BV113 PDF

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BV113. Valuation of Inventory

This Valuation Standard ("Standard") and related guidance are designed to assist Deloitte Advisory
personnel of Deloitte Transactions and Business Analytics LLP (“DTBA”) and Deloitte Financial
Advisory Services LLP ("Deloitte FAS") operating within the Enterprise and Intangible Assets,
Property Plant & Equipment, and Real Estate asset competencies within the Valuation and Modeling
market offering ("Valuation Personnel"), when performing valuation services ("Valuation Services") .
This Standard should be followed by Valuation Personnel in the United States. Individuals
who perform Valuation Services outside of the United States should consult with their
Valuation Services leader to determine the applicable standard or standards to apply.
Both “Needs To” and “Preferred” direction can be found in the Grey Box Standards. For “Needs To”
Grey Box Standards, compliance is expected and exceptions to their direction will be rare.
Documentation demonstrating compliance with “Needs To” Grey Box Standards needs to be
included in the engagement working papers.
For “Preferred” Grey Box Standards, compliance is encouraged, and exceptions to their direction will
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be more frequent compared to “Needs To” Grey Box Standards. Documentation demonstrating
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compliance with “Preferred” Grey Box Standards also needs to be included in the engagement
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working papers.
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As a reminder, you need to document in the engagement working papers (1) your reasons for any
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non-compliance with the Grey Box Standards and (2) the approval of the Designated Valuation
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Partner, Principal, or Director (DVPD) for the engagement of such non-compliance. Generally, you
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need to address questions about the Standards to your Asset Competency Champion or designee.
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This standard explains inventory valuation methods we use when valuing inventory (a) for a business
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combination, (b) for a lump-sum purchase of business assets, (c) for ordinary financial reporting or tax
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reporting, (d) for special tax reporting (such as in connection with IRC section 861 requirements), and (e) for
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asset-based lending.
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In this standard, we:

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• review the definitions, classifications, and principal methods of accounting for inventory;
• summarize the regulatory guidance for valuing inventory in connection with a business combination
or a lump-sum purchase of business assets;
• describe inventory valuation methods and how to perform them;
• identify factors to consider when you perform an inventory valuation; and
• address frequently asked questions.
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This standard was last updated on: 9/16/2016. Please go to {https://financialadvisory.deloitteresources.com/vkg/bval/Pages/BV113Valuation_37249.aspx} to access the
BV113.1 Inventory Overview

Inventory consists of goods that a business owns and holds either for resale or to use in manufacturing
products for resale. These goods can include the company’s merchandise, raw materials, and finished and
unfinished products that have not yet been sold.
Inventory is typically classified as a current asset on the balance sheet. It is usually considered a short-term
asset because it can be converted into cash relatively easily. However, in some industries, some inventory
items may be treated as fixed assets. In the airline industry, for example, repair parts are frequently tracked in a
computerized inventory control system, but they are not really inventory because they are not held for sale or
held for conversion into assets held for sale. You need to read the subject company’s notes to the financial
statements to properly understand inventory components.
Inventory defined
In the context of financial reporting, according to U.S. GAAP ASC 330, Inventory (formerly Accounting
Research Bulletin (ARB) No. 43), the term “inventory” is defined as:
The aggregate of those items of tangible personal property that have any of the following characteristics:
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• held for sale in the ordinary course of business,
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• in the process of production for such sale, or
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to be currently consumed in producing goods or services to be available for sale.
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Inventory types
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Depending on the company’s business, inventory may consist of various types of tangible goods or materials.
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Inventory classification will depend on the operations. A wholesale or retail entity acquires merchandise for
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resale. A manufacturing entity acquires raw materials and component parts, manufactures finished products,
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and then sells them.

