Inventory valuation under IFRS and GAAP: this article is based on a study supported by the IMA[R] research foundation.
We'll review the major milestones on the road to possible convergence, summarize the differences in inventory valuation between IFRS and GAAP, and identify major issues that companies switching to IFRS have to contend with.
According to the 2008 IFRS roadmap, the SEC was supposed to decide in 2011 whether U.S. companies can issue financial statements using IFRS from 2015 onward. In September 2009, the leaders of the G20 nations requested that the international accounting bodies create a single set of global accounting standards by June 2011. In November 2009, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) reaffirmed that they would continue to harmonize their respective standards and try to meet the 2011 deadline. In February 2010, the SEC issued a "Statement in Support of Convergence and Global Standards" and issued a Work Plan highlighting six areas of concern commentators raised.
Although the SEC didn't decide by June 30, 2011, they sponsored a roundtable on July 7, 2011, to further analyze issues related to investor analysis and knowledge of IFRS, as well as the impact of IFRS on smaller public companies and the regulatory environment. In addition, the Office of the Chief Accountant at the SEC issued working papers in May and November 2011 on implementation issues, differences in GAAP vs. IFRS, and analysis of foreign issuers already using IFRS. In November 2011, the Division of Corporate Finance at the SEC also issued an analysis of IFRS in practice.
Currently, most U.S. companies aren't expected to be filing with IFRS for the next five years. Yet the SEC requires three years of comparative statements, which implies that if IFRS becomes applicable by 2015 (as per the SEC statement above), some companies may need to adopt the new standards in 2012. In a speech to the American Institute of Certified Public Accountants (AICPA) on December 5, 2011, SEC Chief Accountant James Kroeker indicated that they "are in the final stages of completion of the majority of the field work related to the Work Plan (2010)." He also said the SEC does need more time and that they are many months away from finalizing any decision related to IFRS (www.sec.gov/news/speech/2011/spch120511jlk.htm).
But the move to converge to IFRS has tentatively been set. Accounting practitioners and educators need to prepare for the transition now and learn the differences between these two sets of standards. Management accountants in particular need to educate themselves about inventory valuation. In manufacturing and merchandising industries with significant inventories, different valuation methods not only affect assets on a balance sheet, but they also result in different cost of goods sold (COGS) reported and have implications for tax planning. For example, Exxon Mobil Corp. reported that its replacement cost of inventories at 2010 and 2009 yearends exceeded its last-in, first-out (LIFO) inventories by $21.3 billion and $17.1 billion, respectively. Because IFRS doesn't allow for the LIFO inventory valuation method, companies like Exxon Mobil, which adopts LIFO under GAAP, would face tremendous difficulty in the transition.
GAAP primarily values inventory just like other assets--at cost of acquisition or production (Accounting Standards Codification[R] paragraph 330-10-30). Valuation for cost of acquisition includes all the costs incurred to bring inventory to a saleable condition and location, and production includes all variable overheads and allocation of fixed overheads. Interest can't be allocated to the cost of inventory during routine production. If the inventory items are specific and separately identifiable, the costs can be uniquely allotted, but if the inventory items are identical and interchangeable, then an assumption of the flow of costs can be made--first-in, first-out (FIFO), average costs, or LIFO. The method chosen should be the one that best reflects income. Standard costs are also accepted provided the company adjusts them to reflect current conditions. GAAP also requires the company to value inventory using the same procedure year after year (Codification paragraph 330-10-15).
If there's evidence that disposing of inventory in the normal course of business will be at lower than cost, then the difference between cost and expected disposal price will be recognized as a loss in the current period ( Codification paragraph 330-10-35). To do so, a company values inventory at market value (lower than cost), which is called the lower-of-cost-or-market rule. The market value is the current replacement cost subject to the following conditions:
* It doesn't exceed net realizable value (selling price in normal business minus reasonable costs of completion and disposal), and
* It isn't less than net realizable value minus a normal profit margin.
One exception to the lower-of-cost-or-market rule is that if there's any evidence that sales would occur at a fixed price, even if current replacement cost is lower than actual cost, then such a loss won't be recognized. If a company used fair value hedges to fix inventory costs, it should adjust the cost of inventory. If inventory has been written down under the lower-of-cost-or-market rule, then the new value would be the cost of inventory in the subsequent period. The lower-of-cost-or-market rule also applies to firm purchase commitments the company can't cancel. Also, the SEC Staff Accounting Bulletin (paragraph 330-10-S99-2) has interpreted that once the inventory has been written down below cost to a new value, it can't be written back up again to historical costs if facts and circumstances change.
