CH 07 SM
CH 07 SM
CH 07 SM
7.1 Under GAAP, inventory is carried at the lower of cost and market.
Market is most commonly either replacement cost or net realizable
value. When the calculated cost figure is materially different from
recent cost figures, companies should be applying the lower of cost and
market valuation method.
7.2 The lower of cost and market rule can be applied to individual items, to
pools of similar items or to the inventory as a whole. Because it is not
practical to apply it on an individual basis, most companies use either
pools of inventory or the whole inventory. The cost of the inventory
which has been assigned using either specific identification, FIFO,
LIFO or weighted average is compared to the market value (usually
either replacement cost or net realizable value). The lower value is
used. If the market value is used because it is lower, then subsequent
recoveries can be recognized to the extent of the write-down(s). This
treatment is similar to that of temporary investments, in which
recoveries are also recorded back to the original cost, if subsequent
increases in market value occur.
1
inventory. In a periodic system when a new inventory item is
purchased it is added to a purchases account. When an inventory item
is sold, no entry is made to the inventory account until the end of the
period when the ending inventory is counted and costed. The cost of
the ending inventory is then used to calculate the amount that should
be removed from the inventory account for the sales during the period.
During the period the inventory account retains its beginning or period
balance. See the answer to Question 7.5 for the advantages and
disadvantages of the two methods.
7.5 The advantage of the perpetual system over the periodic system is that
management has continuously updated information available
concerning inventories and cost of goods sold. This is very important
for inventory management purposes. The disadvantage is that
perpetual systems are more costly to implement. Prior to the advent of
low-cost computing power perpetual systems were only used for low-
volume, high unit cost types of inventories (such as in a car
dealership). Another advantage of the perpetual system is that
inventory shrinkage can be independently determined by combining
the perpetual information with a physical count. An additional cost of
the perpetual system is that the company also has to count its
inventory periodically to verify shrinkage and to assess the integrity of
the perpetual information.
The advantage of the periodic system is that it is less costly. However,
management does not have updated information about inventory
levels. It also has a difficult time determining the amount of inventory
shrinkage. The cost of goods sold is determined by adding the
purchases for the period to the beginning inventory and then
subtracting the inventory cost determined from the physical count. It
is assumed that any inventory that is not there to be counted has been
sold.
7.6 The three major cost flow assumptions are FIFO, LIFO and weighted
average. FIFO (first-in, first-out) assumes that the cost of the first unit
purchased is the first cost to appear in the income statement (in Cost of
goods sold). LIFO (last-in, last-out) assumes that the cost of the last
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unit purchased is the first cost to appear in the income statement.
Weighted average computes an average cost for all units in beginning
inventory and the purchases during the period and assigns this
average cost to the units sold during the period. It is important to
remember that cost flow does not have to match the physical flow of
goods. In fact, in most cases inventory physically flows in a FIFO
manner as companies rotate their inventory and attempt to sell older
items first.
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LIFO most holding gains are unrealized since the cost shown in income
is the current cost. Ending inventory is carried at older prices and
thus contains most of the holding gains. Under FIFO most holding
gains are realized (included in income) since the cost of goods sold
figure is based on older unit prices. Whereas ending inventory is
carried at the most recent prices. The weighted average cost flow
assumption would produce results closer to FIFO but some holding
gains would remain in ending inventory and be unrealized.
7.9 The three main reasons that a company would need to estimate cost of
goods sold or inventory would be: a) the inventory has been destroyed
or stolen and it is impossible to count it; 2) the company wants to
prepare monthly financial statements but does not want to incur the
cost of counting the inventory; and 3) the company wants to have an
estimate of the inventory it has before it begins the physical count so
that it can determine whether goods have been lost or stolen.
7.10 Assuming a trend of rising prices LIFO will produce balance sheet
values of inventory that are significantly lower than those under FIFO.
The cost of goods sold under LIFO will generally be higher than that
under FIFO in any given year. The effect on balance sheet ratios, such
as the current ratio are that a LIFO company will report a lower
inventory value (relative to a FIFO company) and therefore a lower
current ratio (all other things held constant). Ratios that involve total
assets (such as Return on assets) will also be affected by the choice of
LIFO versus FIFO.
