MCQ Quiz

<h3>First Principles Thinking: Inventory Measurement</h3><p><strong>A is correct.</strong> IFRS requires inventory to be carried at the lower of historical cost and net realizable value (NRV). Start from the definition: cost reflects resources already committed, while NRV reflects the economic benefit expected at sale (selling price minus costs to complete and sell). When NRV falls below cost, economic reality says the firm cannot recover cost; therefore, the carrying value must reflect recoverable amount. The write-down is recorded as an expense because it reflects a loss of economic value. This prevents asset overstatement and aligns with prudence.</p><p>B is wrong: IFRS does not allow deferring losses. Losses must be recognized immediately when NRV < cost.</p><p>C is wrong: IFRS does permit write-downs and explicitly requires them when NRV < cost. Cost-only measurement would overstate assets.</p>

<h3>First Principles Thinking: Conservatism and Recoverability</h3><p><strong>B is correct.</strong> Under IFRS, inventory is measured at the lower of cost and NRV each reporting period. If conditions change—e.g., selling price increases—NRV may rise. First principles: carrying amount should reflect recoverable economic benefit, no more and no less. Therefore, if NRV increases after a write-down, IFRS allows reversal, but only up to the original write-down amount so that inventory is never carried above cost. US GAAP, however, adopts a stricter conservatism-based approach: once written down, inventory cannot be written back up even if NRV increases. This avoids recognition of unrealized upward adjustments.</p><p>A is wrong: US GAAP prohibits reversals entirely.</p><p>C is wrong: IFRS allows reversals; GAAP does not.</p>

<h3>First Principles Thinking: Ratio Mechanics</h3><p><strong>A is correct.</strong> Inventory turnover = Cost of sales ÷ Average inventory. A write-down directly reduces the carrying amount of inventory (denominator) while cost of sales either increases or remains stable. First principles: lowering the denominator increases the ratio. Therefore, firms appear to move inventory faster, even though the effect is mechanical. The PDF’s Volvo example shows this explicitly: turnover rises from 5.64 to 7.71 when adjusting for allowance differences :contentReference[oaicite:1]{index=1}.</p><p>B is wrong: write-downs are included in cost of sales, which increases cost and reduces gross profit margin immediately.</p><p>C is wrong: current assets decrease with the write-down, reducing—not increasing—the current ratio.</p>

<h3>First Principles Thinking: Recoverable Value</h3><p><strong>A is correct.</strong> NRV = selling price − costs to complete/sell = 35,000 − 8,000 = 27,000. IFRS requires inventory at the lower of cost (30,000) and NRV (27,000). First principles: choose recoverable amount to avoid overstating assets. Since NRV < cost, carrying value becomes 27,000. However, the question asks: “At what value should inventory be measured?” The cost is 30,000, but the carrying amount must be reduced to 27,000. Thus the appropriate measurement is NRV = 27,000. Among the provided options, the correct interpretation is cost is not used; NRV becomes the carrying amount.</p><p>B is wrong because it is the NRV figure but the question asks which one should be used for measurement; NRV replaces cost because it is lower.</p><p>C is wrong: selling price cannot be used directly for valuation.</p>

<h3>First Principles Thinking: Upper Bound = Original Cost</h3><p><strong>A is correct.</strong> Year 1: NRV 42,000 < cost 50,000 → write down to 42,000. Year 2: NRV rises to 48,000. IFRS allows reversal of write-downs up to the amount of the original reduction, but never above cost. The original write-down was 8,000 (50,000 − 42,000). NRV now exceeds the written-down value by 6,000 (48,000 − 42,000), which is within the allowable reversal. So the new carrying amount is 48,000.</p><p>B is wrong: this ignores the increase in NRV permitted for reversal.</p><p>C is wrong: reversal cannot take inventory above historical cost; cost is the ceiling, but here NRV does not exceed cost (48,000 < 50,000).</p>

<h3>First Principles Thinking: Cost Layers and Obsolescence Risk</h3><p><strong>A is correct.</strong> Under LIFO, the most recent costs flow into cost of sales; the ending inventory consists of older, lower-cost layers. Because these older costs are less likely to exceed current NRV, the likelihood of NRV < cost is lower. First principles: write-downs occur only when recorded cost > recoverable value. Lower recorded cost makes that condition less probable.</p><p>B is wrong: LIFO does not produce replacement cost inventory values; it produces older cost layers.</p><p>C is wrong: LIFO inventories are still subject to lower-of-cost-or-market (US GAAP) or NRV testing.</p>

<h3>First Principles Thinking: Loss Recognition</h3><p><strong>A is correct.</strong> A write-down reduces the carrying amount of inventory (assets). The loss is recognized in cost of sales (or a separate line), increasing expenses and reducing profit, which reduces retained earnings (equity). First principles: inventories represent future economic benefits; if these benefits shrink, the balance sheet and equity must reflect the loss. The PDF highlights these effects repeatedly, noting decreased profitability, liquidity, and solvency metrics :contentReference[oaicite:2]{index=2}.</p><p>B is wrong: write-downs never increase assets or equity.</p><p>C is wrong: cost of sales increases, not decreases.</p>

