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Several factors including increased supply have caused declining prices for live hogs on the spot market. Also as shown below, futures prices will remain below the carrying cost for live hogs until nearly the end of the fiscal year. However, processed pork products such as bacon, loins, and ham remain above the current cost of production. Three Little Pigs Inc. is capable of processing hogs into these products internally at some locations. Unfortunately, not all hogs can be transported and processed at the main processing plants and must be sold as live hogs to third parties at spot market prices. There are four potential alternatives for dealing with the possible need to impair the value of Three Little Pigs Inc.'s inventories.
Alternative 1: Continue to carry all inventories at cost basis.
ARB28, Par.14c ?Such temporary market declines need not be recognized at the interim date since no loss is expected.?
EITF, 86-13 Discussion ?? option 28 requires inventory be written to lower of cost or market unless (1) substantial evidence exists that market prices will recover before the inventory is sold?Write down is generally required unless the decline is due to seasonal pricing fluctuation.?
ARB43, Ch.4, Par.9 ?Where evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss should be recognized...?
If it can be determined that the depressed prices for lean hogs are only temporary, inventories could and should be kept at cost basis. In this case, adjusting prices to match current market prices would not be necessary. Future prices indicate a recovery before the end of the fiscal year. Futures prices will surpass cost in February and remain above cost for the remainder of the fiscal year. The future prices support claims that the price fluctuations are only temporary in nature, and do not reflect a permanent downward shift in hog prices. Since inventories once impaired cannot be marked up to reflect changes in market conditions, this strategy could be beneficial to the company later on. In this case inventory would not be shown on the books at an unfairly low value.
Alternative 2: Mark down all live hog inventories
AICPA Audit Procedures for Agricultural Producers Pt.1 Ch5.02 ?Growing crops and developing animals to be held for sale should be valued at the lower of cost or market.?
ARB43, Ch.4 Par.8 ?A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost.
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ARB43, Ch.4 Par.9 ?The rule of cost or market whichever is lower is intended to provide a means of measuring the remaining usefulness of an inventory expenditure.?
ARB43, Ch.4 Par.16 ?Only in exceptional cases may inventories properly be stated above cost.?
ARB43, Par.14 ?Inventory losses from market declines should not be deferred beyond the interim period in which the decline occurs.?
ARB43, Par.11 "?If there is only one end-product category the cost utility of the total stock---The inventory in its entirety---may have the greatest significance for accounting purposes."
Current market prices reflect an inventory impairment of the live hogs held for sale. The depressed prices will likely remain through the end of the fiscal quarter based off option prices. Any later adjustment will defer losses from market declines beyond this fiscal period if prices do not recover. Adjusting inventory value during the current period is in conjuncture with the periodicity assumption as well as timeliness of information. The AICPA states clearly those inventories of crops and developing animals held for sale should be valued at the lower of cost or market. The AICPA does not provide any provisions for the anticipation of recovering prices. Marking inventories down better reflects the conservative nature within the conceptual framework.
All hogs regardless of whether they will be converted into processed products internally, or sold to third parties shall be marked down. We come about this method based on all hogs being essentially interchangeable and therefore one category up until the time of sale or processing. This is based on the assumption that processing is a significant value added operation, and there fore the increased final value of the processed hog products is derived from the processing or finishing process. Unprocessed or growing hogs do not receive this added value until after the processing. The inventories should not reflect this future processing premium.
Alternative 3: Mark down only live hogs that cannot be processed into pork products
ARB43, Ch.4 Par.11 "Depending on the character and composition of the inventory, the rule of cost or market, whichever is lower may properly be applied either directly to each item or to the total of the inventory (or in some cases, to the total of the components of each major category). The method should be that which most clearly reflects periodic income."
Pigs that are not being raised at locations that prohibit their transport to processing are unaffected by the spot prices of live hogs since they will be processed internally before going to market. Therefore hogs at these locations would require no market adjustment. Conversely the value of the hogs whose location prohibits their economical transport to processing would need to be marked down to reflect their market value. This would comply with the above ARB statement as we would be adjusting values of each category independently to reflect current market changes.
Alternative 4: Evaluate Inventory at the Individual Hog Level
All pigs at all locations under this method would be evaluated for impairment individually, and the resulting impairment, if any would be the sum of the impairment of each individual hog. While this alternative may briefly seem to have its merits, we believe that it has critical faults. Three Little Pigs Inc. produces roughly 4.1 million pigs per year. We believe that the sheer volume of animals that would need to be evaluated would prohibit any reasonable attempt at individual impairment. This method would also fall outside of the criteria set forward by the conceptual framework. It is very doubtful that individual hogs could be evaluated in a timely manner. The cost of this procedure is substantially above any potential benefit that may arise.
Recommendation: Mark down all live hog inventories
We recommend based on the four alternatives presented above that all hogs are impaired and must be marked down to reflect the lower of cost or market. We feel that this would most accurately reflect the intent of US GAAP.