The inventory turnover ratio is directly impacted by the choice of LIFO
versus FIFO. The inventory turnover matches units sold in the
numerator with average units on hand in the denominator. The ideal
ratio would be to compute the ratio using the unit figures.
Unfortunately this information is not available in the annual report.
The cost futures are therefore used. Under LIFO the cost of goods in
the numerator is based on new unit cost, however, the denominator is
based on old unit costs (sometimes very old depending on how long ago
the first inventory was purchased). The ratio is therefore distorted and
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typically is biased upward (in periods of rising prices). Under FIFO, on
the other hand the numerator is based on slightly old unit prices,
whereas the denominator is based on current prices. The bias under
FIFO is not as severe as that under LIFO because the disparity
between unit prices in the numerator and denominator is not as great.
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7.11 a) Weighted average
b) FIFO
Units sold = 30,000 - 10,000 = 20,000
Cost of goods sold = (8,000 x $18.00) + (4,000 x $17.50 ) + (8,000 x
$15.00) = $334,000
c) LIFO
Units sold = 30,000 - 10,000 = 20,000
Cost of goods sold = (6,000 x $14.50 ) + (12,000 x $15.00 )+ (2,000 x
$17.50) = $302,000
7.12 a) FIFO
Ending inventory = $19,000 + 1500 x (42,500 / 2,500)
= $44,500
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b) LIFO
Ending inventory = 30,000 + 500 (45,000/3,000)
= $37,500
c) Weighted average
Ending inventory = 2,500 x [(30,000 + 45,000 + 16,000 + 66,000 +
42,500 + 19,000) / 13,500]
= $40,462.96
7.13 a) FIFO
Total units sold = 270
Cost of Goods sold = (60 x 4) + (200 x 5) + (10 x 9)
= $1,330
Gross profit = (100 x 9) + (170 x 10) - 1,330
= $1,270
b) LIFO
Total units sold = 270
Cost of goods sold = (60 x 7) + (40 x 9) + (170 x 5)
= $1,630
Gross profit = (100 x 9) + (170 x 10) - 1,630
= $970
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7.14 a)
Average cost Specific
Identification
Cost of goods sold $11,200 $8,800
Ending inventory $ 5,600 $8,000
Average cost
(1,800 + 6,000 + 2,800 + 3,000 + 2,000 + 1,200) / 6 = $2,800
Cost of goods sold = 4 x 2,800 = $11,200
Ending inventory = 2 x 2,800 = $5,600
Specific Identification
Cost of goods sold = 1,800 + 2,800 + 3,000 + 1,200 = $8,800
Ending inventory = 6,000 + 2,000 = $8,000
7.15 a) FIFO
Total units sold
= 11,500
Cost of goods sold
= $60,000 + $44,000 + 1,500($60,000 / 5,000)
= $122,000
Ending inventory
= 3,500 x (60,000 / 5,000)
= $42,000
b) LIFO
Total units sold
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= 11,500
Cost of goods sold
= $60,000 + $44,000 + 2,500($60,000 / 6,000)
= $129,000
Ending inventory
= 3,500 x ($60,000 / 6,000)
= $35,000
c) Weighted average
Total units sold
= 11,500
Average cost
= ($60,000 + $44,000 + $60,000) / 15,000
= $10.93
Cost of goods sold = 11,500 x $10.93
= $125,733.33
Ending inventory
= $38,266.67
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7.16 a) Computation of Cost of Goods Sold
c) Weighted average
Average cost
= $57,150 / 2,900
= $19.71
(The average cost is calculated here by including the
transportation-in costs in the amount used to determine the unit cost.
It is also possible to calculate the unit cost without the transportation-
in costs and then to add them to the cost of goods sold.)
