In July of 2015, the Financial Accounting Standards Board (FASB) released an Accounting Standards Update (ASU) to simplify the measurement of inventory. Accounting Standard Codification (ASC) 330 currently requires a company to measure inventory at the lower of cost or market, which could be replacement cost, net realizable value, or net realizable value less profit margin.
Those companies who currently measure inventory using the first-in, first-out (FIFO) or average cost methods should measure inventory under the new ASU at the lower of cost or net realizable value. Net realizable value is the estimated selling price less costs of completion, disposal and transportation. This new method eliminates the floor to ceiling approach as illustrated in the example below.
Assume it is the end of December 2015, and your retail store has 25 cell phones in inventory. You purchased the cell phones directly from the manufacturer at a cost of $250 each and you planned to sell the cell phones at $300 each. It costs the retail sore $25 per unit to get the item ready for sale and actually sell it due to packaging costs and sales commissions. The normal profit margin is expected to be $35 per unit. The replacement cost of the cell phones is $230.
Under the lower of cost or market method, the market amounts are $275 for net realizable value, $240 for net realizable value less normal profit margin, and $230 for replacement cost. Therefore, the inventory market amount is $240, the net realizable value less normal profit margin, as this amount is between the net realizable value (ceiling) and the replacement cost (floor). The inventory would be valued at $240 (the lower of the $250 cost versus the $240 market).
Under the new simplified method, the inventory would be valued at $250 (the lower of the $250 costs versus the $275 net realizable value).
ASU 2015-11 does not apply to any company that measures inventory using the last-in, first-out (LIFO) or uses the retail inventory method as the costs and inherent complexities would not justify such a change.
The new guidance is effective for public entities for fiscal years beginning after December 15, 2016 and for private entities for fiscal years beginning after December 15, 2016, with early adoption permitted. For more information, see the entire pronouncement from the FASB (ASU 2015-11 Simplifying the Measurement of Inventory.)
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