GAAP considers income to have accrued at the time of sale, so profits can't be anticipated by valuing inventory at the current selling price (paragraph 330-10-35-15). But there are exceptions. When the selling price is controlled and costs aren't easily obtained, such as in agricultural products, metals, or minerals, a company can value such inventory at market price minus disposal costs.
Regulation S-X rule 5 provides the disclosure requirements for balance sheet items (paragraph 210-10-S99-1). Inventories are disclosed under current assets. The classes of inventory and the basis of valuation are stated separately. If any costs are allotted to inventory, they have to be disclosed separately, and if a company uses the LIFO method, then it has to disclose the difference between the stated and current value, which is the LIFO reserve.
GAAP--Tax Impact of Inventory Valuation
The IRS tax conformity rule IRC [section] 472(c) requires that companies using LIFO for tax purposes have to use LIFO for income measurement in financial accounting, too. Typically, companies using LIFO tend to have lower tax expenses, but they also have lower financial income. A change in inventory methods can affect the company's taxable income. If the change results in lower taxes, then the company can deduct the entire change in the year of the change, but if the change results in the company owing taxes, then the IRS allows the company to defer the taxes for three years (IRC [section] 481). Also, a gain on sale of inventory and any tax effects on such a gain between related companies can't be recognized until the inventory is sold to an outside party.
Switch to IFRS
IFRS adopted International Accounting Standard (IAS) 2, Inventories, which provides guidance on inventory valuation and applies to companies beginning January 1, 2005. Although the standard is similar to GAAP, the differences can result in substantially different inventory values. Table 1 summarizes the main differences in inventory valuation between GAAP and IFRS.
Table 1: Differences in GAAP and IFRS Regarding Inventory Valuation ITEM GAAP IFRS Applicable ARB 43, SFAS 34, IAS 2, IAS 23 regulations SFAS 151, SEC Staff Accounting Bulletin 5-BB, and SEC Regulation S-X all summarized in Codification paragraph 330. Initial Cost--specific Cost--specific cost, measurement cost, LIFO, average cost, FIFO. average cost, FIFO. Expense Variable costs, Interest to be allotted allotted fixed capitalized if costs. Interest production takes costs not to be substantial time or capitalized if financing element in inventory purchase agreement. manufactured Foreign exchange routinely. differences not to be capitalized. Consistency of All inventories No explicit guidance, measurement having similar so companies can use nature and use LIFO for U.S. inventory must be measured and FIFO for using same international method. inventory. Subsequent Lower of cost or Lower of cost and net measurement market where realizable value. market is replacement cost not exceeding net realizable value and not less than net realizable value minus normal profit. Assessment of Expense in the Net realizable value inventory year market is assessed every time lower than cost, period. Write-downs in resulting in new year when net cost for realizable value is subsequent less than cost. period. No Reversal allowed when reversals circumstances change. allowed. Reversal limited to original write-down--reduction in expense. Intragroup No deferred Deferred taxes can be sales of taxes can be recognized at buyer's inventory recognized as tax rate. the seller can't recognize profits until inventory sold to outsiders. Disclosure Required by the IAS 2 requires specific requirements SEC, not the detailed disclosure. accounting standard. If LIFO used, LIFO reserve disclosure required. Tax If LIFO is used Firms with LIFO implications for U.S. income valuation need to tax reporting, switch to either FIFO LIFO must be or average cost used for valuation, resulting in financial an increase in current reporting. and deferred taxes.
Similar to GAAP, IFRS values inventory at the cost of acquisition or production. Cost of acquisition includes all costs incurred to bring inventory to a saleable condition and location, and production includes all variable overhead and allocation of fixed overhead. Paragraphs 16 to 18 in IAS 2, identify certain costs, such as storage and selling costs, that a company can't add to the inventory cost. When it takes the company substantial time to get the inventory ready for sale, IAS 23, Borrowing Costs, allows interest to be allocated to cost of inventory. Furthermore, IAS 2 specifies that when a company purchases inventory with deferred settlement terms, the difference between the amount actually paid and purchase price is considered interest, so the company can add it to the cost of inventory.
