Three Little Pigs Case I. INTRODUCTION

Three Little Pigs, Inc.(PIGS) provides pork products, and sells a quantity of hogs produced to a number of wholesalers, retailers, and third parties across the United States. PIGS has three inventory departments which consist of live hogs ready for sale, developing animals, and processed pork items. Management has concerns about how to evaluate their different levels of inventory, and how they should account for impairment. The issue of impairment relates only to the live hogs and developing animals sold to third parties because management believes the internal pork products will be able to satisfy the cost of live hogs and animals processed internally.

II. How should the company determine whether an inventory impairment exists i. Should inventory be evaluated for impairment under the lower of cost or market method on a total inventory basis? According to the FASB Accounting Standards Codification ASC 330-10-35-8 (inventory) " 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, the total of the components of each category). The method shall be that which most clearly reflects periodic income." When a firm chooses to value its inventories based on the profitability of one inventory division it makes the assumption that all of the inventory divisions are equal in value to one another. Consequently, this can be a flawed approach when a company has several divisions of inventory that differ in value. Since the majority of PIGS inventory is processed pork products they should separate their inventory categories. The developing animals and live hogs to be processed internally should be grouped together since the final good is the same. Furthermore, the developing animals and live hogs sold to third parties should be grouped together because both consist of hogs being sold to third parties. This grouping would be a more accurate reflection of PIGS income related to its inventory.

ii. Should Inventory be evaluated for impairment under the lower of cost or market by inventory category, e.g.(processed pork, live hogs, developing animals? According to FASB 330-10-35-10 “Similarly, 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 a 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 procedures is applied consistently from year to year”.

Since management believes that the internal pork prices will be able to satisfy the internal processing costs, each inventory category could be tested for impairment as long as management has consistently applied this approach.

iii. Should inventory be evaluated for impairment under the lower of cost or market method based on end product category? According to FASB 330-10-35-9, The purpose of reducing inventory to market is to reflect fairly the income of the period. The most common practice is to apply the lower of cost or market rule separately to each item of the inventory. However, 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. Accordingly, the reduction of individual items to market may not always lead to the most useful result if the utility of the total inventory to the business is not below its cost. This might be the case if selling prices are not affected by temporary or small fluctuations in current costs of purchase or manufacture.
Since the end product is a good depiction of the actual product sold on the market this tends to be the most reliable method for testing impairment. As a result PIGS should aggregate the developing animals and the internally processed hogs into one category. In addition PIGS should group the developing animals and live hogs sold to third parties in another group because the end use is the same. Each group should be evaluated for impairment annually.

iv. Should inventory be evaluated for impairment under the lower of cost or market method on an individual basis, e.g. hog level? In my opinion, the pigs should be valued as a collective group rather than on the individual level because the majority of pig qualities are the same as a group. Although each pig has a distinct quality from the other, it would be time consuming, and difficult to measure the minor costs, and individual differences that arise among each pig.

v. Should inventory be evaluated for impairment on some other basis not described above? As stated above, the inventory method which most clearly reflects income should be used. If management has consistently used a different method that clearly reflects income that method can be used as long as it as permitted by GAAP. Since PIGS experiences seasonal fluctuations it would be more reliable to use historic prices rather than projections based on market prices.

III. If the company determines that an impairment is necessary should the impairment be recognized in an interim period if prices are expected to recover before year end? According to FASB 270-10-50, many publicly traded companies report summarized financial information at interim dates. However, an impairment should be recognized only if it is "other- than temporary" which means that no impairment loss should be reported for inventory when management believes that costs will be recovered. As a result PIGS should not report an impairment loss since management believes that the processed pork future revenues will be high enough to cover the production costs.

IV. Conclusion The method in which inventory is measured can have a substantial effect on a firms financial statements. As stated previously inventory should be reported using the method that most accurately reflects income. This case supported the issue that inventory has a more reliable value when each division is separated and grouped with the commonalities of its end product. The codification provides guidance to ensure that companies measure items like inventory in the correct manner rather than using the method that yields the most favorable operating results.