Recent accounting standards amendments aim to simplify subsequent measurement of inventory.
Does your business have inventory? If so, be mindful that accounting standards are changing how inventory is measured for potential impairment.
In July 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2015-11, entitled “Simplifying the Measurement of Inventory." ASUs are issued to communicate how the Accounting Standards Codification (the source of United States Generally Accepted Accounting Principles) is being amended. The amendments in ASU 2015-11 are designed to simplify the subsequent measurement of inventory.
What is Subsequent Measurement?
A business should initially record inventory for the amount incurred to acquire or produce it (referred to as “cost”). If circumstances later reveal its utility has declined below its cost, accounting standards require inventories to be subsequently measured (valued) and adjusted to the lower, more conservative amount. Evidence for impaired inventory values includes a downturn in sales prices, obsolescence, damage or physical deterioration. The requirement to evaluate inventory for a loss in value and to subsequently measure inventory at that lower value has not changed with ASU 2015-11, but what has changed is the way this measurement is calculated.
What Are the Changes?
Current accounting standards (prior to this ASU) require inventory to be subsequently measured at the lower of cost or market. The term “market” refers to replacement cost (the cost to acquire or produce the inventory currently), provided it does not exceed net realizable value (the “ceiling”) and provided it is not less than net realizable value less an approximately normal profit margin (the “floor”). Net realizable value is defined as “the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation.”
The FASB determined these three measures are unnecessarily complex. Under ASU 2015-11, inventory is subsequently measured at the lower of cost or net realizable value. The measurement is no longer based on replacement cost, and there are no longer “ceiling” or “floor” considerations, thus moving the U.S. accounting standards for subsequent measurement of inventory closer to International Financial Reporting Standards.
The following table sets forth several comparative examples of subsequent measurement of inventory under the current guidance and the new guidance. In each instance, these illustrations assume the utility of inventory has declined below its recorded cost.
As demonstrated, valuing inventory at the lower of cost or net realizable value under the new guidance is a simple and direct method for subsequently measuring inventory. This table also shows that market value under the current guidance varies within the three measures; it is replacement cost, but subject to the “ceiling” of NRV and the “floor” of NRV less an approximately normal profit margin.
The amendments to subsequent measurement in ASU 2015-11 apply to any business with inventory measured using the first-in, first-out (FIFO) method, the average cost method and other methods, with the following exclusions: they do not apply to inventory measured using the last-in, first-out (LIFO) method or the retail inventory method. The FASB decided the costs would not outweigh the benefits for these complex methods.
Fraud Risks Considered
Lenders, auditors and management should remain alert to inventory fraud risks. Businesses that need to carry large amounts of inventory to meet demand could be heavily reliant on bank financing. Lending institutions may require the borrower to achieve benchmark financial ratios. In addition, loan agreements may contain borrowing base calculations that limit borrowings in part based on inventory balances. Loan requirements can create financial pressure on companies to accomplish these financial ratios and maximize their borrowing capacity.
A classic fraud scheme to improve the appearance of the balance sheet (by increasing inventory) and income statement (by decreasing expenses and increasing net income) involves capitalizing general and administrative or other non-production costs into inventory, when in fact these costs should be expensed in the current period because they do not relate to the production of inventory. This risk is greater with a manufacturing company, where the costs of inventory production include an allocation of overhead costs (indirect costs of production) subject to variation and management’s judgment.
Subsequent measurement of inventory at the lower of cost or NRV is one way to ensure inventory is not overvalued. However, this does not completely eliminate the fraud risk of non-manufacturing expenses being included in inventory. Under the lower of cost or NRV guidance, inventory may be valued at a breakeven point (selling price less costs to complete and sell the goods, or NRV) with no further reduction for an estimated profit margin. A fraud perpetrator might allocate some general and administrative costs or other period operating costs into inventory and then “justify” the inventory balances based on the carrying amount being equal to or less than the selling price. In this example, although the carrying amount of inventory is equal to or less than the selling price, the value is in fact inflated because it includes costs that have nothing to do with the acquisition or production of inventory. It is important to consider the nature of costs being included in inventory.
The amendments in ASU 2015-11 are prospectively effective for public and nonpublic companies for fiscal years beginning after December 15, 2016. In addition, the amendments are effective for interim periods of public companies within fiscal years beginning after December 15, 2016, and interim periods of nonpublic companies within fiscal years beginning after December 15, 2017. Early implementation is permitted.
The new guidance in ASU 2015-11 will indeed simplify how inventory is subsequently measured for impairment. I expect many businesses will choose early adoption of this ASU to streamline their financial reporting process. iBi
Philip Schmidt, CPA, CFE is a manager in the Audit Department at Heinold Banwart, Ltd. He can be reached at (309) 694-4251 or firstname.lastname@example.org.