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The art of accounting for inventory · PwC's accounting podcast

• 0:00
  SPEAKER_01: Thought Leadership from PWC.
• 0:06
  SPEAKER_02: Welcome to PWC's Accounting Podcast.
• 0:09
  SPEAKER_02: I'm Heather Horn.
• 0:11
  SPEAKER_02: Thanks for joining me as we continue our Tuesday series where one of our all-star podcast guests takes over the podcast, picking the topics for the month, and joining me on all the episodes.
• 0:23
  SPEAKER_02: For the month of April, our takeover guest is Pat Durbin, a deputy chief accountant in PWC's national office.
• 0:31
  SPEAKER_02: This month, Pat's sharing insights and going back to the basics on some critical accounting areas, including contingent liabilities, subsequent events, and inventory.
• 0:41
  SPEAKER_00: That's really where what I sometimes refer to as the art of cost accounting comes into play.
• 0:47
  SPEAKER_02: That was Pat.
• 0:48
  SPEAKER_02: With supply chain shortages and inflation making businesses focus on inventory management, he's sharing insights on the key accounting concepts and judgments in accounting for and valuing inventory.
• 1:01
  SPEAKER_02: You'll also hear considerations related to different arrangements to finance inventory from consignments to supply chain financing.
• 1:09
  SPEAKER_02: Pat even tells us why us financial accountants should remember back to our cost accounting days.
• 1:15
  SPEAKER_02: Now, I will share that I think inventory is one of Pat's, if not Pat's favorite topic.
• 1:20
  SPEAKER_02: So definitely stay tuned for a great conversation.
• 1:28
  SPEAKER_02: Pat, welcome back to the podcast.
• 1:30
  SPEAKER_02: So nice to have you back today to talk about, I know what's one of your favorite topics and actually has a very uh soft spot in my heart as well, and that is regarding inventory.
• 1:40
  SPEAKER_02: Uh, and I think it's great because our episode we did a few years ago still is continuing to turn out listens.
• 1:46
  SPEAKER_02: So I'm sure people will be happy to have something new to listen to.
• 1:49
  SPEAKER_02: Uh, but before we get into the details of some of the harder questions, maybe we should just start off with a refresher on some of the different ways that we use to determine inventory cost.
• 2:01
  SPEAKER_00: Sure.
• 2:01
  SPEAKER_00: So I mean the the first question really is what we would refer to as kind of the cost flow assumption, or really, you know, what is your um method for determining inventory cost?
• 2:12
  SPEAKER_00: And the the gap here is is really old, actually.
• 2:16
  SPEAKER_00: It's uh older than than me, which uh I know we're on a podcast here, but trust me, I have a lot of gray hair.
• 2:22
  SPEAKER_00: Um and uh there isn't a lot of um extensive gap.
• 2:27
  SPEAKER_00: You know, it's sort of a lot of practical conventions, a lot of uh body of practice that has has built over time.
• 2:34
  SPEAKER_00: But the basic model is you either use what you'd refer to as the first in, first out, or FIFO method, the last in, first out, or LIFO method.
• 2:46
  SPEAKER_00: Um average cost tends to be um a common practice as well, especially if you have a relatively short inventory turnover cycle.
• 2:57
  SPEAKER_00: There is even in some limited cases the notion of using sort of a specific identification approach.
• 3:02
  SPEAKER_00: I'd say that's pretty uncommon.
• 3:04
  SPEAKER_00: Maybe you see it where you have um very unique items, perhaps high value items, you know, think maybe jewelry or those types of things, but tends to be pretty limited.
• 3:15
  SPEAKER_02: Of course, that was the first thing that I did inventory for, and they had specific identification.
• 3:20
  SPEAKER_02: So makes sense.
• 3:21
  SPEAKER_02: High value.
• 3:22
  SPEAKER_00: Yep.
• 3:23
  SPEAKER_02: Uh hey Pat, one of the things I thought was interesting in your notes was the fact that the guidance on inventory, the main guidance, is actually two uh organizations prior to the FASB.
• 3:34
  SPEAKER_02: So what exactly was that?
• 3:36
  SPEAKER_00: Yeah, so way, way back um we had something called the Committee on Accounting Principles, um, which was uh constituted by the AI CPA.
• 3:46
  SPEAKER_00: Um they issued things called accounting research bulletins, and then um that eventually led into the accounting principles board, which was also an AICPA committee.
• 3:57
  SPEAKER_00: Those were both sort of the predecessor entities to the uh what we know now since 1973, the Financial Accounting Standards Board.
• 4:05
  SPEAKER_00: So the gap for inventory actually does have its heritage in um ARB 43, which was in fact a republication of a whole bunch of previous accounting research bulletins too, for that matter, for the real historians out there.
• 4:18
  SPEAKER_02: All right, very good.
• 4:18
  SPEAKER_02: Thank you.
• 4:19
  SPEAKER_02: Definitely like that that part of the history lesson.
