Question

Grass Chopper GrassChopper is North America's largest manufacturer of commercial and residential lawn mowing and turf equipment including mulchers, grass collectors, and edgers. GrassChopper also offers attachments for snow removal and stump cutting. Historically, GrassChopper has relied on two vendors, Bluegrass Motors and Zoysia Machines, to supply various components of the single and twin cylinder engines used in its mowers. GrassChopper views both vendors as qualified and has typically selected between the two based primarily on price and availability. During the past year, GrassChopper purchased approximately 80% of its engine components from Bluegrass and 20% from Zoysia. On August 16, 1999, Zoysia acquired another engine components supply company, Dandy Engines, in a transaction intended by Zoysia to improve its economies of scale. On September 20, 1999, due to concern about possible enhanced price competition from the combined Zoysia and Dandy Company, Bluegrass approached GrassChopper with the following offer: In exchange for GrassChopper granting to Bluegrass an exclusive supply agreement for the next two years, Bluegrass will pay GrassChopper $1,000,000 in cash or other consideration. Pricing for engine components under the two-year exclusive supply agreement will be at "best available," meaning no other customer of Bluegrass will receive a better price on the engine components during the term of the exclusive supply agreement. The cash or other consideration granted would be irrevocable. The offer will expire in 10 days, on September 30, 2000. On September 29, 1999, GrassChopper accepted the offer, and for tax reasons, requested that Bluegrass issue a credit memo as consideration of the exclusivity agreement instead of cash. Bluegrass agreed to accommodate GrassChopper's request, and the following terms were included in the signed exclusivity agreement dated September 29, 1999: A credit memo for $1,000,000 will be granted to GrassChopper. GrassChopper may only apply the credit memo to future purchases. GrassChopper anticipates that purchases of engine component will result in full application of the credit memo within 30 days. Since the exclusive supply agreement states that the credit memo, when issued, is irrevocable, GrassChopper concluded, after consultation with outside counsel, that there were no circumstances, even noncompliance with the terms of the exclusive supply agreement, where Bluegrass could refuse to honor the credit memo. In the event of noncompliance with the terms of the exclusive supply agreement by GrassChopper, however, Bluegrass could choose to discontinue the best pricing offer. GrassChopper's counsel determined that no other economic penalty against GrassChopper could be assessed. GrassChopper's year-end is September 30, 1999. Required: Should the credit memo be treated as income or as an adjustment of inventory cost? When should the income/inventory adjustment be recognized? Comments (3)Should

When should the income/inventory adjustment be recognized?

Answer 1

Step 1

When Company G.C Exercise the credit note:

As enquired by Company G.C, There are no circumstances even if Company B.G refuses to honour the credit memo so company G.C should exercise the credit at the earliest.

Treatment of Credit Note:

The company should not treat it as a discount on purchase on purchase return because it is a big amount (equal to one month's purchase) it will make the purchase costs zero for the month it is exercised in. Inventory will be manipulated if the cost of purchase is recorded as zero.

Instead, Company G.C Should treat it as promotional income from supplier and recognize it at the end of the current month that is at the time of paying for the current month's purchase.

Step 2

The adjusting entry will be

Company B.G..........Dr $1,000,000

Promotional Income...........Cr $1,000,000

[ Being to record credit memo as promotional income against a purchase for the month]

Assuming that the total purchase bill for the month is $1,000,000 and Company G.C needs to make the payment.

Company G.C has exercised the credit note without affecting its inventory costs.

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