Question

At December 31, 2017, Indigo Girls Company has outstanding noncancelable purchase commitments for 36,000 gallons, at \(3.00 per gallon, of raw material to be used in its manufacturing process. The company prices its raw material inventory at cost or market, whichever is lower. Instructions (a) Assuming that the market price as of December 31, 2017, is \)3.30, how would this matter be treated in the accounts and statements? Explain. (b) Assuming that the market price as of December 31, 2017, is \(2.70, instead of \)3.30, how would you treat this situation in the accounts and statements? (c) Give the entry in January 2018, when the 36,000-gallon shipment is received, assuming that the situation given in (b) above existed at December 31, 2017, and that the market price in January 2018 was $2.70 per gallon. Give an explanation of your treatment.

Short answer

(a) The company should report the details of the contract in the notes to the financial statements.

(b) Unrealized holding gain or loss will be recorded by recording journal entries, and it will be reported in the income statement. And estimated liability on purchase commitment will be reported in the balance sheet.

(c) In the journal entry, Purchases (Raw materials) will be debited by $97,200 and estimated Liability on Purchase Commitments will be debited by $10,800 and Cash will be credited by $108,000.

Step-by-step solution

Treatment in the accounts and statements in case (a)

(a) As on December 31, 2017, the market price per gallon equals $3.30 and contract price per gallon $3.00. As market price is higher than the contract price, and the contract is not completed, it should be reported in the notes to its financial statements in its material.

Treatment in the accounts and statements in case (b)

(b) As on December 31, 2017, the market price per gallon equals $2.70 and contract price per gallon $3.00. As market price is below the contract price, hence the company is required to record unrealized holding gain or loss of $10,800.

Unrealized holding gain or loss will be recorded. The unrealized holding loss of $10,800 will be reported in the income statement as “Other expenses and losses” and estimated liability on purchase commitments of $10,800 will be reported in the balance sheet under current liabilities section.

The following journal entry is to be recorded”

Date	Account	Debit	Credit
December 31, 2017	Unrealized Holding Gain or Loss- Income	$10,800
	Estimated Liability on Purchase commitments		$10,800

Calculation of unrealized holding gain or loss

Unrealized holding gain or loss is calculated as:

$\begin{array}{rcl}\mathrm{Unrealized}\mathrm{holding}\mathrm{gain}\mathrm{or}\mathrm{loss}& =& \mathrm{Number}\mathrm{of}\mathrm{gallons}\times \left(\mathrm{Contract}\mathrm{price}-\mathrm{Market}\mathrm{price}\right)\\ & =& 36,000\times \left(\$3.00-\$2.70\right)\\ & =& \$10,800\end{array}$

Treatment in case (c)

(c) The following journal entry will be recorded in this case:

Date	Accounts	Debit	Credit
Jan. 2018	Purchases (Raw materials)	$97,200
	Estimated Liability on Purchase Commitments	$10,800
	Cash		$108,000

Calculation of purchase value

Purchase value is calculated as follows:

$\begin{array}{rcl}\mathrm{Purchase}\mathrm{value}& =& \mathrm{Number}\mathrm{of}\mathrm{gallons}\times \mathrm{Market}\mathrm{price}\\ & =& 36,000\times \$2.70\\ & =& \$97,200\end{array}$