The American Institute of Certified Public Accountants (AICPA) is in the final stages of developing a new Accounting and Valuation Guide on Business Combinations. Because of diversity of practice, the task force decided to carve out the chapter dealing with fair value measurement for inventory assets. The Working Draft of Inventory Valuation Guidance from Forthcoming AICPA Accounting and Valuation Guide – Business Combinations, released November 19, 2018, sought comments from the public. The comment period closed February 1, 2019, and the full guide is expected to be released before the end of this year.
In certain circumstances, inventory assets acquired in a business combination are carried forward at the closing book value reflected on the seller’s balance sheet. This is usually done under the premise that net book value is a reasonable proxy for the fair value of the inventory. If a company’s cost accounting system is robust, the carrying value of the inventory reflects all costs incurred through the balance sheet date. Thus, book value can be considered a reasonable reflection of “replacement cost”.
Fair value, as defined in Accounting Standards Codification (ASC) Topic No. 820, is based on the concept of “exit value” for an asset. If a holder of inventory would look to recoup nothing more than its incurred cost as of a particular date, and relinquish all profit margin related to the inventory to the market participant buyer of the inventory asset, then the traditional approach of using the current carrying value as a proxy for fair value might be appropriate. However, it seems reasonable that a market participant seller of inventory might look to cover costs and receive a proportional share of the profit margin to be earned upon the future sale of the inventory. The methodology and procedures described in the AICPA guidance follow this line of reasoning.
Conceptually, the fair value of inventory would provide the hypothetical seller with fair compensation for the efforts and costs previously incurred and assets used in the production of the inventory. Likewise, the fair value would provide the hypothetical buyer with fair compensation for its purchase, risk, future efforts and assets utilized to complete and dispose of the inventory, post-acquisition.
The analysis of inventory can be thought of as an allocation of value created before the valuation date and value created after the valuation date. In theory, each expense is incurred with the expectation of earning a profit. The ultimate selling price to be received for inventory would reflect compensation for all the incurred expenses, related profits and assets utilized throughout the procuring, manufacturing and sales process. Therefore, the fundamental process of inventory valuation entails the identification of the appropriate expenses and profits in the value chain, beginning with the procurement of raw materials and ending with the sale of finished goods.
One commonly employed method of inventory valuation involves a “top-down” analysis, whereby amounts representing the portion of the value that will be contributed by the hypothetical buyer after the valuation date are deducted from the estimated selling price of the inventory. Conversely, amounts not deducted from the selling price are representative of value contributed by the hypothetical seller before the valuation date.
The selling price should reflect the price a hypothetical buyer of the inventory asset would receive for the final sale of the subject inventory. Selling prices can be derived directly from observed or listed selling prices on a per-unit basis. This analysis may be carried out at the individual product (or SKU) level or at the business unit level, as appropriate. Selling prices can also be derived indirectly through a gross margin analysis, whereby the selling price of the inventory is estimated based on the adjusted book value of finished goods and the gross profit margin percentage. The gross profit margin can either be based on projected or historical financial performance, depending on which is deemed to be the better proxy for the subject inventory.
Each expense in the inventory cycle should be categorized as having either 1) already been incurred and, therefore, reflected in the carrying value of the finished goods inventory; or 2) remaining to be incurred during the sales/disposal process. Classifying expenses as procurement, manufacturing, selling or marketing can serve as an initial step in this bifurcation process. Sales/disposal costs are generally in the form of selling and marketing expenses, while procurement and manufacturing expenses have typically already been incurred for finished goods inventory.
Holding costs may need to be estimated to account for the opportunity cost associated with the time required for a hypothetical buyer to sell the acquired inventory. In other words, this represents the foregone return on investment during the time to sell the inventory. A hypothetical buyer would often consider holding costs in situations where inventory is stored for an extended period of time before the final sale. The inventory valuation would also consider the cost of storage and handling the inventory, or the risk associated with holding the inventory (for example, insurance, shrinkage, obsolescence, etc.)
The guidance goes on to provide illustrative examples and a helpful Q&A section. In short, while the guidance does not introduce completely new methods for valuing inventory, it does suggest a higher degree of rigor and diligence that may differ from what the parties involved in a business combination have historically employed.
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