Measurement of Inventory

The type of inventory valuation can affect the inventory carrying amounts and the cost of sales. Consequently, financial items such as current assets, total assets, and net income are impacted. As such, analysts should analyze financial statements and accompanying notes information regarding inventory accounting policies.

Measurement of Inventory at the Lower of Cost and Net Realizable Value

Recall Net realizable value is defined as the estimated selling price in the ordinary course of business, less the estimated costs necessary to make the sale and the costs to get the inventory in condition for sale.

Both IFRS and US GAAP have specific guidelines for inventory measurement, though there are notable differences.

IFRS Guidelines

Under IFRS, inventories must be measured and carried on the balance sheet at the lower of cost and net realizable value. This measurement is crucial in financial reporting as it ensures that inventory is not overstated on the balance sheet. This is particularly important because the value of inventory can decrease due to factors such as spoilage, obsolescence, or declining selling prices.

The assessment of net realizable value is typically performed item by item or by groups of similar or related items. If the net realizable value of inventory falls below its carrying amount, the inventory must be written down to this net realizable value. The resulting loss is recognized as an expense on the income statement, either included in the cost of sales or reported separately.

In subsequent periods, if the net realizable value increases, previous write-downs can be reversed, but only up to the amount of the original write-down. This reversal is recognized as a reduction in the cost of sales.

US GAAP Guidelines

Historically, US GAAP required inventories to be valued at a lower of cost or market value. However, for fiscal years beginning after December 15, 2016, inventories excluding those measured using the last-in, first-out (LIFO) or retail inventory methods are measured at the lower of cost or net realizable value, aligning more closely with IFRS.

Unlike IFRS, US GAAP prohibits the reversal of inventory write-downs. For inventories measured using LIFO and retail inventory methods, “market value” is defined as the current replacement cost, subject to upper and lower limits. The market value cannot exceed net realizable value, nor can it be less than net realizable value minus a normal profit margin.

Implications of Inventory Measurement on Financial Statements and Ratios

Inventory write-downs decrease reported profits because the loss is recognized as an expense on the income statement. This negatively affects profitability ratios, such as the net profit margin and gross profit margin.

Moreover, the write-down reduces the carrying amount of inventory on the balance sheet, which can negatively affect liquidity ratios like the current and quick ratios. Lower inventory values also reduce the total asset base, impacting solvency ratios such as the debt-to-assets ratio.

Lastly, activity ratios, such as inventory turnover and total asset turnover, can improve following a write-down because these ratios are calculated using a lower asset base (denominator).

Special Considerations

Analysts should be aware of the potential for significant inventory write-downs, especially in industries where technological obsolescence is a major risk. It’s essential to evaluate the potential impact of inventory write-downs on financial ratios, particularly when debt covenants include specific ratio requirements. Breaching these covenants can have severe consequences for a company.

Companies using specific identification, weighted average cost, or FIFO methods are more prone to inventory write-downs compared to those using LIFO. Under the LIFO method, inventory costs are already conservatively presented at the oldest (often lowest) costs, making significant write-downs less likely.

International Accounting Standards 2 (IAS 2), which governs inventories, does not apply to producers of agricultural and forest products, minerals, and commodity broker-traders. These inventories may be measured at net realizable value according to industry practices, often based on market prices if an active market exists.

Question #1

If a company values its inventory at the net realizable value, this will most likely:

1. Improve the company’s profitability.
2. Decrease the company’s inventory turnover.
3. Lead to any loss being recognized as an expense on the company’s income statement.

Solution

The correct answer is C.

When a company’s inventory carrying amount is written down to its net realizable value, the loss is recognized as an expense on the income statement.

A and B are incorrect. If a company values its inventory at the net realizable value, its profitability will decrease as its inventory turnover increases.

Question #2

To find the net realizable value of a company’s inventory, which of the following items ought to be deducted from the inventory’s expected selling price?

1. Selling costs.
2. Costs required to convert inventory into a sellable condition.
3. Both selling costs and costs are required to convert inventory into a sellable condition.

Solution

The correct answer is C.

The net realizable value of a company’s inventory could be figured out using the following equation:

Net realizable value = Selling price in an arm’s length transaction – Cost of sales – Cost required to convert inventory to sellable condition.