The Financial Accounting Standards Board (FASB) recently issued an Accounting Standards Update (ASU) that streamlines the subsequent measurement of inventory, requiring that inventory be measured at the lower of cost and net realizable value. This guidance is a part of the FASB’s simplification initiative and, while not the goal of FASB, will more closely align with International Financial Reporting Standards (IFRS).
The new guidance applies to companies that measure inventory using the retail inventory method (e.g., first-in, first-out (FIFO) average cost). It does not apply to companies that use the last-in, first-out (LIFO) method.
Under current guidance, at each financial statement date, companies must measure inventory at the lower of cost or market (LOCOM). While, in theory, this measurement sounds simple, companies must consider net realizable value (ceiling) and net realizable value less an approximately normal profit margin (floor) in their measurement. FASB determined that the multiple possible outcomes that can result from applying the current LOCOM guidance make the subsequent measurement of inventory unnecessarily complex.
Under the new guidance, at each financial statement date, companies must measure inventory at the lower of cost or net realizable value. There is no longer the complexity of a ceiling or floor. Net realizable value is defined by FASB as the “estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation.”
Example under current and new guidance
The following example illustrates the effect of the application of the new inventory valuation guidance:
- Original cost: $250
- Replacement cost: $200
- Net realizable value: $240
- Net realizable value less normal profit margin: $230
Under the current guidance, the company must compare the original cost ($250) to the replacement cost ($200). In this case, replacement cost is less than the original cost, but additional analysis is required to measure the inventory value. Market value is equal to replacement cost only when it does not exceed the net realizable value ($240) and does not fall below the net realizable value less an approximately normal profit margin ($230). Because the replacement cost does not fall between the ceiling and the floor, the inventory should be written down to net realizable value less normal profit margin — $230.
Under the new guidance, the company must compare the original cost ($250) to the net realizable value ($240). The inventory should be written down to the net realizable value ($240).
The new guidance is effective for public companies for fiscal years beginning after Dec. 15, 2016, and interim periods within those fiscal years. For all other companies, it is effective for fiscal years beginning after Dec. 15, 2016, and interim periods within fiscal years beginning after Dec. 15, 2017. Early adoption is permitted. The new guidance must be applied prospectively after the date of adoption.
Companies are required to disclose the nature and reason for the change in accounting principle in the first interim and annual period of adoption. Let us know if you need help.