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• Merchandise inventory: Goods on hand purchased for resale by a retailer or a trading company
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• Manufacturing inventory: Components, such as raw materials, work-in-process, and finished goods
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• Raw materials: Tangible goods purchased or obtained for direct use in manufacturing goods for
resale; raw materials have not been subjected to any processes to change or add value to them
• Work-in-process (WIP): Goods that are no longer in raw material state but that need further
processing before completion and sale. WIP includes the cost of the direct materials as well as the
direct labor and allocated manufacturing overhead costs incurred. Allocated manufacturing overhead
costs may include indirect expenses such as heat, electricity, and administrative salaries.
• Finished goods: Manufactured items completed and held for sale. Finished goods include the direct
material costs, direct labor and allocated manufacturing overhead costs. An item of inventory may be
a finished good to one company but a raw material to another.
Inventory characteristics
• Inventory does not include either depreciable assets, or goods that will become depreciable when put
into use by the subject company. Nor does inventory include goods held but owned by someone else,
such as goods for sale on commission or on consignment.
• All inventory items, wherever located, need to be included in inventory. A company may own goods
that it does not currently possess, such as goods on consignment or WIP at outside processors, that
need to be included in its inventory balance.
Why value inventory?

Generally, the accounting treatment of inventory is based on the lower of its cost or market value. “Market
value” of inventory is defined as current replacement cost (by purchase or by reproduction). However, many
circumstances require a departure from the lower-of-cost-or-market concept, such as:
• Measuring the value of inventory in the context of a business combination or a lump-sum purchase
of business assets (for financial reporting or tax purposes)
• Reporting for certain federal income tax purposes, such as complying with IRC Section 861 (type of
value is fair market value)
• Asset-based lending (premise of value is usually orderly liquidation value or net orderly liquidation
value)
• Reporting for state or personal property tax purposes (type and premise of value is based on the
relevant state and local tax regulations)
• Miscellaneous other, including setting a transaction sales price for inventory and determining
inventory value in legal disputes or business dissolutions (premise of value will vary case by case)
This valuation standard focuses on the valuation of inventory in connection with a business combination or a
lump-sum purchase of business assets (whether for financial reporting or tax purposes or both), consistent with
most of the inventory valuation engagements that we perform.
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BV113.2 Inventory accounting methods

When valuing inventory in connection with a business combination or a lump-sum purchase of business assets,
you need to understand how the inventory’s carrying value, as shown on the balance sheet, has been
determined.
ASC 330, Inventory, represents authoritative guidance on calculating inventory prices under U.S. GAAP,
codifies the following pronouncements:
• Accounting Research Bulletin (ARB) No. 43, Inventory Pricing

• Financial Accounting Standards Board (FASB) Statement 151, Inventory Costs, issued in 2004,
amends ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight,
handling costs, or wasted material.
Other guidance includes:
• AICPA’s Accounting Standards Division, Task Force on LIFO Inventory Problems issued in 1984 an
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Concerning LIFO Inventories” that provides additional guidance.
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When accounting for inventory under International Accounting Standards (IAS), the authoritative guidance is
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found in IAS 2, Inventories, issued in 1993 and amended in 2003.
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Both U.S. GAAP and IAS hold that the primary basis of accounting for inventory is cost, and both standards
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require a departure from the cost basis of pricing inventory once its utility is less than its cost.
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ASC 330, Inventory, and ASC 450, Contingencies (formerly FASB Statement 5), advise that, where there is
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evidence that the goods’ utility, in their disposal in the ordinary course of business, will be less than cost, the
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goods should be stated at a lower level commonly designated as market, resulting in a concept of stating the
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inventory on a “lower of cost or market” basis.

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Similarly, IAS 2, Inventories, paragraph 9, requires that inventories shall be measured at the lower of cost and
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net realizable value (NRV).