• 4:21
  SPEAKER_02: So then, Pat, why don't we talk first with how we determine cost of inventory?
• 4:27
  SPEAKER_02: Because I think you know everything comes from that.
• 4:30
  SPEAKER_00: Sure.
• 4:30
  SPEAKER_00: And the basic idea is that um inventory should be reflected at its cost.
• 4:36
  SPEAKER_00: That's the basic principle.
• 4:38
  SPEAKER_00: So cost of materials and all of the other costs necessary to bring that inventory into its uh ultimate uh condition.
• 4:46
  SPEAKER_00: Um you could have that, you know, work in process or ultimately as a as a finished good.
• 4:52
  SPEAKER_00: It's a cost accumulation concept.
• 4:56
  SPEAKER_00: Other than those basic cost flow assumptions, there is not a lot of explicit gap on how you determine um all those different elements of cost.
• 5:06
  SPEAKER_00: Certainly the materials piece of it's usually fairly easy.
• 5:09
  SPEAKER_00: You procure materials from someone, there is a cost of procurement that feeds into your inventory, those are your material costs.
• 5:16
  SPEAKER_00: Where it gets a little more interesting is when you start talking about the labor that's needed to then fabricate those materials into something or all of the other costs that the business incurs, um, the machinery cost, et cetera, necessary.
• 5:29
  SPEAKER_00: Because you can't associate those necessarily with a specific item of inventory, you have to come up with some way of essentially allocating those costs to inventory, whether it's the labor cost uh based on the time it takes to do something, or the overhead cost, you know, machinery depreciation, uh, rent for the factory facility, perhaps, you know, those are the types of costs you need to think about also attaching to ultimately your inventory cost.
• 5:58
  SPEAKER_02: Well, and I think Pat, you know, if we think about materials, even direct labor, that seems relatively straightforward, pretty also use the word obvious.
• 6:07
  SPEAKER_02: But I think the overhead types of costs, you know, that's where I at least have seen complexity in practice because how you attribute it, you made the point that you, you know, it's not necessarily uh connected with an individual piece of inventory.
• 6:22
  SPEAKER_02: And again, just how you're gonna do those allocations overall.
• 6:26
  SPEAKER_02: So what can you share with us on that?
• 6:28
  SPEAKER_00: Yeah, you're absolutely right, Heather.
• 6:29
  SPEAKER_00: And that's that's really where what I sometimes refer to as the art of cost accounting comes into play.
• 6:35
  SPEAKER_00: Um, and as you alluded to, I mean, maybe even for as many companies as there are out there, there's probably that many different techniques that people use to allocate overhead to their inventory.
• 6:48
  SPEAKER_00: Um, essentially, the the concept is developing an estimate of your total costs and an estimate of your total production, and then using that as sort of a rate at which you absorb or allocate those overhead costs in the inventory.
• 7:03
  SPEAKER_00: You know, think of your total cost for the year, total estimated production volumes for the year, that gives you sort of a per unit amount of overhead.
• 7:11
  SPEAKER_00: That's the sort of simplistic concept.
• 7:13
  SPEAKER_00: Obviously, you're not always making the same things, um, they don't always have the same processes associated with them.
• 7:20
  SPEAKER_00: So, how how much more granularly you go in terms of breaking down your uh manufacturing operation into departments, different processes, the overhead associated with those, the amount of time it takes for different types of inventory to be produced, all of those are variables then that would affect that basic, you know, kind of concept of how much overhead should I attach to each unit of inventory.
• 7:47
  SPEAKER_00: Um so there's a lot of different ways you can do that.
• 7:50
  SPEAKER_00: Again, based on you know cycle times, in you know, the amount of time it actually takes, the different types of machines, you know, they have different cost profiles, um, all those things can um can factor in.
• 8:04
  SPEAKER_02: So, Pat, let me ask you a couple of follow-up questions on that because I think as soon as you start thinking about a pool of costs, and then now maybe you're projecting an amount that you're producing it just in terms of how frequently you should be adjusting those costs, what sort of increment of time people use, is it every month, is it every week?
• 8:25
  SPEAKER_02: You know, what how how what have you seen in practice in terms of how companies approach this?
• 8:30
  SPEAKER_00: Yeah, no, it's it's a great question, and it is important to think about both the period of time over which I need to be estimating those costs, and then as I think you alluded to, when you're making these estimates, inevitably, because you're basing it on an estimate of production and an estimate of costs incurred, there's a potential, or in fact, a high likelihood, that what you actually end up incurring it may be different than what you anticipated, and so you need to deal with that as well.
• 8:57
  SPEAKER_00: So the overhead allocation process is sort of an annual concept.
• 9:03
  SPEAKER_00: So you sort of are forecasting your estimated overhead cost for the period, the entire annual period, and the estimated production volumes, taking into account seasonality, et cetera, but you're sort of doing it on an annual basis.
• 9:17
  SPEAKER_00: So that's sort of level set one.
