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In 2015, the Financial Accounting Standards Board issued Accounting Standards Update Simplifying the Measurement of Inventory (ASU 2015-11). This standard simplifies the subsequent measurement of inventory by replacing the "lower of cost or market" test with a new "lower of cost and net realizable value test." However, entities that use the LIFO or retail inventory methods, will continue applying their current impairment models.

Current standards require inventory to be measured at the "lower of cost or market," with the calculation of market taking a "ceiling" and "floor" into account. With this consideration market could be either net realizable value (ceiling), replacement cost, or net realizable value less a normal profit margin (floor). The new guidance looks to reduce the multiple possible outcomes and more closely align with International Financial Reporting Standards by comparing inventory cost to only one measure, net realizable value. 

This new guidance does not change the existing calculation used to find net realizable value, which is defined as the "estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation," nor does it change any other areas of the accounting for inventory. 
  

Example - "Lower of Cost or Market" vs. "Lower of Cost and Net Realizable Value"

On September 1, 2017, a distributor purchased 500 units for $250 each and listed them at a selling price of $300. All 500 units were held in inventory as of the year ended December 31, 2017. On November 1, 2017, the manufacturer that built the units reduced their selling price to $200 per unit. With this price reduction, the distributor reduced their selling price to $275 in order to match their competitor's pricing. Assuming there were no costs for completion, transportation, or disposal, the cost of inventory would be calculated as follows:

Current Standard - "Lower of Cost or Market"
Net realizable value (ceiling) = $275
Replacement cost = $200
Net realizable value less a normal profit margin (floor) = $200
Normal profit = $275 - $200 = $75
Normal profit % = $75/$275 = 27.27%
27.27% x $275 = $75
$275 - $75 = $200

In the above example the replacement cost would be the market value as it falls between the upper and lower limit. There would be a lower of cost or market adjustment of $50.

New Standard - " Lower of Cost and Net Realizable Value"

Using the same values as the above example, inventory would be valued at the lower of cost ($250) and net realizable value ($275). As cost is lower, no inventory adjustment would be recorded.

This guidance is effective for interim and annual periods beginning after December 15, 2016 for all public entities. For private entities, the guidance is in effect for all annual periods beginning after December 15, 2016 and interim periods during the fiscal years beginning after December 15, 2017. This guidance should be applied prospectively and can be early adopted. During the period of adoption, all entities must disclose the nature and reason for the change in accounting principle.

 For more information regarding the new inventory standard, please contact your local UHY LLP professional.

By Michelle Moore, CPA