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Principal cost methods

The primary basis of accounting for inventories is cost. The common cost-basis inventory conventions include:
• First-in, first-out (FIFO) • Weighted average cost
• Last-in, last-out (LIFO) • Specific identification
A company may use several methods

concurrently to account for its inventories in its financial statements. The tax laws in effect for the countries
where the company operates may affect which method(s) a company uses to account for its inventories.
a.Description of common cost-basis inventory conventions
FIFO basis – Inventory is accounted for closer to current replacement cost than the LIFO basis.
• This presumes that cost of goods sold reflects the goods with the oldest cost basis and that ending
inventory comprises the goods with the most recent cost basis.
• FIFO charges the oldest costs against revenues on the income statement.
(1) This characteristic is often viewed as a deficiency from a gross margin perspective, because the current
costs of replacing the units sold are not being matched with current revenues.
(2) But on the balance sheet, FIFO inventory represents the most recent purchases and will usually
approximate current replacement costs.
LIFO basis – Inventory is accounted for on the basis of the cost of goods bought or incurred in periods before
the current period.
• This presumes that cost of goods sold reflects the most recently acquired units and that ending
inventory comprises the oldest available goods.
• This seldom corresponds to the actual physical flow of goods.
• LIFO matches the most recently incurred costs against revenues.
(1) This characteristic is often viewed as an advantage from an income statement perspective, because current
costs of replacing the units sold are being matched with current revenues.
(2) But on the balance sheet, LIFO inventory represents the oldest available costs, which usually do not
approximate current replacement costs.
(3) For firms that have used LIFO for many years, the LIFO inventory amount may reflect only a small
fraction of what it would cost to replace this inventory at today’s prices.
Weighted average costing – calculates an average cost per unit by dividing the cost of goods available by total
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units available. This average cost is used to determine both cost of goods transferred out and ending inventory.
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Specific identification – In the case of costly, easy-to-identify inventory, items are sometimes tracked
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b.Inventory accounting effects on income, assets, and cash flow under LIFO and FIFO
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LIFO and FIFO compared– rising price and increasing inventories

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LIFO results in: FIFO results in:

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• higher COGS • lower COGS

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lower taxes higher taxes

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lower net income (EBT & higher net income (EBT &
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• lower inventory balances • higher inventory balances

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• lower working capital • higher working capital

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• higher cash flows • lower cash flows
Note that a company can use LIFO for tax purposes only if it also uses that for financial reporting, so
accounting methods need to conform.
c. LIFO – FIFO conversions
U.S. GAAP requires all companies that use LIFO to report a LIFO reserve, which is the difference between
what their ending inventory would have been under FIFO accounting and its value under LIFO.
LIFO = Inventory at FIFO –Inventory at LIFO
reserve
COGS = COGS LIFO –Change in the LIFO reserve
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= COGS LIFO –(ending LIFO reserve – beginning LIFO reserve)
Principal market methods
Under U.S. GAAP, as outlined in ASC 330, Inventory (formerly ARB No. 43, Inventory Pricing), the term
market, as used in “lower of cost or market,” means current replacement costs (by purchase or by
reproduction) except that:
1. Market should not exceed the net realizable value (NRV) – defined as the estimated selling price in
the ordinary course of business less reasonably predictable costs of completion and disposal.
2. Market should not be less than the NRV reduced by an allowance for a normal profit margin.
The constraint that the market value not exceed the NRV sets the ceiling value when measuring market value.
The constraint that the market value not be less than the NRV reduced by an allowance for a normal profit
margin sets the floor value when measuring market. So, based on the above guidance in Statement 6:
• If current replacement cost > NRV, then NRV is market

• If current replacement cost < (NRV - normal profit margin), then (NRV - normal profit margin) is
market
Further, an approximately normal profit for the work-in-process inventory will be greater than the profit for
acquired finished goods inventory since the profit will include the portion related to the manufacturing effort to
complete the product.
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Also, the costs to complete the manufacturing process should include all inventoriable costs. ASC 330-10-30-2
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through 30-8 provide general guidance for determining which costs should and should not be included in
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Under International Accounting Standards, as outlined in IAS 2, Inventories, paragraph 28, the practice of
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writing down inventories below cost to NRV is consistent with the view that assets should not be carried in
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excess of amounts expected to be realized from their sale or use. IAS 2 defines NRV as “the estimated selling
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price in the ordinary course of business less the estimated costs of completion and the estimated costs
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necessary to complete the sale”. This definition is similar to that in ASC 330, Inventory.
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BV113.3 Regulatory guidance