• 9:19
  SPEAKER_00: Then when you get into a situation where at any point in time you have either allocated more costs than you've incurred to the inventory, or maybe you haven't allocated all the costs you've incurred to inventory, those are called variances.
• 9:35
  SPEAKER_00: We have to figure out what to do with those variances.
• 9:39
  SPEAKER_00: If you get into a situation where you've actually essentially been more efficient, maybe you've produced more or you've actually incurred less costs, and so you end up, based on your sort of original estimate of overhead absorption, ended up allocating more cost to inventory than you actually incurred.
• 9:56
  SPEAKER_00: Well, that that sort of violates the basic principle that inventory should be stated at cost.
• 10:01
  SPEAKER_00: So in that case, they'd actually be stated at above the actual cost.
• 10:05
  SPEAKER_00: So you have to reverse those excess costs that you've capitalized into inventory back into the PL.
• 10:12
  SPEAKER_00: So those are sort of favorable variances.
• 10:15
  SPEAKER_00: It's a little more interesting when you get into a situation where you for whatever reason haven't capitalized all the costs you've incurred.
• 10:23
  SPEAKER_00: Then you sort of have to ask yourself the question: well, did I just have a poor estimate of my actual costs?
• 10:31
  SPEAKER_00: And in fact, those were the real costs that I incurred to produce that inventory, in which case I need to capture those variances and add them to the cost of inventory.
• 10:40
  SPEAKER_00: Or was for some reason there an abnormally low amount of production, or perhaps some costs incurred that really weren't value-added costs.
• 10:50
  SPEAKER_00: That's a little bit more judgmental, but in that case, those costs are going to go, they're essentially going to stay out of inventory and just be charged directly to expense in the period they're incurred.
• 11:02
  SPEAKER_02: So, Pat, as soon as you said low production and you had anticipated one of my questions, because clearly we saw in 2020 disruptions to productions.
• 11:12
  SPEAKER_02: And then even now, given some of the supply chain and other issues, I know some companies maybe haven't had the steady uh production line that they may otherwise.
• 11:21
  SPEAKER_02: And so in a low production cycle, then are you saying some of those costs may wind up to be expensed, or you're going to wind up capitalizing more to the lesser amount of production?
• 11:34
  SPEAKER_00: And that's where it really does become pretty tricky and judgmental.
• 11:38
  SPEAKER_00: You're you're absolutely right, though.
• 11:40
  SPEAKER_00: There were clearly some disruptions that I think you would characterize as abnormal in the case of a dramatic, you know, cessation in production in response to the pandemic, for example, that was sort of would not have been contemplated, presumably, and you'd say that's probably abnormally low.
• 11:57
  SPEAKER_00: And those costs shouldn't just get attached to all the other units you produce, you should run those directly through uh the PL.
• 12:06
  SPEAKER_00: But it it's you know, in outside of those cases where it's very clear it requires a little bit more analysis or judgment to figure out is that truly abnormally low production or abnormally high.
• 12:17
  SPEAKER_00: There's a this concept in the in the guidance that actually talks about normal production levels being a sort of a longer-term concept, you know, over a number of production cycles, taking into account normal variances in production.
• 12:30
  SPEAKER_00: So it's not like there's a hard and fast rule for okay, X is normal and anything different from X in any period is abnormal.
• 12:38
  SPEAKER_00: You know, there's going to be some range of sensitivity there, but it's not explicit and it's definitely a um you know more of a qualitative and judgmental concept.
• 12:48
  SPEAKER_02: Okay, so two follow-up questions.
• 12:49
  SPEAKER_02: So first, you mentioned costs that are not value added, and I can clearly see how there could be circumstances where that would be the case.
• 12:58
  SPEAKER_02: But again, if I'm practicing this art of inventory, which now that you've explained it, definitely there is a lot more to it than just you know doing debits and credits.
• 13:07
  SPEAKER_02: How what types of costs may wind up as being those not value added?
• 13:12
  SPEAKER_02: Or is it again just very facts and circumstances specific?
• 13:15
  SPEAKER_00: Well, I mean, I mean, there's some classic um examples, but I would say it's not an exhaustive list, and it probably does come down to more judgment.
• 13:23
  SPEAKER_00: I mean, certainly truly abnormal things like you know, theft or damage.
• 13:28
  SPEAKER_00: I mean, there's some concept that you're gonna have some waste and scrap in any process.
• 13:32
  SPEAKER_00: That would be be normal.
• 13:33
  SPEAKER_00: So it'd be something outside of that that norm, or for whatever reason you had a a major plant issue, you had to do a lot of rework because you were ending up with defective parts, those sorts of things.
• 13:45
  SPEAKER_00: So it it becomes something you need to identify sort of specifically as to what those costs are, but it's not a um there's not a finite list of what they are necessarily a you know hard and fast rule that every time you see one of those things, it's going to be an abnormal or a non-value added cost, let's say.
• 14:02
  SPEAKER_02: So I know this podcast is not just about cost accounting, but just a couple more questions on it.