<h3>First Principles Thinking: Expense Recognition</h3><p><strong>A is correct.</strong> A write-down reflects a loss of economic benefit. First principles: expenses capture outflows or decreases in economic resources. IFRS requires the loss from declining NRV to be recognized in profit or loss. The PDF shows this for Hatsumei, where the EUR9.3 million decline was recognized as an expense and reduced reported profit :contentReference[oaicite:1]{index=1}. Because this value reduction is operational (inventory impairment), it is included in cost of sales or disclosed separately as an inventory write-down line.</p><p>B is wrong: inventory revaluations do not bypass the income statement under IFRS; OCI treatment is not permitted.</p><p>C is wrong: financing expense relates to capital structure, not asset impairments.</p>

<h3>First Principles Thinking: Market Constraint Logic</h3><p><strong>A is correct.</strong> US GAAP defines “market” as replacement cost but restricts it between the ceiling (NRV) and floor (NRV − normal profit margin). First principles: replacement cost captures current input cost, but unconstrained replacement cost may overstate or understate recoverable value. The ceiling prevents overstated assets (RC > NRV), while the floor prevents excessive conservatism (RC < NRV − profit). The PDF explicitly references these NRV and NRV-minus-profit bounds for GAAP’s LCM rule :contentReference[oaicite:2]{index=2}.</p><p>B is wrong: NRV alone is an IFRS concept; GAAP uses a three-part constraint.</p><p>C is wrong: GAAP requires LCM testing even without obsolescence.</p>

<h3>First Principles Thinking: Matching Principle and Cost Flows</h3><p><strong>A is correct.</strong> A write-down increases cost of sales because the loss is treated as an operating expense. Gross profit = Net sales − Cost of sales, so increasing cost mechanically reduces gross profit margin. First principles: gross margin reflects the core profitability of selling goods; if inventory value collapses, the cost attributed to those goods must be recognized immediately, reducing margin. The PDF shows this via Volvo’s write-down effects on margins :contentReference[oaicite:3]{index=3}.</p><p>B is wrong: ROA is affected but indirectly and later, not most directly.</p><p>C is wrong: write-downs do not directly affect financing costs or EBIT coverage unless operating profit changes significantly.</p>

<h3>First Principles Thinking: Market-Determined Value</h3><p><strong>A is correct.</strong> Inventories whose prices are determined in active, liquid markets—like agricultural commodities—have readily observable fair values. First principles: when markets provide reliable, up-to-date valuation signals, fair value minus selling costs better reflects recoverable economic benefits than historical cost. IFRS allows these items to be measured at fair value less costs to sell, and changes in value are recognized in profit or loss. The PDF highlights this exception to IAS 2 for commodity broker-traders and producers :contentReference[oaicite:4]{index=4}.</p><p>B is wrong: regulatory cost reporting is irrelevant to IFRS valuation rules.</p><p>C is wrong: these inventories can lose value (e.g., agricultural price drops), which is exactly why valuation at fair value is used.</p>

<h3>First Principles Thinking: Allowance Mechanics</h3><p><strong>A is correct.</strong> Inventory allowances reduce the carrying amount of inventory to reflect estimated losses. First principles: the allowance is a contra-asset; adding it back yields the unadjusted gross inventory. From Exhibit 3 Panel A, 2017 total inventories = 52,701 and allowance = 3,489. Thus: 52,701 + 3,489 = 56,190. The PDF provides this exact computed figure :contentReference[oaicite:5]{index=5}.</p><p>B is wrong: this is unrelated to any combination in Exhibit 3.</p><p>C is wrong: this is the already reduced reported inventory, not the gross amount.</p>

<h3>First Principles Thinking: Reversing Allowance Effects</h3><p><strong>A is correct.</strong> Cost of sales reported for 2017 was SEK 254,581 million. A decrease in allowance means a reduction in expense; to compute cost of sales without this adjustment, the reduced expense must be added back. Therefore: 254,581 + 194 = 254,775. This calculation is directly shown in the solution table in the PDF :contentReference[oaicite:6]{index=6}.</p><p>B is wrong: this is the reported value, not the adjusted one.</p><p>C is wrong: no data support this number.</p>

<h3>First Principles Thinking: Ratio Denominator Effects</h3><p><strong>A is correct.</strong> Inventory turnover = Cost of sales ÷ Average inventory. When inventory is written down, the denominator falls immediately while the numerator typically increases (write-down is included in cost of sales). First principles: lowering the denominator mechanically increases any ratio where the numerator is unchanged or rising. The PDF demonstrates this with Volvo’s turnover rising from 5.64 to 7.71 when adjusted for the allowance differences :contentReference[oaicite:7]{index=7}.</p><p>B is wrong: write-downs do not increase sales.</p><p>C is wrong: write-downs increase cost of sales, not reduce it.</p>

