three little pigs case o4-4

Project Description:

case 04-4
three little pigs, inc.
three little pigs, inc. (pigs), a public entity, is a vertically-integrated provider of pork
products to the wholesale and retail food service and institutional markets in the united
states. the company produces approximately 4.1 million hogs per year and processes the
majority of the hogs in its own facilities. the company also sells a portion of the hogs
produced (live hogs) to outside third parties. pigs does not have any firm commitments
to sell live hogs to third parties, nor does it hedge its live hogs through commodity
futures contracts.
there are essentially three major categories of hog inventory—live hogs ready for sale,
developing animals, and processed pork products. farmer joe, ceo of the company, has
represented that the processed pork product prices are sufficient to cover the costs of
producing such products, i.e., the wholesale prices of processed pork products, such as
loins, hams, and bacon exceed the cost to bring such products to market. as a result,
management believes that there is no lower of cost or market issue related to live hogs
ready for sale or developing animals that will be internally processed and sold as
processed pork products. however, there are live hogs in other locations that cannot be
easily transported and processed at the company’s main processing plants. as a result,
these live hogs must be sold to third parties at spot market prices, which have declined, as
further discussed below.
during the company’s fiscal year 2003 (the company’s year-end is march 31), lean hog
pork prices were severely impacted by several factors, including, the capture of the big
bad wolf, which led to an increased supply of pork. in the second quarter ending
september 30, 2002, a further decline in futures prices for the third quarter for lean hogs
has led management to believe that there may be lower of cost or market issues related to
the company’s inventory of live hogs and developing animals held for sale to third
parties. however, farmer joe swears by the hair of his chinny-chin-chin that a writedown is not necessary. he asserts that the price decline reflected in the futures market is
due to seasonal price fluctuations, and, therefore, any impairment, if present, would be
temporary. as support, he points out that the futures prices for lean hogs in the fourth
quarter reflect a recovery in prices, and should be sufficient to recover the cost of the
company’s inventory.
as discussed above, at september 30, 2002, the company had live hogs and developing
animals (in various stages of production) held for sale to third parties. the cost of
producing a hog is currently $38/cwt ($38 per 100 pounds). as a result, the live hogs that
are ready for sale are carried at approximately $38/cwt. the carrying cost for developing
animals, at september 30, 2002, varies based on the stage of production (which lasts
approximately six months). for example, the average carrying costs per cwt of
developing animals to be sold to third parties, classified by month in which maturity of
the animal is expected, are as follows:
copyright 2003 deloitte development llc
all rights reserved. case 04-4: three little pigs, inc. page 2
month of maturity carrying cost*
october 2002 $31
november 2002 $23
december 2002 $16
january 2003 $10
february 2003 $5
march 2003 $3
*all pools of developing animals are expected to have a carrying cost of $38/cwt at maturity
developing animals that are in their second month of development (i.e. will come to
market in january 2003) currently have an average carrying cost of $10/cwt, which is
expected to increase to $38/cwt at maturity.
the futures prices, at september 30, 2002, for lean hogs/cwt are as follows:
october 2002 $29
november 2002 $30
december 2002 $33
january 2003 $37
february 2003 $42
march 2003 $45
despite the fact that current spot market prices for lean hogs are below the company’s
cost, management has indicated that, based on current spot market prices for the various
products, they expect to recover all production costs of the entire hog inventory on hand
(i.e., live hogs and developing hogs to be internally processed and sold to third parties) at
september 30, 2002. in other words, total revenues for the pork products and total
revenues for the sale of the live hogs to third parties, based on current spot prices, will
exceed the sum of the current capitalized cost of producing and processing those hogs
and the expected “cost to complete” for hogs in development.
required:
• how should the company determine whether an inventory impairment exists at
september 30, 2002? more specifically, how should management evaluate
impairment?
i) should inventory be evaluated for impairment under the lower of cost or market
method on a total inventory basis?
ii) should inventory be evaluated for impairment under the lower of cost or market
method by inventory category, e.g., processed pork products, live hogs, and
developing animals?
copyright 2003 deloitte development llc
all rights reserved.case 04-4: three little pigs, inc. page 3
iii) should inventory be evaluated for impairment under the lower of cost or market
method based on end product category, e.g., developing animals and live hogs
to be processed internally are aggregated with processed pork products to
comprise one group and developing animals and live hogs to be sold to third
parties would be aggregated to comprise another group?
iv) should inventory be evaluated for impairment under the lower of cost or market
method on an individual basis to the extent possible, e.g., at the individual hog
level?
v) should inventory be evaluated for impairment on some other basis not described
above?
• if the company determines that an impairment of inventory is necessary, should the
impairment be recognized in an interim period if prices are expected to recover before
year-end?
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