• 14:07
  SPEAKER_02: So, Pat, there's also, you know, I when you say like sort of the normal production cycle, there's some parts that say you could envision would just be produced year after year after year.
• 14:17
  SPEAKER_02: But then other types of things, let's say you were doing um, you know, fast fashion clothing or some other very quick turn types of inventory, then it feels like you almost don't almost have enough time to get into a cycle.
• 14:32
  SPEAKER_02: But in that case, would you say it's whatever's being produced on that production line, you would sort of look at together, or again, it really depends.
• 14:39
  SPEAKER_00: Yeah, I mean that's that's where you get into this concept that like there's so many different varieties of businesses, so many different varieties of inventory.
• 14:47
  SPEAKER_00: Even within a business, you can have inventory that has very different characteristics.
• 14:52
  SPEAKER_00: And um obviously if it has a very short cycle time and it's really not held in inventory, then maybe it doesn't have that much of an impact ultimately on the bottom line, right?
• 15:02
  SPEAKER_00: Inventory really only matters if you're holding inventory from period to period.
• 15:07
  SPEAKER_00: But you, in theory, need to think about those different types of production um environments, different types of products, different cost profiles, and come up with some way to assign costs to those items of inventory.
• 15:22
  SPEAKER_00: But that's again, really, there's no gap that tells you exactly how to do that.
• 15:26
  SPEAKER_00: It really does come down to more just the you know applying those basic concepts of how do I best reflect the cost of the inventory.
• 15:35
  SPEAKER_00: And that is really where I mean cost accounting has a relevance in terms of decision making for businesses, right?
• 15:42
  SPEAKER_00: Um in terms of how they manage their business, in terms of how they measure profitability on individual products.
• 15:48
  SPEAKER_00: So it is relevant, but it also depends a lot on the very unique circumstances of any business.
• 15:55
  SPEAKER_02: So, Pat, one thing I've been listening for, and I don't think I've heard you say a standard cost, and I feel like if we're talking about inventory costing, at least that's typically what you hear people talking about.
• 16:05
  SPEAKER_02: So why the silence there?
• 16:07
  SPEAKER_00: Yeah, it's interesting.
• 16:08
  SPEAKER_00: You're right.
• 16:09
  SPEAKER_00: It is very commonly used in practice, but it is not, in fact, a concept that GAP recognizes.
• 16:15
  SPEAKER_00: As I alluded to earlier, you know, the concept is we record inventory at actual cost.
• 16:20
  SPEAKER_00: Standard cost or standard costing is a cost accounting technique, and it's essentially designed to get back to what I was just alluding to, helping companies manage their manufacturing operation.
• 16:33
  SPEAKER_00: You know, they've identified, okay, it should cost this much to produce this product based on our cost profile, our production capacity, et cetera.
• 16:43
  SPEAKER_00: And in many cases, that is how companies will keep their perpetual inventory records.
• 16:48
  SPEAKER_00: They'll keep their inventory at standard cost because that's you know much easier.
• 16:52
  SPEAKER_00: You can say, okay, I have a unit of this, I know what my standard cost for that unit is.
• 16:57
  SPEAKER_00: You know, I can keep records very easily that way.
• 17:01
  SPEAKER_00: But ultimately, it's just another flavor of the variance concept we were talking about.
• 17:06
  SPEAKER_00: Ultimately, your actual costs incurred are whatever they are, your actual depreciation, your actual labor, et cetera, your actual production is whatever it is, and you're going to end up with some amount of cost that you've actually incurred that's more or less than the amount you've applied to inventory using your standard costing system.
• 17:24
  SPEAKER_00: So you have to go through that whole process of understanding, okay, what are those variances?
• 17:30
  SPEAKER_00: Do I need to take those directly to the PL or do I need to um reallocate cost to inventory to reflect inventory at its actual cost?
• 17:40
  SPEAKER_00: Because ultimately that's what I have to get back to, regardless of whether I'm using standards as a practical uh approach.
• 17:47
  SPEAKER_00: I need to get back to actual cost for the financial statements.
• 17:51
  SPEAKER_02: And then, Pat, I think final question specific to costing itself, the variances that you're talking about from just sort of like a nuts and bolts accounting point of view, they would typically be classified in the inventory line.
• 18:04
  SPEAKER_02: But I guess the point you've been making here is you have to keep them small enough because if those variances grow too much and you haven't been allocating them to inventory, then you can wind up with some, I would assume, out-of-period adjustments.
• 18:17
  SPEAKER_00: Well, in theory, and obviously materiality comes into play anytime, but in theory at any at any period and or for any period, if you have a variance, you need to deal with it in the period.
• 18:31
  SPEAKER_00: So it either should be allocated to inventory and then it becomes part of the cost basis of inventory, or you need to conclude that that no, that was a variance that actually should run directly to the PL.
• 18:42
  SPEAKER_00: Now it would be typically classified in cost of sales in that case, but it would go to the to the PL.
