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Chapter 6: Problem 9

Applying IFRS The French Petroleum Company is a Paris-based oil and gas company that prepares its financial statements using IFRS. During the year, the management of the company undertook a review of the fair value of its oil and gas inventory and found that the inventory had appreciated above its book value of 55 million euros. According to the company's management, the oil and gas inventory was undervalued by 8 million euros. Prepare the journal entry to revalue the company's inventory. (Hint: Credit Asset, revaluation reserve.) How would the revaluation immediately affect the company's (a) current ratio, (b) inventory turnover, and (c) days \({ }^{+}\)sales in inventory?

Short Answer

Expert verified
The revaluation increases the current ratio, decreases inventory turnover, and increases days sales in inventory.

Step by step solution

01

Identify the Increase in Inventory Value

The inventory has appreciated by 8 million euros above its original book value of 55 million euros. This increase represents the undervalued amount that needs to be recognized in the financial statements.
02

Prepare the Journal Entry

According to IFRS, when inventory is revalued, any increase in fair value is credited to a revaluation reserve in equity. The journal entry will be: - Debit Inventory for 8 million euros to increase its value on the balance sheet. - Credit Revaluation Reserve (Equity) for 8 million euros to recognize the increase in value.
03

Effect on the Current Ratio

The current ratio is calculated as Current Assets divided by Current Liabilities. Since increasing the inventory value increases current assets, the current ratio will increase, assuming current liabilities remain constant.
04

Effect on Inventory Turnover

Inventory turnover is calculated as Cost of Goods Sold divided by Average Inventory. An increase in the inventory value will increase the denominator, potentially decreasing the inventory turnover ratio if sales or cost of goods sold do not increase proportionally.
05

Effect on Days Sales in Inventory

Days sales in inventory is calculated as 365 days divided by Inventory Turnover Ratio. With a lower inventory turnover ratio from the increased inventory value, the days sales in inventory would increase, indicating inventory is held longer.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Inventory Revaluation
When companies value their inventory, they might observe changes due to market conditions or other factors. Inventory revaluation allows a company to adjust the book value of its inventory to reflect fair value. In the context of IFRS, revaluing inventory can directly impact the financial statements by showing more accurate asset values. For the French Petroleum Company, their inventory was undervalued by 8 million euros, topping the book value of 55 million euros. They use this information to make their records more precise and trustworthy.
  • Revaluation involves assessing the fair market value.
  • The increase is typically recorded in 'Revaluation Reserve' under equity.
Updating the inventory value helps stakeholders get a clearer picture of the company's true worth.
Journal Entry
Recording an inventory revaluation requires a specific journal entry to reflect the changes accurately. In our example, the French Petroleum Company needs to show an increase in inventory by 8 million euros. The journal entry follows IFRS standards and is executed as follows:
  • Debit Inventory: This action increases the inventory account by 8 million euros, updating it on the balance sheet to its new value.
  • Credit Revaluation Reserve (Equity): By crediting this account, the company acknowledges the gain in inventory value, impacting the equity section of the balance sheet.
This process ensures the financial statements reflect the real worth of inventory, safeguarding against undervaluation and promoting transparency.
Financial Statements
Financial statements provide a summary of a company鈥檚 financial performance and condition. They include the balance sheet, income statement, and cash flow statement. Changes like an inventory revaluation directly affect these records. By adjusting inventory values, the French Petroleum Company benefits by presenting a more accurate asset valuation.
  • The balance sheet reflects the increased assets by the revised inventory value.
  • Equity is adjusted by the same amount via the revaluation reserve.
Accurate financial statements are crucial as they inform investors, creditors, and management in the decision-making process.
Current Ratio
The current ratio is a key financial metric used to evaluate a company's ability to cover its short-term obligations with its short-term assets. It is calculated by dividing current assets by current liabilities. When the French Petroleum Company re-evaluates its inventory, the added 8 million euros increases current assets, thereby boosting the current ratio.
  • Current Ratio = Current Assets / Current Liabilities
  • A higher current ratio indicates a stronger liquidity position.
Thus, by enhancing the inventory value, companies often find themselves in a more financially resilient position.
Inventory Turnover
Inventory turnover measures how many times a company's inventory is sold and replaced over a given period. Calculated as Cost of Goods Sold (COGS) divided by Average Inventory, it assesses the efficiency of inventory management. With the recent inventory increase, the French Petroleum Company might see a change in this ratio.
  • Inventory Turnover = COGS / Average Inventory
  • If the COGS remains the same but average inventory rises due to revaluation, turnover might decrease.
A lower turnover signals slower inventory movement, which could necessitate strategic adjustments to sales or production.
Days Sales in Inventory
The days sales in inventory metric shows the average number of days a company takes to sell its inventory. It is calculated by dividing 365 days by the Inventory Turnover Ratio. Following the revaluation of inventory, the French Petroleum Company may witness an increase in days sales in inventory.
  • Days Sales in Inventory = 365 / Inventory Turnover
  • An increase in this figure suggests that inventory is held longer.
While this can imply inefficiency, it can also reflect strategic choices like stockpiling inventory in anticipation of future demand. Companies need to monitor this closely to optimize inventory management.

