Updated FASB Guidance Clears Up Complexity Issues for Measuring Inventories

Lower of cost or market, a required accounting principle, is a well-known method used to measure inventories. Yet, under this accounting guidance determining the market portion of an equation is complicated, since “market” has several definitions such as replacement cost, net realizable value and net realizable value less an approximately normal profit margin. It’s this inconsistency in defining market value that becomes unnecessarily complex for many entities to apply.

In July 2015, the Financial Accounting Standards Board (FASB) issued ASU 2015-11, which attempts to clarify and simplify accounting for inventories measured using the first in, first out (FIFO) or average cost methods. Under ASU 2015-11, inventories measured using these two methods are required to be stated at the lower of cost or net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business and the less reasonably predictable costs of completion, disposal and transportation. Although the new standard does not apply to inventories measured using the last in, first out (LIFO) or retail inventory methods of accounting, the principles of lower of cost or market have not changed for inventories measured under those methods.

While this new guidance will not require substantial changes to measuring inventories for most entities, it does simplify the determination of market value and takes the variability out of determining which measurement definition to apply for those using FIFO or average cost methods. Disclosure requirements will remain unchanged, as entities are still required to disclose any substantial and unusual losses that result from this subsequent measurement of inventories.

ASU 2015-11 will go into effect prospectively for public business entities starting the fiscal year after December 15, 2016 and interim periods therein. For all other entities, the guidance will go into effect prospectively for fiscal years beginning after December 15, 2016 and interim periods thereafter.  Early application of the ASU is permitted, and upon transition, entities must disclose the nature and reason for the accounting change.

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