BACKGROUND

Disc Importers was a Canadian wholesale company formed in 1982 to distribute imported classical records, or discs, to the Canadian market. The company was based in Burlington, Ontario, and imported all its merchandise from European manufacturers.

During the 1980s, the classical record market in Canada was perceived to be entering a boom period. An expanded selection of recordings and a greater variety of artists, combined with renewed consumer interest in classical music, had produced unit sales growth in excess of 15 per cent per year. Prices were also rising rapidly (much faster than the inflation rate), resulting in a forecast dollar sales growth of 30 to 40 per cent per year for the industry

INVENTORY VALUATION

McFee knew that merchandise inventories should be valued at the lesser of cost or market value. He was unsure, however, which definition of “cost” would be most

appropriate for financial accounting purposes for this company. Also, he was wondering whether it would be preferable to use replacement cost or net realizable value in computing the inventory’s market value.

Conrad Harris, the company’s vice president of finance, opened the discussion by commenting that inventory was the company’s major asset and that much of its bank financing was secured against inventory:

I have a meeting with our banker at the beginning of next month and I am certain he will be examining very closely our financial position as we consider expanding. It seems clear to me that in inflationary times we should choose the method which shows inventory on the balance sheet at its most current value so as to give a true picture of the value of our assets.

The vice president of marketing, Bud Bryson, responded that he could not make any intelligible use of the company’s income statement for measuring and evaluating sales and profitability performance unless the cost of goods sold reflected as closely as possible the current cost of merchandise to the company:

A strong balance sheet is certainly a noble objective and, although I’m not sure that the two are mutually exclusive, I feel that our foremost concern must be with obtaining an accurate, informative income statement to measure our operating results. Otherwise, we cannot properly evaluate our pricing policies and the performance of our sales force.

At this point, Spender, the shipping and receiving manager, interjected:

I don’t see why we should monkey around with any numbers. I have a record of the quantities and costs of all the purchases we have made from our two European suppliers over the past year, and the associated freight charges from dockside to our warehouse (see Exhibit 1). In addition, my assistant has counted the units remaining in each of these lots. From these data, we can compute the precise cost of our ending inventory and, hence, the value of the merchandise we have sold.

Discussion ensued for several minutes about the concerns of the three operating managers. Sensing that a consensus had not yet been reached, Cynthia Hamilton, the president of the company, proposed a fourth alternative:

Since the company’s sole and ongoing line of business is record wholesaling, and since a disc is a disc regardless of when it was purchased, I think that the method for pricing the inventory ought to reflect its average value over the time period under consideration.

We can’t tell by looking at a record when we bought it or what it cost us, so why not just work with one common cost unit for all our stock? It seems to me that this would be a simple, sensible, approach.

MERCHANDISE TRANSACTIONS

In response to questions from the other executives, Spencer informed them that both suppliers’ terms were net 45 days and that the August 2004 order had not yet been paid for. He also remarked that both suppliers had proven to be entirely satisfactory and that there had been no returns of any sort. The prices of classical records had been rising steadily throughout the year, and Disc Importers had just received notice that the manufacturers’ prices had been increased to $4.70 per unit, including freight, as of September 25, 2004. Since July, Disc Importers had been quoting a wholesale price of $5.50 per unit to its retailer customers, but there was increasing pressure from Spencer and others in the company to pass on costs through a price increase of $0.10 per unit in the near future. The company’s direct selling costs consisted of a 4 per cent commission to salesmen, and delivery expenses which typically averaged $0.06 per unit.

SALES RECORDS

Bud Bryson noted that his sales records showed gross sales of 61,230 units during 2004, slightly higher than the company’s initial forecast of 60,000 units. As well, there were firm orders on hand on September 30 for an additional 1,275 units which were in the process of being assembled and packed for shipment. One order of 500 units had been returned in May by a customer who did not require the records at that time. Disc Importers had accepted the return in order to maintain goodwill, and the customer’s account had been credited in full. Another shipment, containing 250 units, had been returned by a customer because of damage. Disc Importers had scrapped the entire lot and immediately shipped a new batch to the customer.

DECISION

At this point, the subject of inventory valuation was tabled until the next meeting at which time McFee was instructed to come prepared with a detailed quantitative analysis of the various options, including a comparative summary of the income statement and balance sheet impacts of the available options. He was also requested to determine the impact of the lower-of-cost-or-market rule upon the company’s inventories.

Exhibit 1

PURCHASE RECORDS FOR THE 2004 FISCAL YEAR

Date Lot No. Received		Quantity Received (Units)	Unit Purchase Cost	Freight Charges	Quantity Remaining on September 30, 2004
O/B		10,000	$4.00	$1,000	2,000
#1	November 2003	25,000	4.25	1,250	5,000
#2	February 2004	30,000	4.35	1,500	13,000
#3	May 2004	15,000	4.53	1,050	8,000
#4	August 2004	40,000	4.61	1,600	31,000
		120,000			59,000

Questions

1. Determine the value of the ending inventory

2. Determine the corresponding cost of goods sold expense for the disc importers for 2004 fiscal year. under each of the four available methods.

3. Identify which method will best meet the concern of each of the four executives in this case.

4. Apply the lower of cost or market value to verify that the cost based valuations are, in fact, lower than the current market value of the inventory.

5. Show the impact of freight charge, theft or damaged or even shrinkage in the cost of goods sold.

Note: the number can be made up