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. Evaluate management's 2015 inventory write-down (Exhibit 1) and related inventory lisclosures (Exhibit 3). Your evaluation should address the following questions on the timing of ecognizing 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. Evaluate the Company's approach to recording the effect of selling the written-down inventory n 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? 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 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): " Market values are the current replacement costs and have been subjected to the ceiling (estimated net realizable value) and floor (estimated net realizable value minus estimated normal profit margin) constraints. The Company uses a range of market values to reflect the uncertainty involved in their determination. 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 10K 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). EXHIBIT 2 Summary Financial Information Balance Sheet Information ( $ in millions): Statement of Operations Information ( $ in millions except per share amounts): 1. The analysts' estimates were prepared prior to the changing market conditions and therefore did not consider the inventory write-down. (A) Summary of Accounting Policies Footnote (Inventory) Inventory is stated at the lower of the first-in, first-out cost or market. Market is based on the estimated net realizable value or current replacement cost. Open purchase order commitments are evaluated on an ongoing basis and expected loss is accrued, if appropriate. Provision of inventory allowances is based on excess and obsolete inventories determined primarily by future demand forecasts. (B) Inventory Footnote Inventories as of December 31. 2014, 2015 are as follows (\$ in millions): As a result of reduction in demand and downward pricing pressure for memory products, the Company recorded a charge to cost of goods sold totaling $39.8 million during fiscal year 2015 The effect of the inventory provision was to write inventory of $129.8 million down to its net realizable value of $90.0 million. The 2015 gross profit would have been $59.4 million or 15 percent if the inventory provision had not been made. (C) Management's Discussion and Analysis of Financial Condition and Results of Operations Our policy is to value inventory at lower of the cost or market for each product category. This policy requires us to make estimates regarding the market value of our inventory, including an assessment of excess or obsolete inventory. We determine excess and obsolete inventory based on an estimate of the future demand for our products within a specified time horizon, generally one year. The estimates we use for demand are also used for short-term capacity planning and inventory purchasing. For the year ended December 31,2015 , the Company recorded an inventory write-down of $39.8 million before taxes as a result of a reduction in demand and downward pricing pressure for memory products. No inventory write-downs were recorded for the analog and mixed signal products. If our demand forecast is greater than our actual demand, or if inventory obsolescence is higher than expected, then it may be necessary to take additional inventory charges, which will decrease gross margin in the future. 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 analvsis indicated that the market value of the memorv products Statement of Operations Information ( $ in millions except per share amounts): " First quarter 2016preliminary amounts reflect the reduced cost of goods sold for the memory products that had been previously written down, but before recording any other inventory allowance adjustments. 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. Evaluate management's 2015 inventory write-down (Exhibit 1) and related inventory lisclosures (Exhibit 3). Your evaluation should address the following questions on the timing of ecognizing 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. Evaluate the Company's approach to recording the effect of selling the written-down inventory n 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? 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 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): " Market values are the current replacement costs and have been subjected to the ceiling (estimated net realizable value) and floor (estimated net realizable value minus estimated normal profit margin) constraints. The Company uses a range of market values to reflect the uncertainty involved in their determination. 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 10K 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). EXHIBIT 2 Summary Financial Information Balance Sheet Information ( $ in millions): Statement of Operations Information ( $ in millions except per share amounts): 1. The analysts' estimates were prepared prior to the changing market conditions and therefore did not consider the inventory write-down. (A) Summary of Accounting Policies Footnote (Inventory) Inventory is stated at the lower of the first-in, first-out cost or market. Market is based on the estimated net realizable value or current replacement cost. Open purchase order commitments are evaluated on an ongoing basis and expected loss is accrued, if appropriate. Provision of inventory allowances is based on excess and obsolete inventories determined primarily by future demand forecasts. (B) Inventory Footnote Inventories as of December 31. 2014, 2015 are as follows (\$ in millions): As a result of reduction in demand and downward pricing pressure for memory products, the Company recorded a charge to cost of goods sold totaling $39.8 million during fiscal year 2015 The effect of the inventory provision was to write inventory of $129.8 million down to its net realizable value of $90.0 million. The 2015 gross profit would have been $59.4 million or 15 percent if the inventory provision had not been made. (C) Management's Discussion and Analysis of Financial Condition and Results of Operations Our policy is to value inventory at lower of the cost or market for each product category. This policy requires us to make estimates regarding the market value of our inventory, including an assessment of excess or obsolete inventory. We determine excess and obsolete inventory based on an estimate of the future demand for our products within a specified time horizon, generally one year. The estimates we use for demand are also used for short-term capacity planning and inventory purchasing. For the year ended December 31,2015 , the Company recorded an inventory write-down of $39.8 million before taxes as a result of a reduction in demand and downward pricing pressure for memory products. No inventory write-downs were recorded for the analog and mixed signal products. If our demand forecast is greater than our actual demand, or if inventory obsolescence is higher than expected, then it may be necessary to take additional inventory charges, which will decrease gross margin in the future. 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 analvsis indicated that the market value of the memorv products Statement of Operations Information ( $ in millions except per share amounts): " First quarter 2016preliminary amounts reflect the reduced cost of goods sold for the memory products that had been previously written down, but before recording any other inventory allowance adjustments