Valuing inventory in the context of a business combination or in a lump-sum purchase of business assets is the
most common reason that we would perform an inventory valuation. A valuation for this reason may be
required for either financial reporting or tax purposes, or both. Both the financial reporting and tax literature
offer regulatory guidance for valuing inventory in these situations. The guidance is summarized below.
Financial Reporting Guidance – US GAAP
Paragraph 37 (c) from FASB Statement 141, Business Combinations, presents general guidance for valuing
inventory assets acquired:
• Finished goods and merchandise are to be valued at estimated selling prices less the sum of (a);costs
of disposal and (b);a reasonable profit allowance for the selling effort of the acquiring entity.
• WIP is to be valued at estimated selling prices of finished goods less the sum of (a);costs to complete,
(b);costs of disposal, and (c);a reasonable profit allowance for the completing and selling effort of the
acquiring entity based on profit for similar finished goods.
• Raw materials are to be valued at current replacement costs.
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Under ASC 805, Business Combinations (formerly FASB Statement 141(R)), finished goods inventory
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acquired in a business combination must be measured at fair value, as of the acquisition date, under the
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requirements of ASC 820, Fair Value Measurements and Disclosures (formerly FASB Statement 157).
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Neither ASC 820 nor ASC 805 provide detailed guidance on valuing inventory. As of the date of preparation
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of this standard, it is believed that inventory fair value measurements under ASC 805 are unlikely to differ
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significantly from those under Statement 141, as described above.

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The FASB's Valuation Resource Group (VRG) met on February 1, 2008, to discuss the fair value of inventory
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(among other topics). When asked to discuss the issue, the VRG indicated that the fair value of inventory is
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probably close to its net realizable value, which allows an acquirer to realize a profit on the selling effort. The
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VRG indicated that this view is supported by ASC 820-10-55-21(f), which provides the following guidance on
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valuing finished goods inventory at a retail outlet:

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For finished goods inventory that is acquired in a business combination, a Level 2 input would include either a
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price to customers in a retail market or a wholesale price to retailers in a wholesale market, adjusted for
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differences between the condition and location of the inventory item and the comparable (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 should 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 fair value of acquired finished goods inventory therefore, in most cases, is determined using a market
participant's assumptions regarding the estimated selling price (in either a retail market or wholesale market
depending on the circumstances) adjusted for both (a) the costs of the selling effort and (b) an approximately
normal profit for the selling effort.
Financial Reporting Guidance – IFRS

Paragraph B16(d) of International Financial Reporting Standards (IFRS) No. 3 (2004), Business Combinations,
presents general guidance for allocating the cost of a business combination to inventory assets acquired. It is
nearly identical to that in Statement 141:
• For finished goods and merchandise, the acquirer shall use selling prices less the sum of (1);the costs
of disposal and (2);a reasonable profit allowance for the selling effort of the acquirer based on profit
for similar finished goods and merchandise.
• For WIP, the acquirer shall use selling prices of finished goods less the sum of (1);costs to complete,
(2);costs of disposal and (3);a reasonable profit allowance for the completing and selling effort based
on profit for similar finished goods.
• For raw materials, the acquirer shall use current replacement costs.
Note that LIFO is prohibited under IFRS.

IFRS No. 3 was revised in 2008 and requires that assets and liabilities acquired in a business combination be
recorded at their acquisition date fair values.; As of the date of preparation of this standard, it is believed that
inventory fair value measurements under IFRS No. 3 (2008) are unlikely to differ significantly from those
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under IFRS No. 3 (2004), as described above.
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Deloitte Touche Tohmatsu published a 164-page guide, Business combinations and changes in ownership
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interests: A guide to the revised IFRS 3 and IAS 27 in 2008 and IGAAP – IFRS in the UK in 2009. You can
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refer to these publications for further information.
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Tax Guidance – Internal Revenue Service (IRS)

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(A) Revenue Procedure (Rev. Proc.) 2003–51

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Rev. Proc. 2003–51 guides taxpayers and IRS personnel in making fair market value determinations for
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inventory acquired when (a);a taxpayer buys business assets for a lump sum or (b);a corporation acquires
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another corporation's stock and elects under IRC section 338 to have the acquisition treated as an asset
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purchase. This Revenue Procedure describes the methods that may be used to determine the fair market value
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of inventory and allocate the purchase price for tax purposes.