IFRS mandates that if inventory items are identical and interchangeable, an assumption of the flow of costs can be made of either FIFO or average costs. Unlike with GAAP, LIFO isn't an acceptable method of inventory valuation. In Panel A of Table 2, we present the inventory valuation disclosure of Exxon Mobil Corp. and Royal Dutch Shell plc. Exxon files under GAAP with LIFO costflow assumption and reports $9.8 billion inventory as of 2010 year-end. Shell follows IFRS with FIFO assumption and reports $29.34 billion inventory. We can compare the inventory of the two top oil and gas competitors if we add the LIFO reserve of $21.3 billion to Exxon's 2010 year-end inventory of $9.8 billion. Similarly, a comparison of inventory valuation between two merchandising firms, Safeway Inc. under GAAP and TESCO plc under IFRS, is provided in Panel C of Table 2.
Table 2: Sample Disclosures PANEL A: MANUFACTURING SECTOR--OIL AND GAS INDUSTRY GAAP Exxon Mobil Corporation Footnote 1 Summary of Accounting Policies Inventories. Crude oil, products, and merchandise inventories are carried at the lower of current market value or cost (generally determined under the last-in, first-out method--LIFO). Inventory costs include expenditures and other charges (including depreciation) directly and indirectly incurred in bringing the inventory to its existing condition and location. Selling expenses and general and administrative expenses are reported as period costs and excluded from inventory cost. Inventories of materials and supplies are valued at cost or less. Footnote 3 Miscellaneous Financial Information In 2010, 2009, and 2008, net income included gains of $317 million, $207 million, and $341 million, respectively, attributable to the combined effects of LIFO inventory accumulations and draw-downs. The aggregate replacement cost of inventories was estimated to exceed their LIFO carrying values by $21.3 billion and $17.1 billion on December 31, 2010, and 2009, respectively. Crude oil, products, and merchandise as of year-end 2010 and 2009 consist of the following: 2010 2009 (billions of dollars) Petroleum products $3.5 $3.2 Crude oil 3.8 3.2 Chemical products 2.1 2.0 Gas/other 0.5 0.3 Total $9.9 $8.7 IFRS Royal Dutch Shell plc Footnote 2 Accounting Policies Inventories are stated at cost to Shell or net realizable value, whichever is lower. Cost comprises direct purchase costs (including transportation), cost of production, and manufacturing and taxes, and is determined using the first-in, first-out (FIFO) method for oil and chemicals and by the weighted-average-cost method for materials. Footnote 13 Inventories $millions Dec 31,2010 Dec 31, 2009 Oil and chemicals 27,742 25,946 Materials 1,606 1,464 Total 29,348 27,410 The cost of inventories recognized in income includes net write-downs and reversals of write-downs, which are driven primarily by fluctuations in oil prices. In 2010, net reversals were $184 million (2009: $1,535 million net reversals; 2008: $1,770 million net write-downs). Table 2: Sample Disclosures PANEL B: MANUFACTURING SECTOR--PHARMACEUTICAL INDUSTRY GAAP Pfizer Inc. Footnote 1 I Cost of sales and inventories: We value inventories at lower of cost or market. The cost of finished goods, work in process, and raw materials is determined using average actual cost. Footnote 10 The components of inventories as of December 31 follow: (millions of dollars) 2010 2009 Finished goods $3,760 $5,249 Work-in-process 3,733 5,776 Raw materials and supplies 912 1,378 Total inventories(a)(b) $8,405 $12,403 (a) The decrease in total inventories is primarily due to the inventory sold during 2010 that was acquired from Wyeth and had been recorded at fair value, as well as operational reductions and the impact of foreign exchange. Also, in the third quarter of 2010, we recorded, in cost of sales, a write-off of inventory of $212 million (which includes a purchase accounting fair value adjustment of $104 million) primarily related to biopharmaceutical inventory acquired as part of our acquisition of Wyeth that became unusable after the acquisition date. (b) Certain amounts of inventories are in excess of one year's supply. These excess amounts are primarily attributable to biologics inventory acquired from Wyeth at fair value and the quantities are generally consistent with the normal operating cycle of such inventory. There are no recoverability issues associated with these quantities. IFRS GlaxoSmithKline plc Footnote 2 Inventories are included in the financial statements at the lower of cost (including raw materials, direct labor, other