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Cost of goods sold = 2,000 x $19.71 = $39,420
Ending inventory = $57,150 - $39,420 = $17,730
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7.17 a) Acquisition cost
Year Sales Cost of goods sold Gross margin
c) The gross margin is higher using the acquisition cost basis in year
one
because market value has fallen below cost. If cost is used as the
basis of valuation, that ending inventory is higher and cost of goods
sold is lower than under the lower of cost and market basis. In year
two, the higher inventory value is carried forward as beginning
inventory, so that cost of goods sold is higher under the acquisition
cost basis. However, the market value of ending inventory is again
below cost, making cost of goods sold lower (and gross margin
higher) under the acquisition basis. In year three, the cost of ending
inventory is below its market value, so that cost (rather than market)
is used under both the acquisition cost and the lower of cost and
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market methods. Still, the gross margin is higher under the lower of
cost and market basis because a lower value of inventory is carried
forward from the prior year as beginning inventory. In the final
year, the gross margin is the same under both methods because the
cost and market values of inventory are the same, and beginning
inventory is also the same for both methods.
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7.18 a) If the lower of cost and market valuation basis is to be applied, and the market
is defined as replacement cost then the inventory should be valued at $18,000 ($6
x 3,000). If market is defined as net realizable value, then the NRV amount would
need to be determined before the lower of cost and market decision can be made.
Other information needed to determine the year-end reporting amount includes the
cost of damaged or obsolete screwdrivers.
b) The decline in replacement cost is relevant because replacement
cost
represents the amount that is required in order to re-purchase the
current number of screwdrivers. If replacement cost has fallen, this
might be indicative of a decline in the realizable value of the
screwdrivers.
c) In 20x1 and 20x2, LIFO shows the highest income. In 20x3, FIFO
shows the highest income. In 20x4, the lower of FIFO cost and market
shows the highest net income. (HINT: to answer this question, assume
purchases in each of the four years was $500,000. Calculate the COGS
for each of the four years under each method. Remember that ending
inventory from the previous year is the beginning inventory of the
current year. The lowest COGS will produce the highest net income.)
d) LIFO shows the lowest income for the four years combined.
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7.20 a)
Units Unit cost Cost
Beginning inventory 15,000 $15 $ 225,000
Production 85,000 18 1,530,000
Additional production 25,000 20 500,000
Ending inventory 0 0
Cost of goods sold 125,000 $2,255,000
b)
Units Unit cost Cost
Beginning inventory 15,000 $15 $ 225,000
Production 85,000 18 1,530,000
Additional production 100,000 20 2,000,000
Ending inventory (75,000) (1,305,000)
Cost of goods sold 125,000 $2,450,000
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7.21 a)
Beginning inventory $ 30,000
Purchases 210,000
Transportation-in 1,200
Ending inventory (??)
Cost of goods sold 40% of $490,000 $196,000
Therefore, ending inventory should be $45,200
7.22 a)
Beginning inventory $28,000
Purchases 84,000
Ending inventory (??)
Cost of goods sold 64% of $140,000 $89,600
Therefore, ending inventory should be $22,400
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7.23 a) FIFO
Units Cost per Unit Total Cost
Beginning Inventory 3,500 $250 $ 875,000
Add: Produced 5,000 400 2,000,000
Goods for Sale 8,500 2,875,000
Less: End. Inventory 4,500 400 1,800,000
Cost of Goods Sold 4,000 $1,075,000
Sales 4,000 $600 $2,400,000
Less: Cost of Goods Sold 1,075,000
Gross Margin $1,325,000
LIFO
Units Cost per Unit Total Cost
Beginning Inventory 3,500 $250 $ 875,000
Add: Produced 5,000 400 2,000,000
Goods for Sale 8,500 2,875,000
Less: End. Inventory1 4,500 See Note 1,275,000
Cost of Goods Sold 4,000 $1,600,000
Sales 4,000 $600 $2,400,000
Less: Cost of Goods Sold 1,600,000
Gross Margin $ 800,000
1
$1,275,000 = (1,000 x $400) + (3,500 x $250)
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b)FIFO
Units Cost per Unit Total Cost
Sales 4,000 $600 $2,400,000
Less: Replacement COGS 4,000 4001 1,600,000
Operating Margin $ 800,000
Add: Realized Holding Gains:
Replacement COGS 1,600,000
Less: Historical COGS2 1,075,000
525,000
3
Gross Margin $1,325,000
LIFO
Units Cost per Unit Total Cost
Sales 4,000 $600 $2,400,000
Less: Replacement COGS 4,000 4001 1,600,000
Operating Margin $ 800,000
Add: Realized Holding Gains
Replacement COGS 1,600,000
Less: Historical COGS2 1,600,000
0
3
Gross Margin $ 800,000
1
Based on average production cost during the year.
