For a manufacturer, inventory is usually the largest current asset and the account where management judgment moves earnings most. Counting is the easy part. The harder question is what the counted units are worth, and the answer lives in an excess and obsolete (E&O) reserve that management builds from its own assumptions.
This guide covers the measurement rule, how reserves are built, what to test, and what the client should hand over.
The measurement rule: lower of cost and net realizable value
ASU 2015-11 changed subsequent measurement in ASC 330 for most inventory. Inventory measured using FIFO or average cost is carried at the lower of cost and net realizable value (NRV). Inventory measured using LIFO or the retail inventory method is outside the ASU. A manufacturer using FIFO or weighted average is therefore on the NRV model.
NRV is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. When NRV falls below cost, the difference is a loss in the period in which it occurs. Replacement cost and NRV less a normal profit margin no longer enter the FIFO and average cost test. For background on the cost flow methods themselves, see inventory costing under ASC 330 and the glossary entry on lower of cost or net realizable value.
Two points matter in the workpapers. First, NRV is measured at the item or group level and depends on the selling price for the finished good, not the raw material price. A resin lot may be worth less than cost only because the finished product it feeds sells at a loss. Second, a write-down establishes a new cost basis. The inventory is not written back up if prices recover, so reserve releases in later periods need a specific explanation.
How E&O reserves are built
Management uses one of three approaches, or a blend:
- Aging-based formula. Percentages applied to items with no usage or sales for set periods.
- Excess-over-demand. Quantity on hand minus forecast usage over a defined horizon, valued at cost less salvage.
- Specific identification. Named parts tied to discontinued products, engineering changes, customer cancellations or quality holds.
Each carries bias risk. A formula can be applied consistently and still be wrong if the aging buckets do not match the product's real life. A forecast can be stale. A specific list can omit the items nobody wants to discuss. The auditor evaluates the method, the data feeding it and the assumptions under AU-C 540; see auditing accounting estimates.
Standard cost, variances and capitalization
Most manufacturers carry inventory at standard cost and capitalize variances at period end. Test that standards approximate actual cost, that purchase price, usage and labor variances are allocated between cost of goods sold and inventory in proportion, and that fixed overhead is allocated on normal capacity, with abnormal idle capacity expensed. Capitalizing too much variance into ending inventory overstates the asset and understates cost of sales. That error survives a clean count.
Risk areas
- Slow-moving finished goods after a product line change
- Raw materials bought in volume for price protection or minimum order quantities
- Work in process with no clear completion path
- Consigned inventory held at customers or third-party warehouses
- Capitalized variances and overhead rates not updated for actual volume
- Purchase commitments above current market, which can require a loss accrual
- Revenue cutoff on bill-and-hold and shipping terms
Audit procedures
- Obtain the perpetual listing and agree it to the general ledger. Treat it as information produced by the entity and test completeness and accuracy; see audit evidence under AU-C 500.
- Observe the count and roll forward. Follow inventory observation procedures, then roll count-date quantities to the balance sheet date using receiving and shipping records.
- Test the aging report. Re-perform the last-activity date for a sample of items using receipts, issues and sales transactions.
- Recompute the reserve. Rebuild management's formula, test inputs, and compare it to the prior year's reserve and to actual disposals.
- Test NRV directly. For a sample of items, compare cost to recent selling prices, subsequent sales and price lists, less costs to sell. Look at gross margin by product line for any line near or below zero.
- Retrospective review. Compare the prior-year reserve to what was scrapped, sold below cost or reworked during the audit period.
- Inquire of operations, sales and engineering. Ask about discontinued products, design changes and customer cancellations, then corroborate against the reserve.
- Review subsequent events. Scrap tickets, price reductions and large returns after year end bear on conditions at the balance sheet date.
Worked example
This example is illustrative. A client holds 400 units of a discontinued fixture at a cost of $95 per unit, a total of $38,000. The client estimates the units can be sold through a liquidator at $60 each, with $8 per unit in selling and shipping cost.
- NRV per unit: $60 minus $8 = $52
- Cost per unit: $95
- Write-down per unit: $43
- Required reserve: 400 x $43 = $17,200
Management's aging formula reserves 25% of the balance for items with no sales in 12 months, which is $9,500. The shortfall is $7,700 against the NRV measurement. The formula is a convenient estimating tool, but the standard requires the NRV result for these units. The auditor documents the liquidator quote as evidence, records the $7,700 difference and evaluates whether similar items elsewhere in the reserve have the same problem.
PBC items
- Perpetual inventory listing by item, quantity, unit cost and location
- Count sheets, instructions and the reconciliation of count to book
- Aging and last-movement report
- E&O reserve calculation, policy memo and support for assumptions
- Standard cost roll and the variance capitalization schedule
- Bills of material for top products, and product discontinuation notices
- Open purchase commitments and cancellation terms
- Consignment and third-party warehouse reports
- Subsequent sales and price lists for slow-moving lines
- Scrap and disposal records for the year
Red flags
- Reserve unchanged from the prior year while sales mix shifted
- Reserve released with no sales or disposal activity
- Large inventory growth against flat or falling sales
- Gross margin improving in a year with shrinking demand
- Count adjustments posted after the count date without support
- Items shown at cost with no movement and no sales forecast
- Management unwilling to share product discontinuation plans
Frequently asked questions
Does a reserve change the cost basis?
Yes. A write-down to NRV creates a new cost basis under US GAAP, and later price recovery does not reverse it.
Can a firm rely on the client's aging formula?
Only after testing the formula, its inputs and its results against actual outcomes. The estimate is management's, and the auditor evaluates it.
Sources
- FASB ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory, as summarized by Dean Dorton in "Highlights of FASB's ASU 2015-11" (September 25, 2015): https://www.deandorton.com/articles/highlights-of-fasbs-asu-2015-11
- FASB ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory
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