are properly prepared according to GAAP. Adjusting inventory values ensures expenses match revenues during the period. Because capitalizing interest is sometimes overlooked, it is import to know what is permitted or required in capitalizing new construction. Making adjustments for gains and losses is important because it has an effect on financial statements. Goodwill is tricky, and one must be careful valuing the intangible asset. Each item will aid in the analysis of the company??™s financial position.
Business Accounting Guides. (2012). Lower of Cost or Market. Retrieved from http://business-accounting-guides.com/lower-of-cost-or-market/
John Wiley & sons Inc. (2012). Cliff Notes: The Valuation of Merchandise. Retrieved from http://www.cliffnotes.com/study_guide/The-Valuation-of-Merchandise.topicArticleId-21081,articleId-20167.html
Jones, C. (2009). Goodwill: You Cant Touch This. Retrieved from http://www.fool.com/investing/general/2009/03/13/goodwill-you-canttouch-this.aspx
Patel, CPA, A. (2010). New Building Capitalization of Interest. Retrieved from http://fblg-cpa.com/Library/Accountin/New-Building-Capitalization-of-Interest.php
Schroeder, R. G. (2011). Financial accounting theory and analysis: Text readings and cases (10th ed.). Hoboken, NJ: Wiley.