Darren Fedon - DLF0011
Case 04-4 Three Little Pigs, Inc.
Background
Three Little Pigs, Inc. (PIGS) is a provider of pork products to the food service industry and institutional markets in the U.S. PIGS develops and produces the majority of their hogs for internal processing (processed pork products) and while selling a portion for outside third parties (live hogs). During PIGS fiscal year 2003, an external factor has increased the supply of hogs on the market which in turn is pushing down futures prices. Management believes that this decline hog prices warrants reviewing their inventory because there may be a lower of cost or market issue. The basis for this assumption is the decline in futures prices in both the second and third quarters. However, the CEO believes that the price fluctuations are due to seasonality and thus temporary in nature, referencing the price recovery in the fourth quarter of the futures market and therefore impairment isn’t necessary.
Issue
PIGS management has concerns about how to evaluate their pig inventory for impairment. Two issues were raised related to inventory evaluation and reporting of the impairment (if applicable). The two issues are as follows: 1) The options for inventory evaluation presented to them are as follows a) total inventory basis, b) inventory category, c) end product category or d) individual basis. 2) Once a correct method has been selected; management will need to determine if impairment is needed, if so, when should the impairment be recognized.

Analysis
For clarity in this case, it needs to be defined whether the live hogs are classified as inventory. According to ASC 905-330-25-3 “Animals with short productive lives, such as poultry, may be classified as inventory. Due to the short productive life of poultry, the cost of flocks may be classified as inventory. The accounting principles for poultry operations are much the same as those for other production animals (see paragraph 905-360-25-4), although the operating cycles are much shorter.”
For the purposes of this case, it will be assumed that the useful life of the live hog assets is “approximately six months,” therefore all live hog assets will be classified as a short productive life asset and may be classified as inventory. Since the asset is classified as inventory, ASC 905-330-35-2/3 states that developing animals and animals held for sale shall be valued at lower of cost or market. Therefore impairment would be allowed under ASC 330-10-35-1.
When addressing how the inventory should be evaluated, there are many options that are available to PIGS; a) total inventory basis, b) inventory category, c) end product category or d) individual basis. On the surface, all four methods of evaluation would be correct in any generality setting. When reviewing PIGS inventory, they classify their inventory into three major categories – live hogs ready for sale, developing animals and processed pork products. According to ASC 330-10-35-8, “Depending on the character and composition of the inventory, the rule of lower of cost or market 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.)” By following the stated codification, PIGS is in compliance with GAAP and is evaluating their inventory in accordance per ASC 330-10-50-1.
But upon further review, there is a more effective way of evaluating the inventory. PIGS has two very distinct categories of inventory – live hogs available for sale and live hogs that will be internally processed and sold as processed pork products. Per ASC 330-10-35-10, “where more than one major product or operational category exists, the application of the lower of cost or market rule to the total of the items included in such major categories may result in the most useful determination of income. When no loss of income is expected to take place as a result of a reduction of cost prices of certain goods because others forming components of the same general categories of finished products have a market equally in excess of cost, such components need not be adjusted to market to the extent that they are in balanced quantities. Thus, in such cases, the rule of lower of cost or market, may be applied directly to the totals of the entire inventory, rather than to the individual inventory items, if they enter into the same category of finished product and if they are in balanced quantities, provided the procedure is applied consistently from year to year.”
When testing for impairment, similar individual inventory items should be aggregated and categorized based on the finished product since they are the forming components of the final product. The developing animals and live hogs to be processed internally with processed pork products should be categorized into one category because the final end product category is the same. Similarly, the developing animals and live hogs to be sold to third parties should be aggregated into another group because the end product is the same, whole hogs held for sale to third parties. Both groups should be evaluated for impairment separately as its own group.
The next question that needs to be answered now that an inventory evaluation has been determined, is whether the inventory is subject to impairment and if so, should it be recognized and reported in the interim period. Per ASC 270-10-45-6(c), “Inventory losses from market declines shall not be deferred beyond the interim period in which the decline occurs. Recoveries of such losses on the same inventory in later interim periods of the same fiscal year through market price recoveries shall be recognized as gains in the later interim period. Such gains shall not exceed previously recognized losses. Some market declines at interim dates, however, can reasonably be expected to be restored in the fiscal year. Such temporary market declines need not be recognized at the interim date since no loss is expected to be incurred in the fiscal year. Based on the determination that we have two distinct inventory categories, each would need to be evaluated for impairment separately.
When looking at the internally processed pork inventory and live hogs available for sale, we can determine that no impairment is necessary due to the current decline in value of the hogs appears to be temporary based on the schedule of futures pricing and should be ultimately recovered by the time the animals have matured. The CEO states that the current decline is due to seasonal fluctuations and that any impairment would be temporary.
Conclusion
It is recommended that PIGS evaluate their inventory based on an end product category method. In doing so, they should still monitor the market for long term declines that would justify the revaluation of inventory based on the lower of cost or market method. Temporary and seasonal price fluctuations aren’t subject to revaluation and reporting on an interim basis is not required. There is no change of accounting principle or change in estimate that would warrant a disclosure in the financial statements. By handling their inventory impairments in this manner, Three Little Pigs, Inc. can be in compliance with GAAP and have a greater assurance in their treatment of their specialized type of inventory.