Question:
It is a wine industry, and the matter is inventory valuation. Please suppose that wholesale and retail prices for expensive French red wines (for instance, those from Bordeaux) have declined significantly over the past four months.
You are to prepare a letter to Romano Wine Company that outlines the scenario, identifies the accounting issue, and give a solution. Specifically, you must address how the Bordeaux red wines can be valued on the May 31, 2004 balance sheet and how that this will impact both the 2004 and 2005 income statements.
Note: You read the balance sheet date correctly--it is May of 2004. The dates and periods of time are very important in this case. Thus, suppose that you are looking into this issue on or about June 15, 2004.
The Case:
The Romano Wine Company is a relatively small, family owned San Francisco company that distributes wine to restaurants, general use liquor stores, and retail wine shops including lots of small boutique shops. Even though Romano is a Sicilian name, the company is recognized for its expertise with French wines, particularly the more expensive reds. Romano has been around since the early sixties and has survived as an independent distributor mostly because of personal relationships established and nurtured over forty years.
One of these close, long-lasting relationships is with Wells Fargo Bank ("Wells"), who gives short-term financing for the company's inventory and long-term financing for the company's offices and warehouse. Wells has always wanted to observe unaudited quarterly financial statements and audited annual financial statements all prepared according to US GAAP. Romano's most current year-end is May 31, 2004 and the subsequent scenario played-out in early June as part of the annual audit.
Romano began to observe soft prices for French reds late in 2003, which continued into the current year. In fact, wholesale prices (and soon after, the retail prices) really started to drop in early spring of this year. As of June 1, prices are down 30-40% from what they were in the fall of 2003 and the auditors have raised an issue about the valuation.
Romano values its inventory using a weighted average cost basis and used the periodic inventory system. About a third of Romano's inventory at May 31, 2004 consisted of red wines from Bordeaux; these 2,100 cases of red wine were purchased at an average cost of $120 per case, and in normal times could sell for roughly $220 a case. The replacement cost of this inventory at May 31st, was $80 a case, and the current selling price is $146 per case.
How could the Bordeaux reds be valued on the May 31st balance sheet and what is the impact, if any, on the 2004 income statement? What can be the impact on the 2005 income statement?
Additional Information:
1) This is not the 1st time that wine prices have fallen (or risen) dramatically. (After all, grapes are a commodity even in the Bordeaux area of France!). Romano's general manager is kind of a wine historian and he says volatility like this happens at least twice each decade, and prices always bounce back.
According to your research the basic reason for the price drop is excess produce, particularly the 1999-2001 vintages. As soon as the distribution channel is cleared (in other words as soon as the wine drinkers of the world start drinking this stuff) prices can return to normal. In fact, Romano thinks that prices have bottomed-out and can start to go back up by the end of the year, and will be very close to their 2003 levels by late spring 2005.
2) As we all know, if stored properly a good red wine can improve in the bottle. Obsolescence/spoilage is not a factor.
3) Romano likes to turn over its inventory about 4 times a year. Essentially, they don't have a choice, because they don't have a lot of excess cash. They must remain their business cycle at a reasonable length. Thus, this whole industry, from growers to distributors to retailers, is characterized by "slow payers". Romano, itself, seldom pays less than then 90 days after delivery! On the other hand, businesses finally pay. A time-honored, unwritten code of conduct is very much evident in this industry.
4) Romano's sales for the year ended 5/31/04 were $2.1 million, and total income was 120,000. Sales, net income, and cash flow from operations were all less than what they were for year ending 5/31/03.
The subsequent is the company's balance sheet as of 5/31/04.
Romano Wine Company
Balance Sheet
May 31, 2004
Cash 85,000 A/P 450,000
A/R (NRV) 500,000 S/T Debt 500,000
Inventory 750,000 L/T Debt 875,000
PPE (NBV) 950,000
Equity 460,000
Total 2,285,000 Total 2,285,000
5) Suppose the current FASB Codification text is the accounting guidance in place during the case timeframe.