4.7 Inventory
Inventory acquired in a business combination must be measured at its acquisition-date fair value — that
is, the price at which market participants would be willing to sell or buy the inventory. Neither ASC 805
nor ASC 820 provides detailed guidance on measuring the fair value of inventory, but carryover of the
book basis of the acquiree’s inventories is not permitted. Because there are many acceptable methods
for accounting for inventory, an acquirer and acquiree often have different policies for doing so. The
method used to account for inventory (e.g., FIFO, LIFO, or average cost) does not affect its fair value
measurement. See Section 4.16 for more information about conforming accounting policies.
The objective of measuring the fair value of inventory is to determine the value
created by the acquiree before the acquisition date. Conceptually, the acquiree
incurs each expense with the expectation of earning a profit. Therefore, the fair
value of inventory consists of the raw materials and the direct and indirect
expenses that were required to bring the inventory to its current state of
completion, plus a reasonable profit margin. Finished goods inventories and
work-in-process inventories are usually valued by using a top-down approach, whereas
raw materials are generally valued by using a bottom-up approach. The fair value of
inventory should be the same regardless of which approach is used.
4.7.1 Finished Goods
The fair value of finished goods inventory is often measured by using a top-down approach, which starts
with a market participant‘s estimated selling price, adjusted for both (1) the costs of the selling effort and
(2) an approximately normal profit for the selling effort. The acquirer’s results of operations after the
business combination should reflect the costs and profits of the selling effort after the acquisition.
Because neither ASC 805 nor ASC 820 provides detailed guidance on measuring the
fair value of inventory, stakeholders have questioned whether an acquirer is
permitted to recognize any profit on finished goods inventory acquired in a
business combination under ASC 820’s exit price notion and highest-and-best-use
concept. When asked to discuss the issue, the FASB’s VRG indicated that the fair
value of inventory is probably close to its net realizable value, which allows
an acquirer to realize a profit on the selling effort. The VRG noted that this
view is supported by ASC 820-10-55-21(f), which provides the following guidance
on valuing finished goods inventory at a retail outlet:
For
finished goods inventory that is acquired in a business combination, a Level
2 input would be either a price to customers in a retail market or a price
to retailers in a wholesale market, adjusted for differences between the
condition and location of the inventory item and the comparable (that is,
similar) inventory items so that the fair value measurement reflects the
price that would be received in a transaction to sell the inventory to
another retailer that would complete the requisite selling efforts.
Conceptually, the fair value measurement will be the same, whether
adjustments are made to a retail price (downward) or to a wholesale price
(upward). Generally, the price that requires the least amount of subjective
adjustments should be used for the fair value measurement.
The costs of the selling effort must be incremental and directly related to the inventory and must
be based on assumptions that other market participants would make. Direct costs are those that
would not have been incurred if the finished goods inventory had not been produced — for example,
transportation, packaging, and direct marketing costs, as well as sales commissions based on the sale
of the inventory. The costs of the selling effort should not include indirect and general expenses not
attributable to the production of the inventory.
An approximately normal profit for the selling effort should be based on the
assumptions of a market participant. The acquirer should not receive credit for
any portion of the selling effort completed by the acquiree before the
acquisition; that effort should be part of the fair value of the acquired
inventory.
4.7.2 Work in Process
An acquirer generally measures the fair value of acquired work-in-process inventory similarly to the
way it measures the fair value of finished goods inventory, except that the measure also includes
estimates for completing the production process. To determine the fair value of work in process, an
entity generally uses a market participant‘s estimated selling price for the finished product, adjusted for
(1) the costs of both the selling effort and the effort to complete the manufacturing process and (2) an
approximately normal profit for both the selling and manufacturing efforts.
An approximately normal profit for the work-in-process inventory will be greater
than the profit for the acquired finished goods inventory since the profit will
include the portion related to the manufacturing effort to complete the
product.
The costs to complete the manufacturing process should include all inventoriable
costs. ASC 330-10- 30-2 through 30-8 provide general guidance on determining
which costs should and should not be included in inventory.
4.7.3 Raw Materials
Raw materials must be measured at fair value as of the acquisition date from the perspective of a
market participant; an acquiree’s cost cannot be presumed to be an item’s fair value. Entities typically
apply a bottom-up approach, which uses a market method for valuation if observable market prices are
available or a cost approach if they are not. The fair value of raw materials inventory will often be similar
to its replacement cost. In accordance with ASC 820-10-35-5, it is assumed in the measurement of a raw
material’s fair value that the transaction to sell the raw material occurs in the principal market or, in the
absence of a principal market, the most advantageous market.
4.7.4 Supply Inventory
Supplies used in the manufacturing process are measured at fair value as of the acquisition date, in a
similar manner to raw materials inventory.
4.7.5 LIFO Inventories
Inventory should be measured at fair value as of the acquisition date. Neither the acquirer’s future
method of accounting nor the acquiree’s past method is relevant in the fair value determination. An
acquirer is not permitted to carry over the book basis of the acquiree’s inventories, including inventories
that will be carried under the LIFO method of accounting even if the acquirer is able to carry over the
acquiree’s prior LIFO basis for income tax purposes.
SAB Topic 5.L (SAB 58) states that registrants should refer to the AICPA Issues Paper Identification
and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories for guidance on determining what constitutes acceptable LIFO accounting practices. The Issues Paper
states that if acquired inventory is treated as a separate business unit or a new LIFO pool, the acquired
inventory should be considered the LIFO base inventory. If, however, the acquired inventory is combined
into an existing pool, it should be considered part of the current year’s purchases. Paragraph 2-15 of
the Issues Paper notes that the order of acquisition approach (first purchase price) to pricing current
purchases is the most compatible with the LIFO objective; however, any of the three approaches noted
in paragraph 2-10 may be used: “(a) the order of acquisition price (first purchase price), (b) the most
recent acquisition price (latest purchase price), [or] (c) the average purchase price.”