ACIS5104 Virginia Tech Inventory Valuation and Disclosures Case Assignment I Requirements You are hired as an assistant controller at Reli ance Corporati

ACIS5104 Virginia Tech Inventory Valuation and Disclosures Case Assignment I Requirements

You are hired as an assistant controller at Reli

ance Corporation in March 2016 (see case below).

Respond to the following requirements. Assume a

35 percent tax rate throughout your analysis.

1. Evaluate management’s 2015 inventory write-

down (Exhibit 1) and related inventory

disclosures (Exhibit 3). Your evaluation should

address the following qu

estions on the timing of

recognizing the write-down, the amount of

the write-down, and the related disclosures.

a. Was the inventory write-down recorded

in an appropriate time period, or should

Reliance have either advanced or postponed

the recognition of the inventory write-down?

Explain. Give plausible reasons why Reliance

‘s management recorded the write-down in

the period that it did.

b. Was Reliance’s application of the LCM princi

ple consistent with GAAP? In particular,

address the appropriateness of:

i. the method of determining the amount of write-down, and

ii. the application of the LCM prin

ciple by major product categories.

2. Evaluate the Company’s approach to recording

the effect of selling th

e written-down inventory

in the first quarter of 2016. Your evaluation should address the following question:

What is the journal entry to

record the $18.6 million reduction

of the inventory allowance?

2

3. The CEO wants to reduce the al

lowance related to the memory

inventory in stock at the end of

the first quarter of 2016 by a

n additional $1.5 million. This r

educed allowance would signal to

the market that 2015 was an isolate

d year in terms of financial

performance. According to the

CEO, increasing the net value w

ould be consistent with the econ

omic reality because the

replacement cost of the memory products inventory – even by mos

t conservative estimates-has

gone up significantly since the

write-down recorded at the end

of 2015. Evaluate the CEO’s

suggestion. Your evaluation shou

ld address the following:

a. Present and explain the journa

l entry to record the addition

al reversal of inventory

allowance as suggested by the CEO.

b. What are the possible motivations in the CEO’s suggestion?