• 18:48
  SPEAKER_00: Now, as a practical matter, right, people probably do look at it and say, okay, is it material or not?
• 18:54
  SPEAKER_00: Or because I'm using standard costing, even though I allocated those variances into inventory at the end of the period, I probably have a reversing entry at the beginning of the next period and I start over.
• 19:05
  SPEAKER_00: So there's a lot of, again, different practical conventions that people use, but in concept, you need to get that inventory at their actual cost at each reporting date.
• 19:14
  SPEAKER_02: All right.
• 19:14
  SPEAKER_02: I think if we had a quote from this podcast, that would probably be the quote because I think you've said that a few times.
• 19:19
  SPEAKER_02: But let's talk about then now more questions on cost, but we I think we should move on.
• 19:25
  SPEAKER_02: So one of the questions I know comes up frequently is changing your inventory, sort of, I guess you call it cash flow methods.
• 19:33
  SPEAKER_02: So, you know, LIFO, FIFO, standard ID.
• 19:36
  SPEAKER_02: And I know another question that comes up frequently in practice is what if you're changing and you want to refine the pool of costs that you're allocating to inventory or that deem to be inventoryable?
• 19:48
  SPEAKER_02: So how do you deal with these changes?
• 19:52
  SPEAKER_00: So a change in the cost flow assumption, so changing from LIFO to FIFO, changing from FIFO to average cost, those are changes in accounting principle.
• 20:03
  SPEAKER_00: They're subject to the guidance on changes in accounting principle, which is in ASC 250.
• 20:08
  SPEAKER_00: That means two things.
• 20:09
  SPEAKER_00: One, you have to justify that the method you're changing to is preferable.
• 20:14
  SPEAKER_00: And I would say it's important to note here GAP expresses no preference on which method of inventory costing is is preferable.
• 20:22
  SPEAKER_00: So in theory, you you have some latitude there.
• 20:25
  SPEAKER_00: Um probably the most common change we've seen here over the last couple of decades at least is people changing from LIFO to FIFO.
• 20:34
  SPEAKER_00: And LIFO could be a whole separate podcast if you really are interested.
• 20:38
  SPEAKER_00: But um suffice to say that um in a period that we experienced, at least up until the last couple of years, a relatively stable inflation, there wasn't a big difference between LIFO and FIFO, and LIFO uh tends to be a very cumbersome and somewhat tedious process to apply in practice.
• 20:57
  SPEAKER_00: Um in any case, we we tend to see that one um with some regularity.
• 21:01
  SPEAKER_00: Um so back to the change in accounting concept.
• 21:04
  SPEAKER_00: So you've got to justify this preferable, and then for a change in accounting principle, under again the the general guidance for changes in accounting principle, you have to retrospectively apply that to all of your periods presented in the financial statements.
• 21:18
  SPEAKER_00: The only exception to that, which is something we rarely see, is if you were changing from FIFO to LIFO, um because there's a notion that you can only um perform retrospective application if it's practicable to do so.
• 21:36
  SPEAKER_00: And because of the fact that you need all of the cost history since essentially the beginning of time to apply LIFO, you can't practically do that if you're changing from FIFO to LIFO.
• 21:47
  SPEAKER_00: If you haven't been keeping those those records, it would be generally impracticable to do so.
• 21:53
  SPEAKER_00: So that's on the change in the cost flow assumption.
• 21:56
  SPEAKER_00: You also mentioned um changing the composition.
• 22:00
  SPEAKER_00: Of inventory costs.
• 22:01
  SPEAKER_00: And that's another area that we haven't spent a lot of time on.
• 22:04
  SPEAKER_00: But sort of particularly in the overhead space, like which types of costs belong in inventories or not.
• 22:11
  SPEAKER_00: Again, there's not an explicit list and gap.
• 22:14
  SPEAKER_00: There's some concepts out there in practice.
• 22:17
  SPEAKER_00: Um, a lot of it gets into like some probably distribution type costs, warehousing, um, interplant, you know, transportation, some of those sorts of things where there's some diversity in practice.
• 22:32
  SPEAKER_00: But if you are changing the composition of cost in inventory, that also would be considered a change in accounting principle because you're nothing's really happened in the business.
• 22:42
  SPEAKER_00: You're just saying, hey, there's a cost here that I wasn't previously considering inventorable, but now I am, or vice versa.
• 22:50
  SPEAKER_00: Again, subject to preferability, retrospective application, et cetera.
• 22:55
  SPEAKER_00: The one thing I would say in this context, or to contrast it, would be from in this whole space of overhead absorption, overhead allocation, there's an ongoing process of kind of refining your estimates of production volumes, you know, the uh estimated spending for those costs.
• 23:15
  SPEAKER_00: And that happens every year, in theory, as you sort of re-evaluate your business operations.
• 23:22
  SPEAKER_00: That's just a change in estimate, part of the ongoing process of doing financial reporting, and that that gets dealt with prospectively.