2
From solution to part a)
3
Note that this is the same as the gross margin in part a).
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c) Unrealized Holding Gains
FIFO LIFO
Replacement Cost of Ending
Inventory1 $2,250,000 $2,250,000
Less: Historical Cost of Inventory2 1,800,000 1,275,000
Unrealized Holding Gain on
Ending Inventory $ 450,000 $ 975,000
Total Gains:
Operating Margin $ 800,000 $ 800,000
Add: Realized Gain 525,000 0
Unrealized Gain 450,000 975,000
Total Gain $1,775,000 $1,775,000
1
4,500 units x $500/unit (Replacement Cost) = $2,250,000
2
From solution to part a).
d) The total gains under both cost flow assumptions are the same.
The reason is that economic income is independent of the cost flow
assumption and the cost flow assumption only affects the timing as to
when income is realized. Note that under LIFO the income reported is
less ($800,000) than that under FIFO ($1,325,000), however, the
unrealized gains are higher ($975,000) than that under FIFO
($450,000). This suggests that when the LIFO layers are liquidated,
the difference ($525,000) will be realized.
7.24 a)
Inventory turnover
Stream Ltd. $470 / [($200 + $160) / 2] = 2.61
Competitor $900 / [($400 + $450) / 2} = 2.12
b)
Gross margin percentage
Stream Ltd. ($600 - $470) / $600 = 21.7%
Competitor ($1,250 - $900) / $1,250 = 28%
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c) On the basis of inventory turnover, Stream is superior because it turns over its
inventory more often.
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the inventory also is very important. Are appropriate amounts of
inventory carried for those products that sell quickly versus those
that sell slowly? If it is a manufacturing company, are there
appropriate balances in the amounts of raw materials, work-in-
process and finished goods inventories? Another measure of
operating success is the amount of inventory that has been returned
by customers as unsatisfactory.
7.26 The foreign competitor might use different accounting policies, such as
different valuation bases for inventory. Different accounting policies
will mean that it is difficult to compare the two companies. A good
understanding of the accounting policies in Canada and in the foreign
country will enable a better understanding of ratios.
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Management Perspective Problems
7.27 In comparing a Canadian and a Japanese company you would first want to
make sure that there were not significant differences in the accounting
principles used by the two companies. If there are significant differences then
the best adjustment would be to convert them to the same principles if
enough information is supplied to do so. For many ratios, such as ROI,
current and quick ratio, etc., there is no need to convert from yen to dollars as
the units of currency are canceled in the calculation of the ratio. Common
size statements could also be used without any adjustment. The only time
you might want to convert would be if you wanted to make some direct
comparisons of balance sheet or income figures as a direct comparison of
sales.
7.29 As a lender, you would be concerned if the company switched from LIFO
to FIFO because this could be a signal that the company would not otherwise
meet the restrictive debt covenant, and its sole motivation for switching
accounting methods is to remain within the covenant. However, FIFO does
result in a more accurate representation of the cost of inventory on hand,
because it allocates more recent costs to inventory. LIFO, on the other hand,
can understate the current ratio because, during a period of rising prices,
inventory is composed of the oldest costs. If the company was in financial
distress, you would be much more concerned about an accounting change
from LIFO to FIFO, because this change is likely an attempt to satisfy the
debt covenants and improve reported operating profits.
7.30 Ratios are very useful as they draw on relationships within the financial
statements. For instance, inventory turnover relates the cost of goods sold to
the level of inventory on the balance sheet. Auditors are very interested in
these relationships. The auditor would be particularly interested in changes
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in the ratios over time as these might signal potential problems or changes in
the recording of amounts in the financial statements.
