OK, let’s start with something positive. The FASB recently issued proposals to simplify two accounting topics, and whaddya know, I am actually in favor of one of them.
The “extraordinary item” income statement category is rarely used, and the highly restrictive criteria for its use may even result in misleading signals to analysts. The stated goal for the FASB’s simplification initiative is to “…improve areas of GAAP for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to users of the financial statements,” so the proposal to eliminate presentation as an extraordinary item is low-hanging fruit. In addition to benefitting users, it is a slight windfall to educators who would be burdened by one fewer set of arbitrary technical rules to cover in the infamously bloated Intermediate Accounting curriculum.
However, proposed ASU 2014-210 to “simplify” the lower-of-cost-or market (LOCOM) rule for measuring inventory is quite another matter. As I will explain, the FASB’s proposal would not reduce complexity to any significant extent; and it would, contrary to the FASB’s committment, reduce “the value of the information provided.”
LOCOM for Inventory, Present and Future
Let’s begin by analyzing the principles-based provisions of LOCOM under existing GAAP, and the rules-based proposal that could replace it.
The current LOCOM principles and rules of application are set forth in ASC 330-10-35-1 through 11. They have survived virtually intact* since their issuance as part of Accounting Research Bulletin No. 29 way back in 1947:
“As a general guide, utility [i.e., economic value] is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. In applying the rule, however, judgment must always be exercised and no loss shall be recognized unless the evidence indicates clearly that a loss has been sustained. There are therefore exceptions to such a standard.” [ASC 330-10-35-4, emphasis supplied]
To handle the concern that replacement cost will not always measure the utility of inventory to an entity, it elaborates that under some circumstances two other measures might more accurately measure utility than replacement cost: net realizable value (NRV); and NRV reduced by an allowance for a normal profit margin. Utility or “market” is best measured by the middle value among the three.
Here is why. The three possible orderings of these three potential “market” measurements, are diagrammed below (stacked from high to low):
Scenario A Scenario B Scenario C
NRV Replacement Cost NRV
Replacement cost NRV NRV less profit
NRV, less profit NRV, less profit Replacement cost
Scenario A is typical of products with long life cycles, such as many commodities. Since the company will inevitably have to replace the inventory after selling its present stock, the current cost of replacement is the best measure of its economic value. Current GAAP would require a write-down if cost (e.g., FIFO, LIFO or whatever other arbitrary assumption the entity is permitted to make) were higher than current replacement cost.
Before proceeding to the other two scenarios, now is a good time to tell you about the FASB’s proposal. Very simply, the Board would replace “LOCOM” with “lower of cost or NRV.” So, along with the relegating to the dustbin of history the underlying economic reasoning for “market” as “current replacement cost,” Scenario A also reveals that the FASB’s proposal would reduce the magnitude, and even the incidence of write downs. This is because NRV is often higher than replacement cost.
Cynical me thinks that the issuers who encouraged the FASB to gut LOCOM may have been less motivated by complexity reduction, and more so by the goal to hide their economic losses from dips in commodity prices.
Scenario B is frequently encountered by companies that sell goods with short economic life cycles, such as fashion clothing and electronics. There will inevitably come a point when they are stuck with obsolete inventory, and a ‘fire sale’ in one form or another will occur; unless it is more economical to simply throw them onto the trash heap, they are going to sell these leftovers for as much as they can get.
Since there is no economic justification for re-stocking obsolete inventory — as reflected by the fact that replacement cost exceeds NRV — current GAAP correctly reasons that NRV is the most appropriate measure of utility under this Scenario B. (And, note that the FASB’s proposed changes would not change the accounting under this scenario.)
Scenario C is most unusual. But, it is not hard to imagine events that would cause replacement costs to plummet. (Think the bursting of the housing bubble in 2008.) GAAP reasons that, under such circumstances, a reliable estimate of utility is very low, given the market disruption that has occurred. Therefore, it is very likely that the FASB’s proposal to use NRV no matter the economic substance would overstate the economic value of inventory.
Why the FASB’s Proposal is a Travesty
Do you remember from above that the FASB promised to limit its simplification proposals to where they maintained or improved the usefulness of the information reported to investors? My simple demonstration conclusively show that the FASB’s inventory proposal breaks that promise. Not only will there will be fewer write-downs, when a write-down does occur, an inferior measure of “market” will be invoked in two of the three scenarios that our accounting ancestors foresaw, and handled in a non-controversial and principled fashion 67 years ago.
Moreover, the FASB’s only other justification, that LOCOM now requires the calculation of three values, is highly specious. Nothing more than common sense is needed to form a valid expectation that the measurement that best represents “market” will be obvious under the vast majority of scenarios; hence, while three measurements may have to be considered, it is very often the case that only one is actually calculated.
But, let’s for a moment concede that three values have to be calculated. If an entity has a sense that the carrying amount of its inventory is impaired, wouldn’t it almost always be the case that competent management will develop estimates of NRV and current replacement cost in the course of dealing with their problem? Aren’t “normal profit margins” already known to management?
And, finally, let’s for the sake of argument concede that the FASB’s proposal actually meets the criteria to be a candidate for its “simplification” initiatives. Shouldn’t the basis for conclusions in the proposing document explain how the FASB’s proposed amendments actually do that?
Yes, of course the Board should provide an explanation. But, as my analysis proves, they can’t; so they don’t say anything much at all. All we can glean from a mere four paragraphs on the subject of two of the most consequential financial statement items to users — inventory and cost of goods sold — is that having only one measure of market is easier than three (and that issuers would scream bloody murder if asked to measure inventory at “fair value” in accordance with ASC Topic 820).
I readily grant that the FASB has numerous stakeholders, like the ones who asked that LOCOM for inventory be simplified. But, the FASB must recognize that they have but one constituency: investors, who have not just been given short shrift, but who are being completely ignored by this proposal.
* * * * * * *
Anybody who reads this blog will know that I am not a fan of historic cost accounting. But, IMHO, the writers of ARB No. 29 crafted the most principled statement in the history of U.S. GAAP. The FASB now proposes to eradicate it, under the false pretense that the resulting accounting is is too “complex.” As an educator, I particularly lament that the only opportunity within a discussion of GAAP for illustrating how the concept of economic income can be operationalized as an accounting principle (just like I did above) will be lost.
Give me 5 minutes, and I’ll list 20 things the FASB should be doing before revising the accounting for inventory. Instead, to shield some “stakeholders” from unwanted inventory write downs, they are more willing to make (once again) a mockery of their vaunted “due process.”
*ARB No. 29 was restated in 1953 as Chapter 4 of ARB No. 43.