Case #5 Inventory Valuation

We started the course looking at the accounting for basic things like bad debts and operating expenses, and that is how we’ll end it. The subject for our last case is inventory valuation.

As you read the case, it will become apparent that there is an added dimension here. We are dealing with a specific and somewhat unique product---classic French red wines—that actually improves with age. Also, there is some real history connected with this case in that the scenario is drawn, for the most part, from something that actually happened.

You are to write a letter to Romano Wine Company that outlines the scenario, identifies the accounting issue, and proposes a solution. Specifically, you must address how the Bordeaux red wines will 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. Therefore, assume that you are looking into this issue on or about June 15, 2004.

Case #5

Inventory Valuation

The Scenario:

The setting for our last case is the wine industry, and the issue is inventory valuation. Before we go into specifics, I am going to ask you to assume that wholesale and retail prices for expensive French red wines (for example, those from Bordeaux) have declined significantly over the past four months. This is purely an assumption for purposes of this case. In reality, I doubt that there has been any such decline.

The Case:

The Romano Wine Company is a relatively small, family owned San Francisco company that distributes wine to restaurants, general purpose liquor stores, and retail wine shops including many small boutique shops. Even though Romano is a Sicilian name, the company is known 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 mainly because of personal relationships established and nurtured over forty years.

One of these close, long-lasting relationships is with Wells Fargo Bank ("Wells"), who provides short-term financing for the company’s inventory and long-term financing for the company’s warehouse and offices. Wells has always wanted to see unaudited quarterly financial statements and audited annual financial statements all prepared according to US GAAP. Romano’s most recent year-end is May 31, 2004 and the following scenario played-out in early June as part of the annual audit.

Romano began to see 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 utilized 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 would sell for roughly $220 a case. The replacement cost of this inventory at May 31^st, was $80 a case, and the current selling price is $146 per case.

How should the Bordeaux reds be valued on the May 31st balance sheet and what is the impact, if any, on the 2004 income statement? What will be the impact on the 2005 income statement?

A proper response should be done within 2 pages or less.

Additional Information:

1) This is not the first 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 main reason for the price drop is excess produce, especially 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 will return to normal. In fact, Romano thinks that prices have bottomed-out and will start to go back up by the end of the year, and may be very close to their 2003 levels by late spring 2005.

2) As we all know, if stored properly a good red wine will improve in the bottle. Obsolescence/spoilage is not a factor.

3) Romano likes to turn over its inventory about four times a year. Actually, they don’t have a choice, because they don’t have a lot of excess cash. They must keep their business cycle at a reasonable length. However, 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 eventually 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 net 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 following 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

Equity460,000

Total2,285,000Total2,285,000

5) Assume the current FASB Codification text is the accounting guidance in place during case timeframe.