Adhering to the International Financial Reporting Standards has become common practice in recent years. According to L. Murphy Smith, in his research summary Key Differences between IFRS and U.S. GAAP: Impact on Financial Reporting, " [o]ver 100 countries now require IFRS as the basis of financial reporting by their publicly-traded companies. In the U.S., convergence of U.S. GAAP to IFRS has been ongoing for many years." The Taiwan government also has been working on adopt IFRS step by step since 2008 and all Taiwan companies must change accounting methods to adopt IFRS methods. Because of using new rules, some complaint comes from those companies.
The Accounting Research and Development Foundation, which establishes the GAAP in Taiwan, was officially established in 1984 and referred to US GAAP until 2008. Because Taiwan GAAP similar with US GAAP, the problem that Taiwan faces will happen in the US. One significant difference of the inventory valuation between US GAAP and IFRS is the Measurement: lower of cost or market (LCM). Inventory is carried at the lower of cost or market and market is defined as current replacement cost in the US (Ernst & Young, US GAAP versus IFRS, 2011) But in IFRS, inventory is carried at the lower of cost
or net realizable value(LCNRV) (Ernst & Young, 2011). The replacement cost is not the net realized value (NRV) because the replacement cost is the amount that needed to acquire the same item again at the present time and NRV is the amount for which an asset can be sold minus the cost of selling it.
This paper will take about the way US GAAP and IFRS differ when it comes to how inventory should be accounted for. These two systems (US GAAP and IFRS) differ in three important areas: the allowable costing methods, how inventory is to be presented, and the reversal of market adjustments. I will focus on which system that provides the method to present inventory is more accurately presents the qualitative characteristic of accounting information, such as which one close to the relevance and which one close to the reliability. To compare the difference of inventory valuation, my conclusion is the LCM can show both the relevance and the reliability on financial reports more than the LCNRV.
In order to accomplish this conclusion, first, to show the similar and different inventory valuation between GAAP and IFRS. And then, to find that there are several elements to affect the result of inventory valuation when using the LCM or LCNRV. By analyzing those elements, to understand the computation process of the designated market value, thus affecting the valuation of inventory. The designated market value is the amount that a company compares to cost (p. 440,Kieso - Intermediate Accounting 13th). Finally, by considering the qualitative characteristic of accounting information, to analyze which method of inventory valuation is more worth than the other.
Under both sets of standards, US GAAP and IFRS, one of the significant difference is the measurement of inventory valuation as table below:
US GAAP
IFRS
Measurement
(LCM)
Inventory is carried at the lower of cost
or market. Market is defined as current
replacement cost, but not greater than
net realizable value (estimated selling
price less reasonable costs of
completion and sale) and not less than
net realizable value reduced by a
normal sales margin.
(LCNRV)
Inventory is carried at the lower of cost or net realizable value. Net realizable value is defined as the best estimate of the net amount inventories are expected to realize.
Source: Inventory- Significant differences, US GAAP versus IFRS The basics, p. 13, Eenst & Young
And the consist of LCM or LCNPV present their elements as table below:
Methods
Process
Elements
LCNRV
Cost
Main elements:
Estimated selling price
Reasonable costs
Designated market value = NRV= estimated selling price - reasonable costs
LCM
Cost
Main elements:
Replacement cost
Minor elements:
Estimated selling price
Reasonable costs
Designated market value = Replacement cost
(Restriction)
(Restriction)
Ceiling : NRV
Replacement cost
Floor: NRV- normal sales margin
* normal sales margin= estimated selling price- replacement cost
Based upon table above, there are two elements in the LCNRV. Because the definition of NRV is same between US GAAP and IFRS (p. 75, KPMG , IFRS compared to U.S. GAAP: An overview, 2009), there are three elements in the LCM.
Main elements affect the designated market value directly. Besides, an element can easy to manipulate by managers if the element be influenced by internal factors. If factors come from external, it is hardly to manipulate. To analyze those elements as following:
Estimated selling price:
There are too many external and internal factors can affect the estimated selling price. Internal factors are such as brand value, pricing decision …etc. External factors are such as substitutes price, similar product price…etc.
Reasonable costs:
It is reasonable costs of completion and sale. Factors that can influence the cost are internal factors such as cost allocation.
Replacement cost:
If the company acquires the inventory by producing, the factor is internal factor, such as the production cost; If the company acquires the inventory by purchasing, the factor is external factor, such as the market price of goods.
According to above analysis, managers can manipulate the estimated selling price easily and hard to manipulate the replacement cost. Thus, NRV, which is estimated selling price minus reasonable costs, can be manipulated easily. I make examples as below table:
Example 1:
Walmart owns an item of inventory having original cost of $1,000. Its replacement cost is $900. The company expects to sell it at $1,100. However an expense of $150 must be incurred to make the sale.
Calculate the value of inventory according to LCM rule.
Ceiling : NRV=1,100-150=950
Replacement cost=900
Floor: NRV- normal sales margin =950-(1,100-900)=750
The value of inventory is $900
The loss on Inventory Value is $100
Example 2:
As the example 1, if managers want to manipulate the value of inventory, to cause that no loss from inventory valuation, he increases the sell price from $1,100 to $1,200.
Calculate the value of inventory according to LCM rule.
Ceiling : NRV=1,200-150=1050
Replacement cost=900
Floor: NRV- normal sales margin =950-(1,200-900)=650
The value of inventory is $900
The loss on Inventory Value is $100
To analyze two examples above, according to LCM rule, the loss on Inventory Value are same. And according to LCNRV rule, the loss on Inventory Value changed from $50 to $0. This means, LCNRV rule cannot prevent the fraud from managers when managers manipulate the estimated selling price. Otherwise, when managers want to manipulate the replacement cost, the result as following table:
Example 3:
As the example 1, if managers want to manipulate the replacement cost, to cause that less loss from inventory valuation, he increases the replacement cost from $900 to $1,000.
Calculate the value of inventory according to LCM rule.
Ceiling : NRV=1,100-150=950
Replacement cost=1000
Floor: NRV- normal sales margin =950-(1,100-900)=750
The value of inventory is $950
The loss on inventory value is $50
I notice that: when managers increase the replacement cost, the loss on inventory value are same because the replacement cost be limited by the ceiling.
To summarize the above, the inventory valuation be calculated by LCM is more advantageous than be calculated because LCM can prevent managers to manipulate the loss than LCNRV. Thus, I agree with US GAAP. LCM is more reliable than LCNRV when using it to present the information . Besides, Using LCM is a much more conservative approach than LCNRV. LCM be least likely to overstate assets when managers intent to fraud. Conservatism is very important when it comes to accounting.
