This month’s column highlights the principal effects of FASB’s Accounting Standards Update (ASU) 2015-11, Simplifying the Measurement of Inventory. While the standard’s primary impact has been felt by financial statement preparers, auditors must likewise be familiar with its guidance. ASU 2015-11 is effective for all business entities pricing inventories on a basis other than last-in, first-out (LIFO) or any retail method for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years for public entities and the following year for private entities. Application in earlier periods is permitted.
Also summarized are other inventory measurement nuances of old GAAP that are easy to miss but that remain in effect post–ASU 2015-11.
Prior to ASU 2015-11, FASB’s Accounting Standards Codification (ASC) Topic 330, Inventory, required entities to measure inventory at the lower of cost or market. The term “market” refers either to replacement cost; net realizable value (NRV), which is the estimated selling price in the ordinary course of business, minus costs of completion, disposal, and transportation (commonly called “the ceiling”); or NRV less an approximately normal profit margin (commonly called “the floor”). Under ASU 2015-11, entities should now measure inventory covered by the ASU at the lower of cost or NRV.
A subtle, easily overlooked effect of ASU 2015-11 is that the term “market” should no longer be used in accounting policy or other disclosures in reference to inventories, except in transition or when inventory is priced on a LIFO or a retail method basis. Instead, the term should be replaced with “net realizable value.”
Transition and Implementation
When adopted, ASU 2015-11 is applied prospectively to inventory measurements, and no adjustments to opening inventory values are permitted. If an entity has written down below cost any inventory measured by any method other than LIFO or a retail method, the reduced value continues upon adoption to be considered the new cost, as it always has. Disclosure of the nature of and reason for the change in accounting principle—and its effect, if significant—is required in the first interim and annual period following adoption (ASC 330-10-35-19, -20, and -65-1e; ASC 250-10-1).
In the period of adoption, preparers— and auditors—must first ascertain if the pre-adoption opening inventory balances reflected any significant market value writedowns. If so, then they must determine if any of the same specific inventory line items that were marked down to market values in the opening inventory are still contained in the closing inventories. Because those values are treated as revised cost values in the ending inventories, it makes no difference how those market values were determined at the end of the prior period. Preparers and auditors must examine such items, however, and consider whether further obsolescence markdowns are now required because the items are a year older, or whether carrying values require further reductions from pre-adoption market value to a lower NRV. The aggregate, separate effect of the latter (but not the former) represents the effect of an accounting change that must be disclosed if material.
If, at the end of the period of adoption, the NRV determined for any inventory line item is higher than the pre-adoption market value (most likely replacement cost), no adjustment should be recorded for that item, and if there are no other items subject to adjustment, there is no effect of the accounting change.
Disclosure of Significant Estimates
Making reliable estimates of downward inventory adjustments may be difficult in periods of economic stability, but more so in periods of economic volatility. Accordingly, when significant, these estimates should ordinarily be included in required disclosures about the use of estimates (ASC 275-10-50-8).
Inventories and cost of goods sold are typically estimated at interim reporting dates by a valuation method different from that typically used at or near annual physical inventory dates, usually the gross profit method. If significant, the method of estimating interim inventories should ordinarily be disclosed as an accounting policy in the interim financial statements (ASC 235-10-50-1–4). Any significant true-up adjustments that result from reconciliations with physical inventory should also be disclosed in the period of such adjustment (ASC 270-10-45-6a).
The method of estimating interim inventories should ordinarily be disclosed as an accounting policy in the interim financial statements.
Because inventory writedowns taken at year end are deemed to be a new cost prospectively, unlike valuation allowances that are applied to other assets, they may not be restored in future years (ASC 330-10-35-14). On the other hand, recognition of interim inventory valuation writedowns taken on the same inventory line items at interim reporting dates are generally required under GAAP to be restored in future interim periods if no longer applicable (ASC 270-10-45-6). If at the time the interim financial statements are prepared, however, such interim declines in inventory values can reasonably be expected to be restored within the same fiscal year, then they need not be recognized at the interim reporting date, since no inventory loss is expected to be incurred in that fiscal year. Although not expressly required by the ASC, if such unrecognized temporary inventory valuation declines are material, they should ordinarily be considered for disclosure in the interim financial statements of significant estimates (ASC 270-10-45-6c).
Risk Associated with Inventory Valuation Allowances
Because of the matters discussed above, auditors should be wary of the risk of inadvertent (or intentional) inventory markdown restorations in annual financial statements that are, in fact, departures from GAAP that can occur when companies use valuation allowances and fail to track specific markdowns by product line items. In fact, GAAP effectively states that marking down individual line items is a requirement except in specified limited circumstances (ASC 330-10-35-9–11). Any permissible use of an aggregation rather than an individual item approach for inventory valuation adjustments that has a potentially material effect on the determination of periodic income should be disclosed as an accounting policy (ASC 235-10-50-1–4).