Professional judgment framework

Inventory: lower of cost or market

Background

Company JK's common shares are held by the Kay family.JK has significant bank loans, which require the company to submit audited financial statements. JK manufactures high-technology consumer electronics and has a December 31 year-end.JK generally closes its year-end books by the middle of February in preparation for the year-end audit.

JK began manufacturing BOX A, its first version of a computer tablet, in the first quarter of 2017. Early in the third quarter of 2018, JK introduced BOX B, its newest computer tablet, with several enhanced features over BOX A. Production of BOX A was halted after the second quarter of 2018 and replaced by production of BOX B. The sales of BOX B have been very strong since its introduction; however, this has resulted in a reduced demand for the remaining units of BOX A.JK has two competitors with products similar, but not identical, to Box A, in terms of functionality.JK has historically been the product leader in this industry and has been able to command a higher sales price than its competitors, generally ranging from 10% to 15%.

The CFO believes that there is an impairment issue related to the BOX A inventory. The CFO believes bonuses may still be earned in 2018 if the write-down of the BOX A product line is minimal. In compliance with ASC 330-10-35-1C, JK is required to determine if any adjustments are necessary to value its LIFO inventory at the lower of cost or market. The ASC master glossary provides the following definitions of market and net realizable value:

Market:

"As used in the phrase lower of cost or market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meets both of the following conditions:

a.Market shall not exceed the net realizable value.

b.Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin."

Net realizable value:

"Estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal."

Historically, JK has applied the lower of cost or market rule directly to each item of inventory. The normal profit margin has been 20% of the selling price.

In early February 2019, as directed by the CFO, the controller of JK began the process to value the BOX A units in inventory at December 31, 2018. Available information regarding this inventory follows:

Fiscal 2017 and 2018 data

Fiscal 2017 financial information was audited and a clean opinion was issued.There have been no significant changes in systems and controls.

All inventories use the LIFO costing method. The average cost for each unit of BOX A produced in 2017 was $100. Due to reduction in the number of units produced, the average cost for each unit of BOX A produced in 2018 was $110. At December 31, 2017 and 2018, BOX A inventory represented 30% and 15% of total assets, respectively.

Sales of BOX A represented 40% of JK's revenue in 2017 and 15% in 2018.

The last quarter of the year has historically been the best sales quarter, largely due to holiday-related sales. The average selling price of BOX A in 2017 was $144. In 2018, the average selling price began to drop when a competitor introduced a technology-enhanced computer tablet late in the first quarter and the decline continued when BOX B was introduced in the third quarter. The average selling price per unit for BOX A was $140 in the first quarter, $120 in the second quarter and $100 in the third quarter. In response to the falling demand for BOX A, starting in the fourth quarter of 2018, JK reduced the selling price by 20%, to $80.

January 2019 data

Despite the reduced selling price, JK's two largest customers, Better Buyer and Pad Warehouse, which account for 70% of JK's sales volume, have refused to purchase any more units of BOX A. In their view, the technology of BOX A is outdated and unsalable. To make matters worse, these customers are pressuring JK to take back 5,000 units of BOX A they both still have on hand.

-Company policy is not to allow customers to return inventory unless there is a warranty issue. The CFO has taken the position that they should not allow these two large customers to return unwanted product because it may indicate a higher inventory write-down is required.

-The controller met with the Senior VP of Sales to discuss the value of the BOX A units. The VP expressed concerned that, if the unwanted BOX A product is not taken back, the company's distribution channels for BOX B could be disrupted.

A long-time discount chain customer, Slash, honored their outstanding purchase contract and, in January 2019, took possession of 10,000 units of BOX A at $110 per unit.

Early February 2019 data

Because of the significance of the customer relationships, rather than take the 10,000 units back from Better Buyer and Pad Warehouse, which had been sold at an average price of $110, JK decided to issue credit memos totaling $600,000, resulting in a deeply discounted sales price of $50 per unit.

The Senior VP of Sales, an industry veteran with a long history of solid forecasting of other products made by JK, does share some good news. The current forecast is to sell 40,000 units of BOX A in 2019 (of which 10,000 units were sold in January) and the remaining 10,000 units in 2020. This forecast is based, in part, on discussions with and letters from a discount chain in a third-world country, Global Discount, which may be willing to buy 20,000 units of BOX A for $1.8 million. The VP of Sales believes this transaction has a 50% chance of occurring based on direct conversations with the VP of Purchasing at Global Discount. If this transaction does not occur, the VP of Sales estimates the selling price of the remaining 30,000 units in 2019 to be $60 per unit. The selling price of the remaining 10,000 units in 2020 is forecasted to be discounted $20 per unit from the 2019 price.

The controller becomes aware that the sales incentive cost on BOX A doubled to $10 per unit beginning in 2019.

At a senior management meeting, the CEO made it clear she would prefer to write this inventory down as far as possible to be conservative and to enhance the chance for bonuses in 2019. The CFO expressed his concern that a write-off that is too significant could result in no bonuses in 2018.

A popular industry magazine published an article outlining the shortcomings of BOX A and recommending consumers don't purchase this product and, instead, purchase BOX B.

In its history of sales of other technology products, JK has observed that there is a market of customers who shop low price points despite newer, available technology; however, the time lag of this interest, about 18 months, continues to shorten.

The following is a brief summary of the BOX A inventory quantities since its introduction.

Quarter ended Quantity produced Quantity sold Quantity in inventory

March 31, 2017

60,000

50,000

10,000

June 30, 2017

70,000

60,000

20,000

September 30, 2017

90,000

75,000

35,000

December 31, 2017

75,000

70,000

40,000

March 31, 2018

90,000

35,000

95,000

June 30, 2018

10,000

30,000

75,000

September 30, 2018

-

15,000

60,000

December 31, 2018

-

10,000

50,000

Required

Deliverables:Completed Judgment Application Framework Template and Memorandum prepared by your team (as described below).These are to submitted to your instructor on or before the case study deadline.

Reference the professional judgment framework handout and application template separately provided. Read the Professional Judgment materials ( PowerPoint slides and word document) to become familiar with the judgment process to be applied in this case study

As the controller, use your judgment to recommend the carrying value for the BOX A inventory at December 31, 2018. Using the professional judgment framework, complete the application template for all process steps and provide the appropriate information in the documentation column.

-In performing your analysis, you should use an Excel spreadsheet to support any calculations.

Using the information you documented regarding the overarching considerations and the specific considerations for each process step in the framework, use the tool below to document your judgment about the specific amount of write down you are recommending JK record in a draft memorandum format that you will provide to the CFO (not to exceed three pages).Be sure to include specific references to the applicable guidance and quote the applicable guidance.Also, attach your Excel spreadsheet with your calculations. Upon completing your documentation, make sure that you are able to answer the following considerations:

-Is the documentation sufficient to support your judgment?

-Can another professional understand how you reached your conclusion (including why reasonable outcomes and possible alternatives identified were not selected)?

Tool to document the judgment

DRAFT memorandum

Inventory: lower of cost or market

February 2019

To: CFO

Prepared by: [Team Members]

Issue:

Facts:

Analysis:

Judgment: