On July 23, the Financial Accounting Standards Board (FASB) updated U.S. Generally Accepted Accounting Principles (GAAP) to simplify the ways certain businesses report inventory. Accounting Standards Update (ASU) No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory, requires businesses that use the first-in, first-out (FIFO) or average cost method to measure inventory at the lower of cost or net realizable value (NRV), instead of at the lower of cost or market value. Most, but not all, stakeholders welcome this change.
Too many options
Under Accounting Standards Codification (ASC) Topic 330, Inventory, companies must value their inventory at the lower of cost or market. But “market” can mean different things. It can be:
- Cost to replace an item on the open market,
- Net value a seller will realize for the item during a normal business transaction (minus costs), or
- Net realizable value less an estimate of the normal profit margin.
Many companies and investors are overwhelmed by all of these options. So in 2014, the FASB started a project to reduce the multiple ways businesses measure inventory.
Negative feedback from major retailers
The changes FASB originally proposed for inventory accounting applied to all companies, regardless of how they measured inventory. However, some large retailers — including Target and Wal-Mart — complained that the proposal didn’t take into account the nuances of calculating inventory under the last-in, first-out (LIFO) or retail inventory methods.
The concerns from major retailers were significant enough for the FASB to reconsider the scope of its project. In May, the board agreed that it would exempt businesses that measure inventory using LIFO or the retail inventory method from implementing the simplified rules. Some FASB members, however, dissented to the final update because, in their view, the amendments allowed continued inconsistency in how companies measure inventory.
Practical application guidance
Except for companies that use LIFO or the retail inventory method, under the new rules the value of inventory on the balance sheet should be the lower of cost or NRV. The FASB defines NRV as “the estimated selling price in the normal course of business, minus the cost of completion, disposal, and transportation.” Businesses that use FIFO or the average cost method will no longer consider replacement cost or net realizable value less a normal profit margin when measuring inventory.
Similar to the existing rules, a business must reduce the value of inventory on its balance sheet and report a corresponding “writedown” on its income statement if the NRV of inventory falls below its original cost. After a writedown occurs, NRV becomes the new cost basis and can’t be written back up to original cost in subsequent periods.
Companies can apply the lower of cost or NRV standard either directly to each inventory item or to inventory in its entirety, depending on which approach most clearly reflects periodic income. To illustrate, suppose that Company ABC has three products in its inventory with the following values:
Company ABC has two options under the simplified rules: 1) apply it on a product-by-product basis and write down $80,000 for Product C (which is the only product that has an NRV below its original cost) or 2) apply it on an aggregate basis and record inventory at its total original cost of $1.3 million (requiring no writedown). It’s up to the company’s management to decide which alternative makes the most sense.
Laid-back implementation schedule
The new rule goes into effect for fiscal years that begin after December 15, 2016. Public companies will begin applying the changes to quarterly reports in 2017. Private companies and other organizations will begin applying them to quarterly and other reports covering less than a year in 2018.
Early implementation is permitted, but companies that apply the amendments ahead of the effective date must switch to the new accounting method at the beginning of the reporting period in which they are adopted. These changes can also be adopted prospectively, without adjusting prior period results.
To learn more about the inventory reporting guidelines, contact Dan Ward, Manager, Audit Services, at 314.983.1237.