7.31 a)The lower of cost and market rule should be followed if Proposal 1 is adopted
with the inventory reduced from the current carrying value of $3,500,000 to its expected
selling prices of $2,000,000. A loss of $1,500,000 should be reported when the carrying
value is reduced. With Proposal 2, it appears the company will make a profit if the
inventory is sold to third-world countries and no reduction in carrying value would be
needed.
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b) One alternative is for the company to continue to market the
product in
the normal manner. It does have low fat content. A high salt content
is a relative judgment and it is not the only product on the market with
high salt content. Many popular products also have preservatives. It
is not clear whether or not the chemical preservatives actually are
harmful to those who consume the product. Since sales apparently
have fallen dramatically, the company would need to either launch a
new sales campaign, redesign the product, or discontinue the product
and sell the remaining inventory as suggested in Proposal 1.
Selling the remainder of the product to the public may involve other
losses beside those absorbed on this product. The company has lost
sales due to the publicity and additional adverse publicity is likely to
hurt the sales of other products. The company may be much better off
if it pulls the product from the market and sells it to be blended into
cattle or hog feed.
If management has concluded the product is unhealthy, the company
might elect to remove the product from the consumer market as well in
response to a sense of social responsibility.
The second proposal by the company is to sell the product in third-
world countries. If the standards are not sufficient to protect the
consumers in those countries, the consumers may currently be buying
products of much poorer quality or that may be much more harmful
than this product. This line of reasoning leads to the conclusion that
everyone would be better off if the product is sold in the third-world
countries. Our government would even be better off since sale in the
international markets would help Canada by contributing to its level of
exports.
However, it is worth noting that though the product has not been
banned in Canada, its popularity has dropped as a result of adverse
publicity associated with selling what some regard as an unhealthy
product. If it is argued that the company should not sell the product in
Canada because it is not healthful, the same argument would apply to
sales in third-world countries.
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Many other perspectives may be presented for this case. As suggested
above, it might be suggested the company go back to the test labs and
redesign the product to reduce the salt content and amount of
preservatives. It could then produce a new improved version of the
product and advertise that it is sensitive to the dietary needs and
health of its customers and wishes to market only products of highest
quality.
This case is intended to raise a spectrum of questions faced daily by
business entities. At one end of the spectrum of thought, virtually no
product in the marketplace is as good as it could be. Automobiles could
have better brake systems and accident restraint devices than are
currently employed. Most breakfast cereals could have less sugar
content and more vitamins. Nearly all of the pieces of clothing you
wear can be set on fire and will burn. At what level of flammability
should clothing be kept from the market? How does a conscientious
management conclude that one piece of clothing should be produced
and another not, that it should reduce the sugar content of its most
popular cereal, or put better brake systems on its automobiles? In
some cases, standards have been developed by industry or government
agencies and products are rated. However in many cases such guides
are not available.
Management is responsible for the quality of the product it sells to
customers and also is responsible for earning a fair return to the
investors who created the company. Neither the customers nor the
investor is well served if products of poor quality are produced, nor are
they well served if the company attempts to sell a product of such high
quality that the company eventually goes out of business.
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litigation is already in process, disclosure should be made in the
footnotes to the financial statements.
7.32 a) The estimated cost of Black Lights inventory on hand at the end of
the first quarter of 2001 is $510,000 estimated using the gross profit
method as follows:
b) The gross profit method works reasonably well for interim estimates
of
inventory on hand, but it is not accurate enough to use regularly in
annual financial statements. Changes in underlying cost patterns and
other changes could easily result in highly inaccurate dollar amounts
being reported if only estimates were used in determining the balance
in inventory over a longer period of time. Some companies use the
gross profit method to estimate inventory on a regular basis, but
sometime during the year, they will conduct a physical count to adjust
the estimate to the actual inventory on hand.
c) The gross profit method will provide reliable results so long as cost
patterns remain stable, and the selling price and mark-ups are
predictable. In general, all factors affecting the gross profit percentage
must remain more or less unchanged for this method to provide
reliable results.
