In a quest for simplification, accounting rulemakers have identified what many consider to be an easy fix for measuring the current value of inventory when there’s suspicion it may be diminishing as products sit in a warehouse or gather dust on a store shelf.
The Financial Accounting Standards Board has proposed a plan to reduce the number of data points companies will have to produce to determine the value that should be reflected on the balance sheet for inventory. That means fewer steps, simpler controls, and fewer opportunities for error. According to a recent analysis by Audit Analytics, in 2012 inventory ranked third on the list of reasons why companies disclosed deficiencies in their accounting procedures.
FASB says it hears from those who rely on financial statements that inventory accounting is unnecessarily complicated because it can lead to several potential outcomes. "It is a problematic area," says John Hepp, a partner with Grant Thornton. "Anything to do with valuation has been a concern of the Public Company Accounting Oversight Board over the last several years." So FASB has decided to make it less complicated by reducing the steps to arrive at a current value for inventory when its value might be “impaired,” or somehow reduced from what the company paid to acquire it.
“When you’re trying to calculate replacement cost or normal profit margins, there’s some judgment involved. So this would remove some of the noise and judgments and not dramatically change financial performance.”
Rick Day, Partner, McGladrey
“The question here is how to do you value inventory when you buy it for X and now it is worth something other than X,” says Robert Chersi, executive director for the Center for Global Governance, Reporting and Regulation at Pace University. The conservative approach, long the basis for writing accounting rules, would require companies to reflect that loss as soon as they see it, not waiting until the sales cycle is complete and the loss is real. “So if you’re carrying inventory and you know when you sell it there’s going to be a loss, don’t wait for the loss. Book it today.”
Under current Generally Accepted Accounting Principles, companies are required to show a value for inventory based on cost or market value, whichever is lower. GAAP allows a number of methods for setting the cost of inventory: average cost, first-in-first-out, last-in-first-out, or the retail inventory method. Those cost methods are untouched by FASB’s simplification proposal. It’s the steps for determining market value that are reduced and simplified under FASB’s proposal.
Current GAAP says market value is determined as replacement cost, net realizable value, or net realizable value minus an approximately normal profit margin. The use of all three data points sets a “floor” and a “ceiling” on the possible value, says Beth Paul, a partner with PwC. If the replacement cost falls in the middle, that’s the market value to be compared to cost. If it is below the floor or exceeds the ceiling, then the floor or ceiling figure becomes the constraint on the market value.
No Floor, No Ceiling
FASB’s proposal is to do away with the floor and ceiling, or the need to calculate replacement cost or expected profit margins. Instead, companies would calculate only the net realizable value of inventory, something they do under existing standards already. Net realizable value is defined as the estimated selling price under normal business conditions minus reasonably predictable costs of completing and delivering the goods. “The proposal would remove one of the challenges in practice today, which is preparers spending time trying to figure out the floor and ceiling,” says Paul.
VALUING INVENTORY
The following, from AccountingExplained.com, provides a clear, plain English definition of how to value inventory.
Assets are generally stated in the financial statements according to the cost principle. However, in case of inventory, cost principle is abandoned and lower of cost or market (LCM) rule takes its place. This rule states that inventory should be measured at the lower of:
Cost; or
Market Value
Market value means the replacement cost of the inventory. Replacement cost may be in the form of purchase cost or manufacturing cost. In other words, market value is amount that we would have to pay to acquire inventory of the same quantity and quality through purchase or through manufacture. However, upper and lower limits have been placed on the market value of inventory.
Upper limit (also called ceiling) is the net realizable value (NRV) of inventory. NRV equals expected selling price less the sum of expected cost of completion and expected cost needed to make the sale.
Lower limit (also called floor) is net realizable value less normal profit margin on the inventory.
The LCM rule can be applied to inventory on individual items basis, inventory class basis or to entire inventory. However the choice must be consistent.
Example
Company A owns an item of inventory having original cost of $900. Its replacement cost is $880. The company expects to sell it at $980. However an expense of $40 must be incurred to make the sale. Calculate the value of inventory according to lower of cost of market rule.
Solution
Upper Limit: NRV = 98- - 40 = $940
Replacement Cost: = $880
Lower Limit: NRV – Normal Profit = 940 – (980 – 880) = $840
Since the replacement cost of $880 lies within the limits set by LCM rule, it is allowable market value of the inventory. This market value is to be compared to the original cost of inventory which is $900. Since the market value of inventory is lower than its original cost therefore it should be stated at $880 in the financial statements.
Source: AccountingExplained.com.
Reducing the variables in measuring the market value of inventory would also bring U.S. GAAP closer to International Financial Reporting Standards, says Rick Day, a partner with McGladrey. FASB’s objective is not necessarily convergence with IFRS, but it’s a welcome result, he says. The proposal would also make inventory measurement more consistent with measurements for other non-financial assets, he says. “When you’re trying to calculate replacement cost or normal profit margins, there’s some judgment involved,” he says. “So this would remove some of the noise and judgments and not dramatically change financial performance.”
Removing the floor and ceiling concepts would unravel a knot in accounting rules that has existed since the 1940s, says Joel Osnoss, a partner with Deloitte & Touche. “It’s just too complex,” he says. “It’s ironic it took this many years” for standard setters to address it. “This proposal takes the theoretical measures out and asks: What would it cost to recreate that item?”
Because the proposal is focused only on measuring the market value for inventory, it does nothing to address complexity in calculating costs of inventory he says. “LIFO is a very complicated, involved process that takes higher priced inventory out of inventory sooner,” he says. “Some believe it is overly complicated, but it’s a tax strategy, and a lot of companies use LIFO for tax. If you use it for tax, you have to use it for books.” IFRS does not permit LIFO, but U.S. companies that depend on it to minimize their tax liability would not likely give it up without a fight.
FASB’s proposal will affect any company that carries inventory, but the effect is probably greatest for entities where inventory pricing can be volatile, such as with certain commodities, says Day. “Think of ethanol where grain can change dramatically in value,” he says. “If there are big swings in those types of products, estimation is difficult. If the product you’re selling is not as elastic or doesn’t move the way raw material pricing works, it’s even more difficult.”
Comments on the proposal so far have been few, with very little opposition to the idea. Tom Selling, an independent consultant, is one such opponent, however, saying the proposal would obscure financial information for users when companies operate under situations where the floor and ceiling are highly relevant. That includes, he says, instances where product lifecycles are particularly long or short. “For those financial statement users who prefer conservative measurements, the exposure draft would reduce conservatism by reducing the incidence of write-downs and would result in failures to record a sufficient write-down,” he wrote.
FASB expects to finalize the rule so that it would be effective for annual and interim periods beginning after Dec. 15, 2015, and it plans to allow early adoption. If finalized by the end of this year, that means calendar-year companies could begin applying it immediately, says Hepp. “FASB is just looking for quick simplification,” he says. “This is one they ought to be able to get out the door fairly quickly without any controversy.”
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