direct costs, and related production overheads) and net realizable value. Cost is generally determined on a first-in, first-out basis. Prelaunch inventory is held as an asset when there is a high probability of regulatory approval for the product. Before that point a provision is made against the carrying value to its recoverable amount; the provision is then reversed at the point when a high probability of regulatory approval is determined. Footnote 9 Inventories The following expenses were included in operating profit: 2010 2009 2008 ([pounds sterling]m) Cost of 7,014 6,743 5,734 inventories included in cost of sales Write-down of 305 276 298 inventories Reversal of (66) (116) (118) prior year write-down of inventories The reversals of prior year write-downs of inventories principally arise from the reassessment of usage or demand expectations prior to inventory expiration. Footnote 14 The group is required under IFRS to create a deferred tax asset in respect of unrealized intercompany profit arising on inventory held by the group at the yearend by applying the tax rate of the country in which the inventory is held (rather than the tax rate of the country where the profit was originally made and the tax paid, which is the practice under U.K. and U.S. GAAP). As a result of this difference in accounting treatment, the group tax rate under IFRS increased by 1.7% in 2010 (2009--0.5% increase, 2008--2.1% increase) arising from changes in work-in-progress and finished goods. Footnote 23 2010 2009 ([pounds sterling]m) Raw materials and consumables 1,466 1,153 Work-in-progress 751 1,437 Finished goods 1,620 1,474 3,837 4,064 Table 2: Sample Disclosures PANEL C: MERCHANDISE SECTOR--CONSUMER GOODS RETAILING GAAP Safeway Inc. Footnote A Merchandise Inventories Merchandise inventory of $1,685 million at yearend 2010 and $1,629 million at yearend 2009 is valued at the lower of cost on a last-in, first-out (LIFO) basis or market value. Such LIFO inventory had a replacement or current cost of $1,720 million at yearend 2010 and $1,692 million at yearend 2009. Liquidations of LIFO layers during the three years reported did not have a material effect on the results of operations. All remaining inventory is valued at the lower of cost on a first-in, first-out (FIFO) basis or market value. The FIFO cost of inventory approximates replacement or current cost. The company performs physical counts of perishable inventory in stores every four weeks and nonperishable inventory in stores and all distribution centers twice a year. The company uses a combination of the retail inventory method and cost method to determine the cost of its inventory before any LIFO reserve is applied. The company records an inventory shrink adjustment upon physical counts and also provides for estimated inventory shrink adjustments for the period between the last physical inventory and each balance sheet date. Footnote J Taxes on Income 2010 2009 Deferred tax liabilities: Property $(649.5) $(626.3) Inventory (306.5) (286.9) Investments in foreign operations (60.2) (54.5) (1,016.2) (967.7) IFRS TESCO plc Note 1 Accounting policies Inventories Inventories comprise goods held for resale and properties held for, or in the course of, development and are valued at the lower of cost and fair value less costs to sell using the weighted average cost basis. Note 15 Inventories 2/26/2011 2/27/2010 [pounds sterling]m [pounds sterling]m Goods held for resale 3,142 2,726 Development properties 20 3 3,162 2,729
If the company adjusts standard and retail costs to reflect current conditions, IFRS accepts them. There are exceptions to IAS 2. IFRS doesn't apply IAS 2 to agricultural produce, minerals, and mineral products and to brokers and dealers whose inventory is always valued at selling price minus costs of selling.
IFRS requires a company to value inventory at the lower of cost or net realizable value (or fair value). Net realizable value is the estimated selling price minus the estimated costs necessary to make the sale. In the three panels of Table 2, companies under GAAP report inventories valued at the lower-of-cost-or-market rule, and companies under IFRS report inventories valued at the lower of cost and net realizable value.
If the market price is lower than cost, IFRS also recognizes an expense in that period. But unlike GAAP, IFRS allows companies to reverse the expense in the period when the market price goes back to above cost. Table 2 features an example of such reversals in Panel A (Royal Dutch Shell plc footnote 16) and Panel B (GlaxoSmithKline plc's footnote 9).