• 23:30
  SPEAKER_00: So there's no change in accounting principle concept when you're talking about changing just your overhead absorption rates.
• 23:37
  SPEAKER_02: All right.
• 23:38
  SPEAKER_02: So, pal, let me go back for a moment to the change in cost assumption uh from LIFO to FIFO, for example.
• 23:46
  SPEAKER_02: And you mentioned that one is not preferable than another, which you anticipated in one of my questions.
• 23:52
  SPEAKER_02: But then you also mentioned that we do see changes and that the company needs to say that's preferable for that particular company.
• 24:00
  SPEAKER_02: I'm guessing you're going to tell me this is facts and circumstances, but are there any sort of typical types of things people would be looking at to say one method was more preferable for them than another?
• 24:13
  SPEAKER_00: So the the concept of preferability generally is focused on what's better information for the users of the financial statement.
• 24:22
  SPEAKER_00: So it's very much a qualitative assessment.
• 24:25
  SPEAKER_00: There aren't that many places where GAP explicitly expresses a preference.
• 24:31
  SPEAKER_00: And it does tend to be specific to a particular company.
• 24:36
  SPEAKER_00: In the context of inventory, um, one of the things we look at is, you know, if you think about the big difference LIFO versus FIFO.
• 24:45
  SPEAKER_00: So LIFO is very much a focus on your most current costs are reflected as inventory or as cost of sales against your most current revenues.
• 24:56
  SPEAKER_00: But the number that ends up on the balance sheet can be costs from forever ago, right?
• 25:01
  SPEAKER_00: So the balance sheet doesn't have as much relevance in that context.
• 25:06
  SPEAKER_00: So depending on the the circumstances the company's faced with, how much emphasis maybe investors are placing on the number on the balance sheet could be a consideration.
• 25:16
  SPEAKER_00: Peer comparability is something we tend to think about when we think about preferability.
• 25:22
  SPEAKER_00: It's not really explicit in the guidance, um, but if you think about the user perspective, they're trying to make comparisons across an industry.
• 25:32
  SPEAKER_00: Having you know a consistent or comparable method of inventory costing with most of your peers is is usually an argument we think about.
• 25:41
  SPEAKER_00: So those are some of the things that um would would come into play, but it's uh there's not a really a finite list of considerations.
• 25:47
  SPEAKER_02: All right, that's helpful.
• 25:48
  SPEAKER_02: So then, Pat, let's move on.
• 25:50
  SPEAKER_02: So we've spent time obviously talking about the cost method, cost composition, but one of the things I actually thought we may start with was uh inventory evaluation and impairment, because that's obviously when you're looking at the balance sheet, a huge piece of what you're looking at.
• 26:06
  SPEAKER_02: And I if my memory serves me right, the gap in this area actually is a little more current, at least for part of it.
• 26:12
  SPEAKER_02: So, what are the models that you should be looking at when you're thinking about uh impairment?
• 26:18
  SPEAKER_00: So the the concept for impairment of inventory is what's known as net realizable value, meaning the inventory should be carried at cost, not to exceed its net realizable value.
• 26:29
  SPEAKER_00: Net realizable value essentially means the estimated selling price of the inventory in the ordinary course of business.
• 26:36
  SPEAKER_00: Now, if it's inventory that's in process, you've got to take into account the estimated cost to complete and compare that to the estimated selling price.
• 26:44
  SPEAKER_00: But that's essentially your threshold for whether or not the inventory is impaired.
• 26:50
  SPEAKER_00: A couple of key concepts here.
• 26:53
  SPEAKER_00: The notion is estimated selling prices in the ordinary course of business.
• 26:57
  SPEAKER_00: So even if you've had some sort of shift in the market, for whatever reason, you've had a price decrease at a point in time, but you expect that to be temporary and to recover before you sell the inventory, you can anticipate that potential recovery.
• 27:14
  SPEAKER_00: Obviously, you need to have some evidence that you expect that recovery to occur, but it's a little different than some of our other impairment models where there's a much more strict focus on what was the price or what was the value at the balance sheet date.
• 27:30
  SPEAKER_00: So this concept of sales in the ordinary course of business is is somewhat unique to the um the inventory model.
• 27:38
  SPEAKER_02: So then, Pat, let me jump in here with a question.
• 27:41
  SPEAKER_02: How would you think then, if you have locked-in long-term contracts that are above the current market price, how do they factor into this?
• 27:48
  SPEAKER_00: So those would be sales in the ordinary course of business.
• 27:51
  SPEAKER_00: And if you have sales contracts or commitments to sell at that price, that's the price that you would factor into your NRV or net realizable value assessment.
• 28:01
  SPEAKER_00: So even though perhaps for whatever reason, if you tried to go out and enter into a new contract for sale, it would be at a lower price.
• 28:08
  SPEAKER_00: If you're able, because of your existing contractual relationships, to sell it at a higher price, you would avoid having a net realizable value issue.
• 28:16
  SPEAKER_02: All right.