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The three basic methods to determine the fair market value of inventory identified in Rev. Proc. 2003–51 are
the replacement cost method, the comparative sales method, and the income method:
• Replacement cost method: The replacement cost values inventories at replacement cost – that is,
what it would cost to assemble identical inventories under prevailing market conditions. The
replacement cost generally provides a good indication of fair market value if inventory is readily
replaceable in a wholesale or retail business or for raw materials. But it may not be appropriate in
establishing the fair market value of WIP or finished goods of a manufacturer.
• Comparative sales method: The comparative sales uses the actual or expected selling prices of
finished goods to customers in the ordinary course of business as the base amount that must be
adjusted for factors relevant in determining the inventory's fair market value, including:
o The time required to dispose of the inventory

o The expenses that would be expected to be incurred in the disposition
o A profit commensurate with the amount of investment in the assets and the degree of risk
• Income method: The income method, when applied to fair market value determinations for finished
goods, recognizes that finished goods must generally be valued in a profit-motivated business. In
using this method, the fair market value is based on the amount that could be attributed to finished
goods to pay all costs of disposition and provide a return on the investment during the period of
disposition.
The replacement cost method and the comparative sales method are similar to the guidance provided within
FASB Statement 141, Business Combinations. The income method has no comparable guidance in financial
reporting guidance.
(B) Legal precedent
Tax court cases provide additional insight into the valuation of inventory for US federal tax purposes. See
Appendix B for some court cases and their inventory-related issues.
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As of the date of this Valuation Standard, it is expected that the framework based on this guidance from FASB
Statement 141 will lead to a conclusion of fair value, consistent with that of FASB Statement 157, as codified
in topic ASC 820, Fair Value Measurements and Disclosures.
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BV113.4 Valuation methodologies –

business combinations lump-sum asset
purchases
When valuing inventory as part of a business combination or a lump-sum purchase of business assets, the
acquiring entity in future periods would recognize only profits associated with value added to the acquired
inventory after the acquisition date. The acquiring entity would not recognize profit associated with the
purchased value of the inventory.
Generally, it would not be appropriate to assign the acquired entity’s carrying value to the cost of the acquired
finished goods and merchandise and WIP inventories, because the acquired entity’s carrying value does not
reflect the manufacturing profit. The manufacturing profit as of the acquisition date is considered as part of the
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value assigned to the inventory; accordingly, the manufacturing profit associated with the value-added
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manufacturing activities needs to be included in deriving the fair value or fair market value of inventory.
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Valuation Standard - BV113.4.A
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When valuing inventory that has been subject to any value-added manufacturing activities through the
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valuation date, you need to include the profit associated with the inventory given its current state and exclude
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the profit associated with the activities that will occur subsequent to the valuation date (i.e., the buyer’s
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portion of the profit).

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Accordingly, you need to include documentation in the engagement working papers supporting your
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consideration of the profit associated with future activities that will be completed by the buyer (i.e., the
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buyer’s portion of the profit).

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Valuation professionals outside of the United States should consult with their Valuation Services Leader for
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the appropriate Standards that apply.