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Most popular questions from this chapter

Lower-of-Cost-or-Net Realizable Value Method The McQuenny Company's ending inventory is composed of 100 units that had an acquisition cost of \(\$ 25\) per unit and 50 units that had an acquisition cost of \(\$ 30\) per unit. If 150 units have an NRV of \(\$ 27\) per unit, what value should be assigned to the company's ending inventory assuming that it applies the lower-of-cost-or-net realizable value method on an individual item basis?

Just-in-Time Inventories Nevada Manufacturing Company uses the perpetual inventory system and plans to use raw material costing \(\$ 2,100,000\) in making its products. Nevada will operate its factory 300 days during the year. Currently, Nevada follows the just-in-case philosophy with its raw materials inventory, keeping raw materials costing \(\$ 20,000\) in its raw materials inventory. Nevada plans to switch to the just-in-time manufacturing philosophy by keeping only the raw materials needed for the next two days of production. Calculate the new raw materials inventory level after Nevada implements the just-in-time manufacturing philosophy.

Describe how each of the following inventory costing methods is used with the perpetual inventory system: (a) Specific identification; (b) Weighted-average cost; (c) First-in, first-out; and (d) Last-in, first-out.

Inventory Costing Methods-Periodic Method Arrow Company is a retailer that uses the periodic inventory system. On August 1, it had 80 units of product \(\mathrm{A}\) at a total cost of \(\$ 1,600\). On August 5 , Arrow purchased 100 units of \(A\) for \(\$ 2,116\). On August 8 , it purchased 200 units of \(A\) for \(\$ 4,416\). On August 11, it sold 170 units of A for \(\$ 4,800\). Calculate the August cost of goods sold and the ending inventory at August 31 using (a) first-in, first-out, (b) last-in, first-out, and (c) the weighted-average cost methods. Round your final answers to the nearest dollar.

Departures from Acquisition Cost Determine the proper total inventory value for each of the following items in Parker Company's ending inventory: a. Parker has 70 model \(X 3\) cameras in stock. The cameras cost \(\$ 160\) each, but their year-end net realizable value is only \(\$ 140\). b. Parker has 600 rolls of film that are past the expiration date since film is now a slow moving item. The film cost \(\$ 2.00\) each and normally sells for \(\$ 4.00\). Parker has put the expired film on clearance and is selling it for \(\$ 1.50\) per roll. There are no related selling costs. c. Parker has five computers in stock that have been used as demonstration models. These computers cost \(\$ 400\) and normally sell for \(\$ 550\). Because they are used, Parker is selling them for \(\$ 350\) each. Expected selling costs are \(\$ 10\) per computer. New models of the computer (on order \(\mathrm{Z}\) ) will cost Parker \(\$ 420\) and will be priced to sell at \(\$ 590\).
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