• 28:17
  SPEAKER_02: That's definitely something we see in the commodity business.
• 28:20
  SPEAKER_02: And then one more question for you.
• 28:22
  SPEAKER_02: For us, use word older accountants.
• 28:25
  SPEAKER_02: I think we're probably more familiar with lower of cost or market versus now this terminology of net realizable value.
• 28:32
  SPEAKER_02: What is there an easy way to explain the difference?
• 28:35
  SPEAKER_00: So you're right.
• 28:36
  SPEAKER_00: I mean, um, for a long time the threshold was lower of cost or market.
• 28:41
  SPEAKER_00: Um, the the concept of lower of cost or net realizable value was introduced probably seven, eight years ago now and was really intended to simplify the inventory assessment.
• 28:53
  SPEAKER_00: Importantly, though, that only changed for some inventories.
• 28:57
  SPEAKER_00: If you're applying LIFO or another very unique method called the retail inventory method, you are still following the lower of cost or market concept.
• 29:07
  SPEAKER_00: So lower of cost or net realizable value, lower of cost or market, what's the difference then between net realizable value and market?
• 29:15
  SPEAKER_00: So the concept of net realizable value is actually part of determining market.
• 29:20
  SPEAKER_00: But as defined, market is the replacement cost of the inventory, but in the specific inventory framework for lower of cost or market, that replacement cost, which is really what market is, is bounded at the upper end by net realizable value of the inventory, and at the lower end, the net realizable value less a normal profit margin on the inventory.
• 29:49
  SPEAKER_00: So you sort of have this band in which you know market is contained.
• 29:54
  SPEAKER_00: And it was, I think the idea was well, in most cases you end up looking at net realizable value anyway.
• 29:59
  SPEAKER_00: So let's just simplify it.
• 30:01
  SPEAKER_00: But then there are some perhaps unintended consequences for LIFO and and retail inventory methods.
• 30:07
  SPEAKER_00: So they just left those alone.
• 30:09
  SPEAKER_02: And just in the interest of education, retail inventory method, is there an easy way to explain?
• 30:15
  SPEAKER_00: So as you might expect from the name, it's used by retailers.
• 30:19
  SPEAKER_00: And the idea here is you essentially come up with your inventory cost by reference to the retail selling price.
• 30:26
  SPEAKER_00: It's intended to align with sort of how retailers actually keep their inventory.
• 30:31
  SPEAKER_00: Um, obviously, that has to be sort of anchored in some relationship between their actual costs and their retail selling prices, but instead of keeping cost records at a detailed level, you sort of keep the inventory at retail price, and then some percentage of that becomes your inventory cost.
• 30:49
  SPEAKER_02: Ah, makes sense.
• 30:50
  SPEAKER_02: Okay.
• 30:50
  SPEAKER_02: So then let me ask a question.
• 30:52
  SPEAKER_02: And in a way, this goes back to this uh question I asked you about long-term contracts where you've kind of locked in uh a higher sales price because obviously there's someone on the other side of that contract that's also locked in a higher purchase price than maybe the current market price.
• 31:07
  SPEAKER_02: And clearly in the current environment with supply chain and otherwise, you know, people may not be receiving their inventory um when they're expecting to.
• 31:16
  SPEAKER_02: So does the purchaser in that scenario, when you have long-term contracts, do they have any accounting that they should be thinking about?
• 31:26
  SPEAKER_00: Yeah.
• 31:26
  SPEAKER_00: So in the context of a committed purchase of materials, um you need to sort of think of that as inventory that I'm going to get because I can't avoid completing the purchase.
• 31:40
  SPEAKER_00: And if you're in a situation where when you purchase that, or at the moment it becomes inventory, were I to apply this lower cost or net realizable value concept to it, I would have an impairment of that inventory.
• 31:53
  SPEAKER_00: I sort of apply that same concept to the committed but not yet actually purchased goods.
• 32:01
  SPEAKER_00: It's interesting because that's there, there aren't a lot of places in GAAP where we accrue losses on what you would call an executory contract, but this is one explicit place where, again, if I've committed to purchase materials and it has to be an unavoidable commitment.
• 32:15
  SPEAKER_00: It can't just be like uh, well, that's the contract I have, but I may or may not buy it.
• 32:19
  SPEAKER_00: But if you're committed to purchasing a specific quantity at a price that's going to result in a net realizable value issue for you, you have to anticipate that loss prior to actually procuring the inventory.
• 32:32
  SPEAKER_02: And then is that normally a and like an adverse purchase commitment liability, or how do you see people actually recording that?
• 32:39
  SPEAKER_00: Aaron Powell That's that's what it would be called.
• 32:41
  SPEAKER_00: It would be an adverse purchase commitment.
• 32:43
  SPEAKER_00: You'd accrue some loss because you don't have an asset to attach any valuation to at that point.
• 32:49
  SPEAKER_00: And then once you procure the inventory, it would just presumably move from a liability to a part of your LCM or sorry, your lower of cost or net realizable value reserve.