IAS 2 paragraph 36 requires detailed disclosures of inventory classification; the accounting policy; cost formula used; fair value less costs to sell; inventory expense for the period; write-downs and reversals of write-downs, if any; reasons for reversals; and value of any inventory used as collateral. As IFRS doesn't allow LIFO, there's no need for any LIFO disclosures.
Although IFRS has far more disclosure requirements than GAAP, companies following GAAP have disclosures on inventory classification, accounting policy, cost basis, and LIFO disclosure, if necessary. They also provide voluntary disclosures on write-downs if they are material and inventory expenses for the period in the form of cost of goods sold in the income statement.
IFRS--Tax Impact of Inventory Valuation
Unlike GAAP, gain on sale of inventory between related companies requires that the seller recognizes deferred taxes at the buyer's tax rate. Consider GlaxoSmithKline plc. Its 2010 year-end statement footnote 14 illustrates the tax impact of switching from GAAP to IFRS (see Panel B of Table 2).
Implications of Switching to IFRS Inventory Valuation
The switch to IFRS will most impact companies using LIFO to value inventory. According to the "Incorporating IFRS into Intermediate Accounting" presentation at the 2008 American Accounting Association (AAA) annual meeting, the IRS estimates that removing LIFO will result in more than $10 billion in increased tax revenues. LIFO requires companies to include current inventory costs in income calculation. With a mild increase in inventory costs, LIFO methodology can result in lower taxable income and lower taxes--the higher the cost increase, the bigger the tax advantages. For the year 2010, Exxon Mobil had a LIFO reserve of $21.3 billion. Given the effective tax rate of 45% in footnote 18, if Exxon were to switch to IFRS reporting and use FIFO, its taxes would increase by $9.6 billion. Therefore, it would be all the more necessary for the IRS to remove the conformity rule and allow companies to report taxable income using LIFO and financial reporting with either FIFO or average costs. Robert Bloom and William Cenker suggested another option, which would be to encourage companies to reduce inventory reserves over the next few years while IFRS gets phased in (www.journalofaccountancy.com/Issues/2009/Jan/DeathOfLIFO.htm).
Implementing IFRS in the United States also requires coordinating many regulatory authorities. The PCAOB has to educate its employees so they can answer audit questions; the IRS, as mentioned earlier, should remove the conformity rule; and the SEC will have to educate employees on how to investigate companies that report using IFRS.
In the 2008 IFRS roadmap, the SEC allowed an option of early adoption of IFRS by the largest companies in the U.S. under certain conditions. In order to do so, the companies had to get a "no-objection" letter from the Division of Corporate Finance at the SEC. The letter would be valid for three years, and companies had to provide an IFRS-to-GAAP reconciliation. The earliest companies could do so was as of December 31, 2009. The rest of the companies would adopt IFRS by 2015, provided the SEC approved such an action in 2011. As we mentioned before, the chief accountant of the SEC stated that they need more time to analyze as to when to adopt IFRS. One note: Some commentators about the SEC roadmap objected to the early adoption by large companies on the grounds that a dual system would make it difficult to compare companies and, further, some companies may opportunistically decide which accounting system to adopt.
In addition to complying with the potential rule change to IFRS for reporting, companies must update information systems for new reporting structures and recheck internal controls. There are also implications in tax planning and changes to any contractual agreements, such as loan covenants. Since the Sarbanes-Oxley Act requires the CEO and CFO to sign a certificate taking responsibility for the financial statements, these executives have to understand the impact of the change. Transitioning to IFRS involves getting auditors, corporate accountants, corporate executives, and accounting students educated about the differences between IFRS and GAAP.
Sudha Krishnan, Ph.D., is a professor of accountancy in the College of Business Administration at California State University in Long Beach. You can reach Sudha at (562) 985-5757 or email@example.com.
By Sudha Krishnan and Ping Lin, CMA
Ping Lin, CMA, Ph.D., is an associate professor of accountancy in the College of Business Administration at California State University in Long Beach and a member of IMA's San Antonio Chapter. You can reach Ping at (562) 985-4560 or firstname.lastname@example.org.
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|Title Annotation:||IMARESEARCH; International Financial Reporting Standards; Generally Accepted Accounting Principles; Institute of Management Accountants|
|Author:||Krishnan, Sudha; Lin, Ping|
|Date:||Mar 1, 2012|
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