ACIS 5104-Fundamentals of Accounting Case Assignment I, Fall 2018 Instructor: Sudip Bhattacharjee 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 October 29, 2018. 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 writedown? 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? 1 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? 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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