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Debating inventory valuation.

I read with considerable interest the article, "Valuing Inventory at the Lower of Cost or Market," by Bruce Wampler and Travis Holt in the January 2013 issue of The CPA Journal. On the positive side, 1 found it to be a more comprehensive examination of certain difficult, but fundamental, issues involving lower of cost or market (LCM) inventory valuation than I have seen in my more than 45 years of practice as an auditor. Despite its extensive analysis, however, I found the article to be somewhat misleading in at least one critical respect. In addition, it muddies or fails to make several relevant points that I would consider important, and it also contains some internal contradictions.

An Unqualified Conclusion

In their final paragraph, the authors suggest, without qualification, that only the individual-item approach to LCM valuation will ensure "strict compliance with U.S. GAAP." In this unqualified conclusion, the article fails to consider (as it acknowledges elsewhere and as is discussed below) the exception clearly stated in U.S. GAAP that, in certain limited circumstances, some aggregation of items is more appropriate than the individual-item approach.

Despite their unqualified conclusion about GAAP, for "practical" reasons, the authors recommend considering an alternative approach, such as line item aggregation or use of a valuation allowance. They suggest that such consideration be made based on a materiality evaluation and a cost-benefit analysis, even though they subtly admit elsewhere that obtaining sufficient data to enable and support an intelligent materiality evaluation ordinarily would require incurring substantially the same cost as compliance.

The Overall Message

It is the overall message of Wampler and Holes article that I believe is misleading--that is, that the primary reason individual market markdowns would be "preferable" to using a valuation allowance is that this method produces "the most conservative" result. This leads readers to conclude that use of a less preferable (i.e., less conservative) approach would, nevertheless, still be GAAP, despite inconsistencies with certain basic principles thereof. The main point the authors fail to adequately drive home is that using a valuation allowance, when coupled with failure to track specific markdowns, might likely result in inadvertent (or intentional) markdown restorations that are, in fact, departures from GAAP.

Furthermore, the authors tail to point out that if adopted as a "practical" shortcut, such a practice would carry with it a burden of justification far beyond merely forming an unsubstantiated belief that any resultant misstatement is not material. Gathering sufficient data to constitute persuasive quantitative evidence would be necessary, especially if the entity's financial statements are to be audited. Management's inability to produce sufficient quantitative evidence to be persuasive might likely lead auditors to report a scope limitation that would be unacceptable to financial statement users. In my opinion, therefore, the practice of using valuation allowances or aggregations of inventory line items inappropriately beyond the limited guidance set forth in GAAP (see below) to determine LCM valuation adjustments should be more vigorously discouraged than in this article.

In fact, although there is no prohibition clearly articulated in U.S. GAAP (i.e., FASB's Accounting Standards Codification [ASCII) against the use of an inventory valuation allowance, there is likewise no clear indication that is it acceptable. Nevertheless, the common use of such allowances is evident in financial statement disclosures. (SEC Staff Accounting Bulletin Topic 5BB is titled "Inventory Valuation Allowances," but there is also no hint in the text as to whether their use is acceptable under GAAP.)

Subject to the few circumstances where aggregation is warranted (and, in fact, required), unless market markdowns are tracked by individual inventory line item (regardless of whether they are lumped together and presented in the balance sheet as a contra-asset in a valuation allowance account), there is no way to assure against the risk of inadvertently violating the most basic principle of LCM accounting in subsequent annual periods. That is the risk that once marked to market, the reduced value becomes the new "cost." In other words, except for interim reporting purposes pursuant to ASC 270-10-45-6c (which is not mentioned in the article), and in certain special circumstances discussed in ASC 330-10-35-16 (which is not discussed here or in the article), market markdowns at the end of a fiscal year can never be restored (ASC 330-10-35-14).

In short, the overall tone of the article conveys a message that there is considerably more flexibility and room for judgment by financial statement issuers than I believe GAAP suggests. In this regard, I am referring to the brief but useful guidance that is provided in ASC 330-10-35-9 through ASC 330-10-35-11 but is not cited in the article. This guidance effectively states that marking down individual line items is more than a mere preference among various available alternatives; rather, it is a requirement (except in limited circumstances, such as those described in the cited paragraphs that also effectively dictate when these alternatives are required). Although judgment might be needed to apply this guidance, it does not afford unrestricted options, as the article implies.

The Principal Risks of Misstatement

In essence, there are two separate, primary categories of inherent risk of material misstatement that could be significant with regard to the application of LCM accounting; therefore, they should be of concern to both management and the auditors. Both are discussed, more or less, in Wampler and Holt's article; they are the risk of--

* inadvertent or intentional (i.e., for fraudulent purposes such as earnings management) restoration of the prior year's market markdowns, and

* improper offsetting of the current year's decreases against increases in market value, due to an inappropriate aggregation of line items.

The first of these two types of risks, although always associated with market markdowns, is generally more significant when valuation allowances are used; the second may be equally significant with or without such allowances.

The article correctly cites ASC 330-10-35-8, stating that LCM accounting "may properly be applied either directly to each item or the total of the inventory. (or, in some cases, to the total of the components of each major category) ... which[ever] most clearly reflects periodic income" (i.e., not whichever is more conservative). This is a GAAP requirement, not merely "a general preference" for applying LCM adjustments in an individual line item basis, as is suggested by the article; incidentally, the article contradicts itself elsewhere by stating that only the individual line item basis truly is GAAP.

Other Issues

Whenever management's selection of an aggregation versus individual-item approach for LCM adjustments requires the application of considerable judgment or has a potentially material effect on the determination of periodic income, it represents an accounting policy decision that should be disclosed pursuant to ASC 235-10-50-1 through ASC 235-10-50-4 (but rarely is).

To their credit Wampler and Holt also discuss the fact that the inclusion of inventory market markdown in cost sales is semantically incorrect; in fact, it is not "technically inaccurate" from an accounting point of view. Although FASB does not define "cost of Sales," and ASC 330-10-35-1 merely states that market markdowns "shall be recognized as a loss of the current period," it is generally accepted and recognized that such adjustments typically go through cost of sales, except as provided below. The authors' assertion, therefore, that the separate presentation of such charges in the income statement is "conceptually preferable" is not based on any accounting of financial reporting concept; however, U.S. GAAP provides that if such an item is not routine but rather is "unusual in nature or occurs infrequently," it should be either presented separately in the income statement or disclosed in the notes (ASC 225-4045-16 and 225-20-50-3).

In conclusion, despite the foregoing observations, I believe the article provides valuable insight into the formidable challenges inherent in LCM accounting.

Howard B. Levy, CPA

Piercy Bowler Taylor & Kern Las Vegas, Nev.
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Title Annotation:letters to the editor
Publication:The CPA Journal
Article Type:Letter to the editor
Date:Mar 1, 2013
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