Article Published: February 10, 2016
Article Published: February 10, 2016
By Lindsay Andrews, CPA, Louis Plung & Company
Before you start reading, you should know that for most manufacturers, one of the most complex areas of financial reporting, and what drives their operations, is inventory. Depending on the organization size, stating inventory properly can be an extremely time-consuming and complex process. A few steps to account properly for inventory are below.
• Counting your physical inventory on hand
• Reconciling the physical inventory to accounting records
• Determining reorder points
• Applying overhead costs incurred properly to work in process and finished goods inventory
• Reviewing cost assignments
• Verifying proper cut-off based on vendor and customer terms
• Measuring the inventory value (Which has been addressed in the new Accounting Standards Update)
While some procedures for tracking and stating inventory may be done daily, testing inventory value and potential impairment may be completed at relatively longer intervals, such as monthly, quarterly or at the annual close. The Financial Accounting Standards Board (FASB) issued guidance in 2015 to help simplify the calculations performed regarding the valuation measurement of inventory held.
Companies that have inventory should be familiar with the lower of cost or market principal, which has been the generally accepted way of valuing inventory dating back many years (this valuation method was included in accounting research bulletin 43, issued in June 1953). Accounting Standards Update (ASU) 2015-11 regarding changes to the measurement of inventory was issued earlier in 2015. It replaced the long-standing lower of cost or market valuation methodology with lower of cost or net realizable value.
This new ASU is part of FASB’s simplification initiative, and it applies to all inventory measures except for last-in-first-out (LIFO) and the retail inventory method (RIM). For entities that use LIFO or RIM, they will continue to use existing impairment models.
The actual value of inventory held on companies’ books will only change due to this new ASU if the value of inventory declines or is impaired, as the guidance on cost is not amended. The change is that entities are now required to compare the cost of inventory to only one measure (net realizable value), and not the three measures required by the lower of cost or market guidance. Previous guidance required that “market” (which is deemed to be current replacement cost) be compared to a “ceiling” (net realizable value), which it cannot exceed, and to a “floor” (net realizable value, less an approximate normal profit margin) which it cannot fall below.
When companies make their current calculation of lower of cost or market, they should already be calculating the net realizable value, and the new guidance does not change that calculation. FASB defines net realizable value as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.”
The guidance is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years.
All Other Entities
The guidance is effective for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017.
Businesses are permitted to use early adoption, and must apply the guidance prospectively after the adoption date. The only new disclosure requirements for financial statements are the nature and reason for the change in accounting principle, which are applicable at implementation. It is expected that many businesses will consider early adoption due to the new ASU simplifying the impairment calculations for inventory.
About the Author
Lindsay Andrews is an Audit Manager with public accounting firm Louis Plung & Company, LLP. Andrews’ audit practice focuses on manufacturing, construction, non-profit, and employee benefit plans. For questions on inventory valuation, Andrews can be reached at firstname.lastname@example.org.