Client_Understanding_Paper

Client Understanding Paper After reviewing the financial papers of ABC Company, XYZ Accounting Inc. sent a request for more information and have been asked to clarify the need for the following information: lower of cost or market inventory valuation, capitalizing interest, gain or loss on asset disposal, and goodwill impairment. This paper is an explanation of the requested information. Inventory valuation Inventory usually accounts for a significant part of any company’s current assets, and to maintain accurate financial statements, it is necessary to measure properly ones inventory. The value of inventory is directly related to the cost of goods sold, and therefor affects the company’s working capital and net income. When valuing inventories it is necessary to know three things (1) the quantity of goods on hand, (2) the cash flow assumption from that inventory and (3) the market value of the inventory. The inventory quantity can be acquired by a physical count, perpetual records, or an estimate. There are four methods used to calculate cash flow assumptions, first-in first-out (FIFO), last-in first-out (LIFO), specific identification, or cost averaging. To avoid misleading investors, it is important to value the market value of inventory conservatively (Schroder, Clark, & Cathey, 2005). The lower of cost or market value (LCM) method as outlined in the Financial Accounting Standards Board (FASB) statement SFAC No. 2 is a conservative way to value inventory. This is a method, which uses the lower of either (1) the cost of the asset or (2) the market price or replacement cost of the asset to value inventory. For example, if a company purchases 20 computers for $600 a computer and a month later the computer manufacture introduces a new model of computer, the model the company purchased is then worth $400. The company will value the computers at $400 rather than $600, and report an inventory value of $8,000. Capitalizing Interest In addition to properly valuing inventory, it is important to value properly property, plant, and equipment. These assets are useful to investor because they are an indication of the company’s physical resources and potential for future cash flow and company liquidity. When accounting for the cost of plant, property and equipment, accountants must consider all expenses incurred in the purchase or construction of the asset. One of the costs in building construction that needs to be included in the cost of the building is any interest incurred during construction. This only includes the amount of interest incurred during the period of time the asset is under construction or being prepared for use. This is the interest on the debt that was used to finance the construction of the building. According to the FASB’s statement SFAS No. 34, interest should be capitalized or added to the cost of the building for the period of time the building was being prepared for use (Schroder, Clark, & Cathey, 2005). The capitalized interest is then considered part of the cost of the building and this is the amount reported on the balance sheet, and used to calculated depreciation expense for the asset. Interest incurred on the financing of the building after the building is put into use however, it is no longer considered part of the cost of the building it then becomes an operational expense. Gain or Loss on Asset Disposal When a company sells an asset for cash, the entire proceeds from the sell are recorded on the cash flow statement as an investing activity. When an asset is sold, traded or exchanged, and the transaction results in an amount less than the book value of the asset, the result is a net loss. Generally Accepted Accounting Principles require the transaction be recorded as a reduction of net income by the amount lost and is recorded in the operational section of the cash flow statement. When the transaction results in an amount more than the book value of the asset, the result is a net gain, this transaction will increase the net income on the cash flow statement. For example, if a company purchases a vehicle for $30,000 then uses the vehicle for five years, during this time the vehicle depreciates $12,000 and has a book value of $18,000. When the company sells the vehicle for $20,000 it recognizes a $2,000 gain from the sell. If however, the company were to have sold the vehicle for $15,000 it would have recognized a $3,000 loss. Goodwill for Impairment A company records goodwill on the financial statements when a it purchases another business for an amount above the fair value of the assets of that business. The value of goodwill recorded is calculated by subtracting the sum of all the assets of the business from the purchase price of the business. Goodwill is recognized on a separate line as an intangible asset on the balance sheet of the acquiring business. Impairment, on the other hand, occurs when the value of an asset has decreased more than the accumulated depreciation on that asset. According to FASB statement SFAS No. 121, companies must review the value of long-lived assets for impairment whenever the book value is affected adversely. Changes that affect an assets value include market value, the way the asset is used, legal factors or business climate that decrease the value of the asset, costs incurred on the asset that exceed the original cost of the asset, and forecast of continued losses incurred from the asset (Schroder, Clark, & Cathey, 2005). Goodwill for impairment occurs when the book value of the business purchased under goodwill increases. In this event, the value of goodwill decreases and the balance sheet is adjusted to goodwill for impairment. This loss decrease the company’s income on the balance sheet, as the value of the asset has decreased. For example, if a company purchases a business worth $100,000 for $500,000 it will record $400,000 of the expense as goodwill. After the purchase the value of the acquired business increases to $300,000 the company will adjust the goodwill for impairment by the difference of $200,000 therefor reporting a goodwill expense of $200,000. We hope this has been a helpful explanation of your questions, and ABC Company can understand the importance of reporting all company financial information accurately. If anyone at ABC Company has any further questions, we will be more than happy to assist you. References Financial Accounting Standards Board. (n.d.). FASB. Retrieved from http://www.fasb.org Mirza, A. A., Orrell, M., & Holt, G. J. (2008). Wiley IFRS. Practical Implementation Guide and Workbook (2nd ed.). : John Wiley & Sons, Inc.. Schroder, R. G., Clark, M. W., & Cathey, J. M. (2005). Financial Accounting Theory and Analysis (8th ed.). : John Wiley & Sons, Inc..