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d) Conditions that might cause the gross profit method to provide
unreliable results include:
1. price changes that were not recorded or taken into account in
determining the gross profit margin
2. special merchandise purchases that are sold at a different gross
profit margin.
3. Losses of inventory due to damage.
4. Losses of inventory due to theft and other causes.
5. Errors in recording inventory sales or purchases.
The gross profit method of inventory estimation is relevant and timely
but it is not objective and accurate enough for complete reliance.
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Reading and Interpreting Published Financial Statements
7.34 a) In 1999, the inventory turnover was 101 days which was slightly
slower than 1998. This turnover rate means that inventory sells in just
over three months. Based in the product life of beer, just over three
months is probably reasonable.
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Recording the raw materials at the lower replacement had no effect on
the inventory turnover.
7.35 a)
Inventory Turnover 1999
$1,546,723 / [($160,092 + $254,690) / 2] = 7.46 365 / 7.46 = 49
days
b) The turnover ratio in 1998 was just over two months; in 1999 it was
about a month and a half. For some items (computers, printers, etc.)
this is probably a reasonable turnover rate. For items like televisions
and appliances this may seem to be too rapid. It is likely that Future
Shop has an arrangement with its suppliers to get inventory quickly.
If this is the case, it would be able to operate with a lower inventory
level because of these arrangements.
d) Future Shop is using the lower of average cost and net realizable
value. Costs consist of invoiced cost plus freight and duty, net of
discounts. This information is found in Note 1 (e).
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preferred in order to avoid carrying obsolete inventories. Thus, the fact
that SoftQuad Inc.s turnover has declined in 1997 might indicate
ineffective management. However, three days extra should not cause a
lot of concern. Selling its entire stock in approximately two months
would appear to provide a reasonable level of risk management
regarding obsolescence.
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7.38 a)
Inventory Turnover
Based on total inventory Based on finished goods
1998 $385.9 / $162.2 = 2.38 385.9 / 48.5 = 7.96
1997 $297.4 / $83.1 = 3.58 297.4/ 26.8 = 11.10
7.39 a)
Current Ratio
1998 $31,485,630 / $10,407,217 = 3.03
1997 $35,181,221 / $15,824,046 = 2.22
c)
Gross profit percentage
1998 $1,174,874 / $17,294,375 = 6.8%
1997 851,047 / 9,052,647 = 9.4%
31
In 1998, the gross profit declined to 6.8%. The reason for the decline is
that sales did not quite double from 1997 but the cost of goods sold
more than doubled thus reducing the gross profit. Costs increased
proportionately more than sales.
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CASE
7.41 Bema Gold Company
a) Current ratio
1998 $30,166 / $12,737 = 2.37
1997 $48,044 / $14,821 = 3.24
1. Have there been any recent reports about Bema find reclaimable
deposits of gold?
2. In what parts of the world is Bema operating?
3. Are there any political risks in any of the countries in which Bema
is operating?
4. Why are the investors willing to buy new shares issued by Bema
when it has not had a profit in 1996, 1997 or 1998?
5. What has been the recent trend in the market price of Bemas
shares?
6. Because this company is not operating at a profit, it is not likely
that it will be paying any dividends in the near future. As an
investor, should I just be looking for the market price of shares to
increase?
7. What exploitable mineral properties does Bema own?
8. What is the mineral content of these properties?
9. Is it economical for Bema to extract these minerals?
10. Why did the company write down mineral properties, inventory and
notes receivable in 1998?
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Critical Thinking Question
7.42 There are many possible items that could be included in this report.
The following is a list of suggested items:
1. what kind of inventory are you going to sell?
2. who will select and buy the inventory?
3. who will arrange for transportation from the Czech Republic of
Canada?
4. who will contact the government about import duties?
5. who will arrange financing?
6. what impact will the change from Czech currency to Canadian
dollars have on the decision making?
7. how much financing will be needed?
8. where will the inventory be stored in Canada?
9. who will contact stores in Canada about selling the inventory?
10. how will you decide on an appropriate selling price?
34