(Calculate

the

adjusted EPS based on the additional reversal of inventory to justify your answer) ACIS 5104-Fundamentals of Accounting
Case Assignment I, Spring 2019
Instructor: Paolo Petacchi
Objectives:
? To examine the issues of inventory valuation and disclosures and managerial motivations
in managing earnings.
?
To develop the skills required for analyzing financial statements.
Instructions:
? This is a graded homework assignment. You can use your book and notes to complete
this assignment. However, please work on the case individually.
?
Please read the attached case information carefully and answer all questions below. Please
write concisely and clearly, using your best composition skills.
?
This assignment is due on April 22, 2019. Please use the Assignments function in Canvas
to submit your assignment prior to class on the due date.
Requirements
You are hired as an assistant controller at Reliance Corporation in March 2016 (see case below).
Respond to the following requirements. Assume a 35 percent tax rate throughout your analysis.
1. Evaluate management’s 2015 inventory write-down (Exhibit 1) and related inventory
disclosures (Exhibit 3). Your evaluation should address the following questions on the timing of
recognizing the write-down, the amount of the write-down, and the related disclosures.
a. Was the inventory write-down recorded in an appropriate time period, or should
Reliance have either advanced or postponed the recognition of the inventory write-down?
Explain. Give plausible reasons why Reliance’s management recorded the write-down in
the period that it did.
b. Was Reliance’s application of the LCM principle consistent with GAAP? In particular,
address the appropriateness of:
i. the method of determining the amount of write-down, and
ii. the application of the LCM principle by major product categories.
2. Evaluate the Company’s approach to recording the effect of selling the written-down inventory
in the first quarter of 2016. Your evaluation should address the following question:
What is the journal entry to record the $18.6 million reduction of the inventory allowance?
3. The CEO wants to reduce the allowance related to the memory inventory in stock at the end of
the first quarter of 2016 by an additional $1.5 million. This reduced allowance would signal to
the market that 2015 was an isolated year in terms of financial performance. According to the
CEO, increasing the net value would be consistent with the economic reality because the
replacement cost of the memory products inventory – even by most conservative estimates-has
gone up significantly since the write-down recorded at the end of 2015. Evaluate the CEO’s
suggestion. Your evaluation should address the following:
a. Present and explain the journal entry to record the additional reversal of inventory
allowance as suggested by the CEO.
b. What are the possible motivations in the CEO’s suggestion? (Calculate the adjusted EPS
based on the additional reversal of inventory to justify your answer)
CASE
Reliance Corporation (Reliance, or the Company) is a leading semiconductor company
providing (1) analog and mixed signal products and (2) high-performance memory products for
communications, computing, industrial, and consumer electronics industries. Reliance’s primary
customers are manufacturers of personal computers, computer peripherals, networking
equipment, telecommunications products, and wireless products. These businesses are
characterized by rapid technological changes, evolving industry standards, heightened
competition, and product obsolescence.
Incorporated in Delaware in 1993, Reliance has been quite successful realizing average
gross profit margins of 35 percent for both product lines over the first decade of its existence.
The Company’s Board of Directors has consistently placed Reliance’s performance in the top
quartile in the semiconductor industry and has always approved a generous executive
compensation package (base salary, annual bonuses, and long-term incentives) to its senior
management. A minimum of 75 percent of the targeted annual bonus is based on the
achievement of predetermined corporate earnings goals beyond threshold levels of performance.
The current bonus agreement provides for an annual bonus to senior management equal to 75
percent of their base salary if earnings per share before non-recurring charges exceed $0.34 per
share. Up to an additional 25 percent of base salary may be awarded based on the Board of
Directors’ subjective evaluation of management’s performance. Stock option awards offered
under the long-term incentives plan provide for a vital partnership between senior management
and other shareholders.
The analyst community is also impressed with Reliance’s past performance and has
assigned a AAb rating to the Company’s bonds (an investment grade rating from Moody’s) as
well as a multiple of 22 to its earnings (i.e., a price to earnings ratio of 22). Its 2015 consensus
earnings estimate for Reliance was $0.35 per share.
Inventory Write-down in Fourth Quarter of 2015
The Company and the semiconductor industry overall did not perform well in 2015.
Specifically, the high-performance memory products segment of Reliance’s business
2
(traditionally representing 40 percent of the Company’s revenue) experienced a significant
downturn. Demand slackened because the growth in the computer and communications markets
was far less than estimated. Further, a Chinese firm-Chiang Corporation-began producing a
competing memory product that substantially increased industry supply. Combined, the domestic
industry suffered a severe erosion of both demand (decrease of 22 percent) and average selling
prices (decrease of 30 percent). Consequently, Reliance reported significantly lower 2015 sales
than expected for its high-performance memory products. Memory product sales decreased to
$120 million in 2015 while the memory product gross profit was a negative $30 million (-25
percent).
The Company’s policy is to value inventory at the lower of cost or market (LCM) for
each product category, rather than on an item-by-item, or total inventory basis. Management
completed a LCM analysis for both the analog and mixed signal inventories and the memory
product inventories in January 2016 (see Exhibit 1). No write-downs were recorded for the
analog and mixed signal products because their market values exceeded the cost. Although
sufficient demand for the memory products is expected for 2016, demand weakened, and the
downward pricing pressures from the weakened demand and increased supply caused the
Company to record an inventory write-down of $39.8 million before taxes in the fourth quarter
of 2015. This process consisted of writing down memory inventory of $129.8 million to its
estimated net realizable value of $90.0 million. The write-down is included in the cost of goods
sold and was recorded as follows ($ in millions):
2015
After the inventory provision, the Company reported a net loss for the year ended
December 31, 2015 of $50.4 million or $0.59 per share, substantially below the consensus
3
analysts’ earnings forecast of $0.35 per share.1 The Company issued its 2015 financial statements
on February 20, 2016. The Company’s summarized financial data for the past three years (2013,
2014, and 2015) are presented in Exhibit 2. Inventory-related disclosures from the 2015 financial
statements and Form 10-K are provided in Exhibit 3.
Subsequent Recovery of Inventory Values in First Quarter of 2016
On February 26, 2016, an explosion at Chiang Corporation’s factory destroyed a
significant portion of its production capability. Chiang Corporation’s management indicated that
it would take from two to three years to restore the capacity. As a consequence, market
conditions improved for Reliance and its competitors. Prices increased approximately 20 percent
toward the end of the first quarter of 2016, although they did not return to the levels enjoyed in
early 2015. Accordingly, analysts revised the first quarter and annual 2016 consensus earnings
forecast for Reliance to $0.14 per share and $0.43 per share, respectively (an increase from $0.04
per share and $0.17 per share, respectively).
2013
2014
2015
2013
2014
2015
1. The analysts’ estimates were prepared prior to the changing market conditions and therefore did not consider the
inventory write-down.
4
2015
2014, 2015
2014
2015
$0 in 2014
$39.8 in 2015.
2015
2015
2015
During the first quarter of fiscal 2016, the Company’s revenue from memory products
was greater than management had expected at the beginning of the quarter, when the yearend
LCM analysis was completed. Memory product revenue totaled $52.4 million with a gross
margin of 19.8 percent. The gross margin in the preliminary results for the first quarter of 2016
reported in Exhibit 4 reflects the reduced cost of goods sold from selling memory products that
had previously been written down by $18.6 million in 2015 (the portion of the 2015 inventory
write-down that related to inventory that was sold during the first quarter of 2016).
Management performed a LCM test for the inventory at the end of the first quarter of
2016 (see Exhibit 5). The analysis indicated that the market value of the memory products
exceeded the inventory’s recorded and historical cost.
5
March 31, 2016
March 31, 2016
2016
2016
201
2016
6
6
2015

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