• 33:00
  SPEAKER_02: All right.
• 33:01
  SPEAKER_02: And then Pat, uh, that's obviously one thing companies may be dealing with right now.
• 33:05
  SPEAKER_02: Any other areas where there's new developments that companies should be thinking about, just maybe from more of like a business or current events side?
• 33:14
  SPEAKER_00: So it's and it's not really related necessarily to like determining inventory cost, but we are definitely seeing, I'll say, other dynamics in the supply chain where people are perhaps looking to finance their inventory in um other ways.
• 33:32
  SPEAKER_00: Um a classic way that you might have seen, you know, kind of for a long time is consignment inventory.
• 33:38
  SPEAKER_00: That's where you know somebody selling something sort of you know puts inventory on on hand with a consignee, but the consignee doesn't take possession of it until they actually sell it.
• 33:50
  SPEAKER_00: So in a way, they're providing financing, if you will, to that consignee of the inventory.
• 33:56
  SPEAKER_00: Um that becomes more of a question of whose inventory is it.
• 33:59
  SPEAKER_00: You get into sort of the the control question.
• 34:02
  SPEAKER_00: We've also seen some cases where um there are intermediaries getting involved in the supply chain to provide essentially a form of working capital financing.
• 34:15
  SPEAKER_00: Um, some of those may even look at times like purchasers and resellers of the goods, even though they're actually uh, in a sense, or from a substantive standpoint, really only providing financing.
• 34:30
  SPEAKER_00: So again, you get into a question of like whose inventory is it for those parties?
• 34:34
  SPEAKER_00: Are they really resellers or are they simply financing uh the purchase of the goods?
• 34:40
  SPEAKER_00: So I would say they're not, again, specific to how much cost should be an inventory, but it's really a question of whose inventory is it and making sure you understand those arrangements and maybe some of the elements of the economics there are those inventory costs or costs of procurement, or do those become financing costs of one of the counterparties because they're actually paying somebody for a service that includes financing rather than just the procurement of goods.
• 35:08
  SPEAKER_02: So, Pat, if you are involved in one of those arrangements, is there a specific gap you should be looking at, or is it really again comes down to the substance and facts and circumstances of the arrangement?
• 35:18
  SPEAKER_00: Definitely more the latter.
• 35:20
  SPEAKER_02: All right.
• 35:20
  SPEAKER_02: I feel like that's another refrain for some of this.
• 35:23
  SPEAKER_02: Um and so then, Pat, one of the things I always like to close with, as you all know, is that you have obviously years, as you said at the beginning, of experience dealing with inventory issues.
• 35:34
  SPEAKER_02: So any particular advice that you would give to companies or anything sort of like from a practical point of view in terms of best practices that you could recommend?
• 35:44
  SPEAKER_00: I mean, I do feel like um if you stay anchored in that fundamental concept of inventory should be reflected at its actual cost, and you sort of just always keep that in the back of your mind.
• 35:55
  SPEAKER_00: That that's really critical.
• 35:57
  SPEAKER_00: Um there are a lot of variations and a lot of different ways that can all be acceptable, but it's important that you sort of pick your horse and ride it.
• 36:08
  SPEAKER_00: You know, be consistent once you've decided, or if you're going to change, make sure you've been thoughtful about the why.
• 36:14
  SPEAKER_00: And is that a change in accounting principle or or a just a normal process of revising your estimates and pay attention to the variances?
• 36:24
  SPEAKER_00: I mean, probably the one place that we've you know seen people get tripped up sometimes if they're not paying attention to those variances, because it can create challenges not just in terms of the day-to-day accounting, but when you think about the um the impairment assessment or the net realizable value assessment, if you haven't properly captured your variances, you're not going to get the right answer in that analysis either.
• 36:45
  SPEAKER_02: Well, and I think, Pat, it's also interesting to me in reflecting on this, you know, you mentioned the very beginning, this uh accounting model dates all the way back to ARB 43.
• 36:55
  SPEAKER_02: And I think sometimes there could be an assumption if it's almost like it's simple or easy.
• 36:59
  SPEAKER_02: Oh, we haven't needed new gaps, so it must not be that complex.
• 37:03
  SPEAKER_02: But this is also a place where clearly, as you've said, business and accounting intersect.
• 37:08
  SPEAKER_02: And so really staying on top of this and actually devoting resources to it seems like a worthwhile area.
• 37:14
  SPEAKER_00: Yeah, and definitely it's a great point, especially as businesses evolve as your operations evolve.
• 37:19
  SPEAKER_00: That's really when you want to be paying attention.
• 37:21
  SPEAKER_02: All right.
• 37:21
  SPEAKER_02: Well, Pat, as always, such a pleasure to have you on.
• 37:24
  SPEAKER_02: Thanks so much for joining me.
• 37:25
  SPEAKER_00: Thanks, Heather.
• 37:27
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• 37:48
  SPEAKER_02: From Thought Leadership at PWC, I'm Heather Horn.
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