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You can use one of three common valuation methodologies to estimate the fair value or fair market value of
inventory acquired in a transaction:
• Replacement cost method

• Comparative sales method (tax purposes) or NRV less reasonable profit allowance for completing and
selling effort of the acquiring entity (financial reporting purposes)
• Income method
When choosing an inventory valuation methodology, you need to consider the various types of inventory to
ensure that the inventories are valued according to their appropriate classification: finished goods, WIP, or raw
materials. You also need to understand the nature of the inventory and the amount of value-added activities
that have occurred through the valuation date. Valuing inventory is an inherently factual determination, so
using rigid formulas are not appropriate.
When valuing inventory for financial reporting purposes, it is necessary to consider market participants’
assumptions. At a minimum, consideration needs to be given to the market participant’s assumptions on:
• the expected or anticipated profit on the work-in-process and finished goods inventory
• the contribution of profit by other identified assets (trademarks, trade names, brand, technology, etc)
to the inventory
• the premise of value (e.g., going-concern or liquidation value)
• the net realizable value of the inventory
When valuing inventory that is unique or highly specialized, for example in the pharmaceutical and consumer
business sectors, industry subject matter specialists need to be consulted. Further, when valuing processed
based inventory (e.g., chemical and petrochemical manufacturers, energy producers, and oil refiners) industry
subject matter specialists need to be consulted.
Valuation Standard - BV113.4.B

When valuing inventory that is unique in nature, it is preferred that you consult with industry subject matter
specialists and document the consultation in the engagement working papers.
Replacement cost method
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The replacement cost method generally provides a good indication of value if the inventory is readily
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replaceable in a wholesale or retail business, but does not generally apply to WIP or finished goods of a
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manufacturer. Inventory’s replacement cost is determined as of the valuation date, which may differ from the
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inventory’s cost when it was actually purchased. R

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The replacement cost method may be appropriate for the inventory of a wholesale or retail business because, in
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the normal course of business for these types of companies, there are fewer expenses involved in acquiring an
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inventory of goods relative to disposing of the goods. Most expenses relate to selling the inventory, so the
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replacement cost method may involve fewer subjective estimates than other methods. Also, when valuing the
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inventory of a distribution business, where the turnover is extremely high and the distributor incurs little or no
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shipping, handling, or repacking costs associated with the inventories, the replacement cost method might be
FI US TH TER
appropriate.
TE D R A
IT AN FU M
LO SS BE RY
DE CE TO TA
For WIP or finished goods of a manufacturer, the replacement cost method would generally not be appropriate,
AC OT PRIE
as it would not capture the manufacturing profit associated with the value-added activities. But the replacement
N RO
P
cost method is often used to value raw materials of these types of companies as of the date of acquisition,
because, generally, no value has been added to them through the manufacturing process or the holding of the
inventory.
Steps in performing the replacement cost method include:
Step 1 – Determine the replacement or reproduction cost of the individual items. This will be the base amount.
• The replacement or reproduction cost needs to be based on market conditions prevailing as of the
valuation date.
• The direct costs of replacing or reproducing the inventory may include both direct material costs and
direct labor costs incurred in purchasing, receiving, and handling the inventory.
Step 2 – Adjust the base amount for relevant factors:
• Providing a fair return to the seller on expenditures made in accumulating and preparing the inventory
for distribution to account for the profit associated with those activities. This may include related costs
that the buyer would have incurred in acquiring the same quantity of inventory (such as purchasing,
handling, transportation, etc.).
• Providing business continuity to the buyer. For example, a fully stocked inventory available to fulfill
customer orders may have a value in excess of its replacement or reproduction cost because it
provides for business continuity.
• Slow-moving or obsolete merchandise inventory that may be unsuitable for customers. Existence of
goods unsuitable for customers may result in a value less than the cost of replacement.
• Overstocked inventory may reflect a discount to the cost of replacement.
Comparative sales method (tax purposes) or NRV less reasonable profit allowance for
completing and selling effort of the buyer (financial reporting purposes)
The comparative sales method, as described in Rev. Proc. 2003–51, uses the actual or expected selling prices
of finished goods to customers in the ordinary course of business as the base amount and then adjusts this
amount for other factors generally relevant to inventory’s value. The comparative sales method is equivalent to
the NRV method, reduced by a reasonable profit allowance for the selling effort of the acquiring entity, as
described in the financial reporting literature.
The comparative sales method may be more appropriate when valuing finished goods and WIP inventory of a
manufacturer because manufacturers generally have few costs of disposition related to the inventory relative to
the costs incurred to manufacture the inventory. Therefore, they would have fewer potential subjective
OF
estimates as inputs in performing the comparative sales method. In addition, this method is preferable when
ON
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there have been a significant amount of value added activities performed to the inventory.
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O RI
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Steps in performing the comparative sales method include:
AU
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Step 1 – Determine the estimated selling price of the inventory in a completed condition. If the inventory
TO SC
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being valued is WIP, the estimated selling price of the inventory is based on the estimated selling price of the
ES SU ED N
P. EC R
IC IS UT O
RV LS IB SE
inventory once it is completed.

