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11.2 Lower of cost or market
Publication date: 20 Jul 2016
us Utilities guide
The primary measurement basis for inventories is cost, provided cost is not higher than the net amount realizable from the subsequent sale of the inventories. The type of inventory typically held by utilities and power companies, including fuel and environmental assets, may be particularly susceptible to potential lower of cost or market write-downs due to the volatility in related prices. Reporting entities should assess the carrying value of inventory on a periodic basis. They may need to make adjustments to the recorded balances triggered by recent events, including changes in spot and forward prices, changes in legislative and regulatory requirements, and other economic or technological factors, such as changes in the planned resource mix or new technology that affects asset usage.
11.2.1 Lower of cost or market adjustments
ASC 330 establishes LOCOM as the guiding principle to apply in assessing whether cost or a lower estimate of net realizable value should be used in valuing inventories. ASC 330-10-20 defines “market” as current replacement cost provided that it meets two specified conditions.
Definition from ASC 330-10-20
Market: As used in the phrase lower of cost or market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meets both of the following conditions:
- Market shall not exceed the net realizable value
- Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin.
Net realizable value is equal to estimated selling price less reasonably predicable costs to sell. For liquid assets (such as natural gas) held for sale, the current spot market price usually equals net realizable value, unless the assets require transportation to the liquid selling point (in which case transportation costs would need to be incorporated). Determination of the market price for less liquid assets or assets held for use may be more difficult and application of the guidance requires judgment.
Excerpt from ASC 330-10-35-4
In applying the rule, however, judgment must always be exercised and no loss shall be recognized unless the evidence indicates clearly that a loss has been sustained.
Figure 11-1 summarizes key factors to consider in assessing an LOCOM measurement.
Figure 11-1
Inventory LOCOM considerations
Inventory LOCOM considerations
Inventory held for use |
Inventory held for sale |
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Basis of evaluation
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Key questions
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Other
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In performing an LOCOM assessment, the reporting entity should consider the intended use of the inventory (whether held for sale or held for use) as it may impact the assessment. Market price volatility and the seasonality of the inventory may also impact the assessment. In particular, the evaluation of fuel or environmental assets held for sale may be complex because of the need to consider future sales commitments and seasonal price fluctuations.
The following questions address common application matters related to the LOCOM principle and inventory impairments.
Question 11-1
How should spot and forward prices be considered in performing a LOCOM assessment?
How should spot and forward prices be considered in performing a LOCOM assessment?
PwC response
Reporting entities should record LOCOM adjustments in the period the loss is sustained; therefore, spot price declines as of the balance sheet date may indicate the need for a LOCOM adjustment. In addition, reporting entities should consider changes in spot prices subsequent to the balance sheet date in evaluating whether an LOCOM adjustment is necessary. Specific considerations include:
- Increases in prices after the reporting date may indicate that a previously observed price decline is temporary
- If forward prices indicate a price recovery, it may be appropriate to maintain inventory at carrying value
- Continued price declines after the reporting date may confirm the existence of underlying issues at that date in the valuation of the inventory
The trend in both spot and forward prices at the balance sheet date will provide information that can be used to determine whether a LOCOM adjustment is necessary. If a price recovery above the current carrying value is not expected before the inventory is expected to be sold, the inventory should be written down to net realizable value in the current period, absent firm sales commitments at prices above the current carrying value. Once the carrying value has been written down, a subsequent write-up of the carrying value is precluded, except as discussed in UP 11.2.2.
Question 11-2
How does a lower of cost or market adjustment to inventory affect earnings if the inventory is the hedged item in a cash flow hedge?
How does a lower of cost or market adjustment to inventory affect earnings if the inventory is the hedged item in a cash flow hedge?
PwC response
It depends. Reporting entities may designate the forecasted purchase or sale of inventory (e.g., natural gas) as the hedged item in a cash flow hedge. If the hedge is effective, any gains or losses on the hedging derivative are deferred in accumulated other comprehensive income until the forecasted purchase or sale affects earnings. Reporting entities are required to perform LOCOM adjustments on inventory in accordance with ASC 330, even if hedge accounting is applied. However, ASC 815-30-35-43 provides specific guidance regarding the treatment of deferred hedging gains and losses related to a hedged asset or liability for which an impairment loss is recorded.
If, under existing requirements in GAAP, an impairment loss is recognized on an asset or an additional obligation is recognized on a liability to which a hedged forecasted transaction relates, any offsetting net gain related to that transaction in accumulated other comprehensive income shall be reclassified immediately into earnings. Similarly, if a recovery is recognized on the asset or liability to which the forecasted transaction relates, any offsetting net loss that has been accumulated in other comprehensive income shall be reclassified immediately into earnings.
Therefore, if a reporting entity records an LOCOM adjustment of inventory that has been designated as the hedged item in a cash flow hedge, it would also concurrently reclassify to earnings an equivalent amount of any gains deferred in accumulated other comprehensive income related to the hedge. As a result, there may be circumstances when a reporting entity can mitigate or eliminate the effect of an LOCOM adjustment. See DH 9.2 for further information on evaluating impairments in conjunction with hedge accounting.
New guidance
In July 2015, the FASB issued ASU 2015-11, Simplifying the Measurement of Inventory, which simplifies the LOCOM analysis discussed above. This ASU is effective in fiscal years beginning after December 15, 2016, and may impact the evaluation of inventory impairment.
11.2.2 Interim period considerations
ASC 270 provides some flexibility in accounting for inventory price declines in interim periods. This is particularly useful in considering LOCOM adjustments related to fuel inventory and environmental assets classified as inventory, because of their potential for significant price volatility. ASC 270-10-45-6(c) provides guidance in addressing interim fluctuations in inventory prices.
Inventory losses from market declines shall not be deferred beyond the interim period in which the decline occurs. Recoveries of such losses on the same inventory in later interim periods of the same fiscal year through market price recoveries shall be recognized as gains in the later interim period. Such gains shall not exceed previously recognized losses. Some market declines at interim dates, however, can reasonably be expected to be restored in the fiscal year. Such temporary market declines need not be recognized at the interim date since no loss is expected to be incurred in the fiscal year.
ASC 330-10-55-2 references this guidance, indicating that write-downs are generally required unless the decline is due to seasonal price fluctuations.
Consistent with this guidance, reporting entities can consider forward prices when evaluating price declines in an interim period. If forward prices indicate that the decline is seasonal with recovery expected, and the reporting entity has the ability and intent to hold the inventory until prices recover, it may not be necessary to record a write-down in an interim period.
Furthermore, as noted in ASC 270-10-45-6(c), if a write-down is recorded and prices subsequently recover, a reporting entity may only restore amounts previously written-off if the price recovery occurs in the same year.
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