How are inventories valued subsequent to acquisition?

Answer 1

VALUATION SUBSEQUENT TO ACQUISITION

Both U.S. GAAP and IFRS require firms to initially record inventories at acquisition cost The market value of inventories may change, however, while the firm holds the inventory awaiting its sale to customers. Market value generally means replacement cost, the amount the firm would have to pay to replace the inventory.

Increases in Market Value

Inventories may increase in market value subsequent to acquisition for various reasons. A shortage of a key raw material (such as oil or nickel) may increase the market value of that raw material and therefore increase the replacement cost of inventory of which the raw material is a component. A new labor agreement may increase labor cost and thereby increase the replacement cost of manufactured inventories.

Decreases in Market Value

Inventories can decrease in market value for various reasons. A competitor may introduce a technologically superior product; a product may include materials found to contain a health hazard; the introduction of a lower-cost raw material lowers the manufacturing cost of a product using that raw material as a component.

In contrast to the treatment of increases in market value, both U.S. GAAP and IFRS require firms to write down (that is, reduce the balance sheet carrying value of) inventories when their replacement cost, or market value, declines below acquisition cost. Accountants refer to the inventory as impaired and to this valuation as the lower-of-cost-or-market basis. The journal entry to record the inventory impairment results in a loss and a new balance sheet carrying value that is the lower of cost or market value. U.S. GAAP does not permit firms to recognize subsequent value increases, even if the new value remains less than the original acquisition cost. In contrast, IFRS permits firms to reverse previous impairments, up to the amount of the original acquisition cost of the inventory, if the circumstances that caused the inventory impairment no longer exist.

U.S. GAAP specifies that, in the context of inventories, market means replacement cost, except that market may not exceed net realizable value (estimated selling price less cost to complete and sell the inventory) and may not be less than net realizable value reduced by a normal profit margin.

IFRS specifies that, in the context of inventories, market means net realizable value.

Calculating Cost of Goods Sold Using Different Bases of Inventory Valuation

The lower-of-cost-or-market basis for inventory valuation is a conservative accounting policy because (1) it recognizes losses from decreases in market value before a sale occurs, but recognizes gains from increases in market value above original acquisition cost only when a sale occurs, and (2) it reports inventories on the balance sheet at amounts that are never greater, but may be less, than acquisition cost.

Subsequent Sale of Inventory Adjusted to Lower-of-Cost-or-Market

If the inventory that the firm has written down (or marked down) remains salable, the firm will record revenues on the eventual sale of the items. The firm will debit Cost of Goods Sold and credit Inventory at the time it recognizes revenue. The difference between the amount of revenue and the amount of cost of goods sold is the gross margin on the transaction. Holding the selling price constant, the lower-of-cost-or-market adjustment reduces the carrying value of the inventory in the period of write-down but increases the gross margin recognized on the eventual sale of the inventory in a future period.

When both the write-down (or mark-down) and the sale of the marked-down inventory occur in the same reporting period, the income statement for that period captures both effects: the impairment loss (mark-down) will offset the lower market value of inventory recognized as cost of goods sold. If the firm does not sell the marked-down inventory until a later reporting period, the impairment loss will reduce income in an earlier period, but the later, higher gross margin in the period of sale will offset the loss. Lower of cost or market does not change total net income over the life of the item but does result in lower reported income in the earlier periods.