<h3>First Principles Thinking: Transparency of Recoverability</h3><p><strong>A is correct.</strong> IFRS requires firms to disclose inventory carrying amounts by category, the amount of write-downs, the amount of reversals, and the circumstances that led to them. First principles: because inventory value reflects future economic benefit, users need information on valuation uncertainty, obsolescence, and NRV recoverability. The PDF outlines that entities must disclose detailed changes in inventory allowances, including reversals, cost formulas used, and carrying amounts across work-in-progress, raw materials, and finished goods :contentReference[oaicite:1]{index=1}.</p><p>B is wrong: IFRS does not permit such limited disclosure; users need category-level visibility.</p><p>C is wrong: valuation method alone is insufficient; IFRS mandates both method and quantitative detail.</p>

<h3>First Principles Thinking: Cost Layer Mechanics</h3><p><strong>A is correct.</strong> FIFO assumes earliest cost layers become cost of sales first. If prices are rising, these older layers are cheaper. First principles: cost of sales declines because cheaper inputs are matched with current revenues, increasing profit, while newer higher-cost layers remain in inventory, increasing the reported asset. The PDF notes this contrasts with LIFO, where the newest costs enter cost of sales and inventory reflects older, cheaper layers :contentReference[oaicite:2]{index=2}.</p><p>B is wrong: FIFO does not match current costs to current revenues—that is LIFO’s theoretical advantage.</p><p>C is wrong: FIFO increases ending inventory in inflation, not decreases it.</p>

<h3>First Principles Thinking: Closing Inventory Mechanics</h3><p><strong>A is correct.</strong> Cost of sales = Beginning inventory + Purchases − Ending inventory. If ending inventory is understated, cost of sales becomes artificially high because the subtraction term is too small. First principles: higher cost of sales reduces gross profit and net income. The PDF highlights understanding inventory adjustments because they directly affect margins and turnover calculations :contentReference[oaicite:3]{index=3}.</p><p>B is wrong: it reverses the direction of the error.</p><p>C is wrong: inventory errors flow directly into cost of sales and profit.</p>

<h3>First Principles Thinking: Restoring Recoverable Value</h3><p><strong>A is correct.</strong> IFRS requires reversals of write-downs to be recognized in profit or loss in the period of reversal, typically reducing cost of sales. First principles: the carrying amount must reflect updated NRV, but inventory cannot exceed historical cost. The PDF notes that reversals are recognized as income in the current period, not retrospectively :contentReference[oaicite:4]{index=4}.</p><p>B is wrong: reversals must go through profit or loss, not directly to equity.</p><p>C is wrong: IFRS prohibits retroactive restatement for inventory reversals.</p>

<h3>First Principles Thinking: Loss Removal</h3><p><strong>A is correct.</strong> A write-down is an expense. First principles: removing an expense increases net income by the same amount. Reported net income = 52.0; write-down = 9.3 → adjusted net income = 52.0 + 9.3 = 61.3. The PDF emphasizes how Hatsumei's profitability was materially affected by this EUR9.3 million loss and demonstrates the magnitude of adjustments analysts must consider when reversing abnormal inventory valuation changes :contentReference[oaicite:5]{index=5}.</p><p>B is wrong: this is reported net income, not adjusted.</p><p>C is wrong: it incorrectly subtracts instead of adding the write-down.</p>

<h3>First Principles Thinking: Cross-Firm Comparability</h3><p><strong>A is correct.</strong> Analysts aim to compare economic reality across firms. Different methods (FIFO vs weighted average) or inconsistent write-down practices distort inventory, cost of sales, and margins. First principles: comparability requires aligning measurement bases so ratios like inventory turnover, gross margin, and ROA reflect differences in operations, not accounting choices. The PDF’s Volvo example illustrates how varying obsolescence allowances materially affect turnover and cost of sales, requiring adjustments for meaningful comparison :contentReference[oaicite:6]{index=6}.</p><p>B is wrong: GAAP never prohibits comparison; analysts must adjust for comparability.</p><p>C is wrong: inventory adjustments do not alter revenue recognition.</p>

<h3>First Principles Thinking: Earnings Quality and Managerial Bias</h3><p><strong>A is correct.</strong> Write-downs depend on estimates of NRV, obsolescence, and market conditions. First principles: when measurement relies on subjective inputs, managers may adjust write-downs to smooth earnings—either recognizing large losses in poor years (“big bath” behavior) or delaying losses to inflate current income. The PDF warns that inventory valuation introduces judgment (NRV estimation, allowance size), enabling opportunistic earnings management and reducing transparency :contentReference[oaicite:7]{index=7}.</p><p>B is wrong: tax effects vary across jurisdictions and do not universally increase.</p><p>C is wrong: write-downs do not eliminate the requirement for annual NRV reassessment.</p>