SE A TR U
Y ERI IS AL
OR T , D N
IS MA ED TER
• The estimated revenues associated with the inventory in a completed condition may be calculated by
DV SE AT IN
L A E UL R
IA TH IRC , FO
multiplying the inventory items on hand times the expected selling price per item. But an alternate
NC OF C LS
approach that may provide an estimate of the selling proceeds would be to use the expected margins
NA E ER IA
FI US TH TER
associated with the inventory. In this calculation, you would take the completed inventory cost figure
TE D R A
IT AN FU M
LO SS BE RY
(which would equate to the cost of goods sold) and divide by the estimated cost of goods sold as a
DE CE TO TA
AC OT PRIE
percent of sales, on a normalized basis. For example, if the completed inventory cost figure was $75
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and the expected cost of goods sold as a percent of sales was 60%, then the expected selling proceeds
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would be $125 (calculated as $75 / 60% = $125). If you are valuing WIP, you would first estimate the
value of the WIP in a completed condition before using the cost of goods sold percent to estimate the
selling proceeds.
Valuation Standard - BV113.4.C

Consideration needs to be given to both historical margins and prospective margins on the inventory being
valued. You need to a) consult with management and b) document in the engagement working papers the
prospective margin that is likely to be realized on the subject inventory.
Step 2 – Subtract the costs to complete, if applicable.
Valuation Standard - BV113.4.D
The costs to complete inventory depend on factors such as the cost of production and the state of completion.
They are also related to the subject company’s accounting policies on the absorption of costs into the
inventory. If the accounting treatment of cost absorption does not match actual expenditures, then you need to
consider adjustments to the costs to complete.
You need to a) consult with management, and b) document in the engagement working papers your
understanding of the company’s cost absorption treatment and any adjustments to the costs to complete.
• Finished goods typically have no remaining costs to complete. If valuing WIP, the remaining costs to
transform the inventory to a finished good state are needed.
Step 3 – Subtract disposal costs
• Disposal costs represent the estimated costs necessary to make the sale. The classification of disposal
costs may differ based upon the nature of the subject company’s operations (e.g., a manufacturer or a
retailer).
OF
• Disposal costs need to reflect all expenses expected to be incurred in disposing of the inventory – for
ON
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example, discounts, sales commissions, freight, and shipping charges. The existence of slow moving
ZA
RI
or overstocked inventory also needs to be considered as this may impact disposal costs.
O
TH
•
AU
For manufacturing operations, costs to dispose may include the expenses necessary for the selling
PR .
E SED
R
IO
effort but would generally not include corporate overhead such as general and administrative expenses
TH LO
TO SC
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or research and development related expenses.

T DI
ES SU ED N
P. EC R
IC IS UT O
• For retail operations, costs to dispose may include inventory stocking costs but it is generally
RV LS IB SE
SE A TR U
Y ERI IS AL
inappropriate to allocate general and administrative overhead costs to finished goods inventory in the
OR T , D N
IS MA ED TER
acquisition. However, in certain circumstances it may be necessary to allocate a portion of a retail

DV SE AT IN
L A E UL R
operation’s general and administrative overhead costs to finished goods inventory if the general and
IA TH IRC , FO
NC OF C LS
administrative overhead costs are principally related to the nature of the subject company’s business.
NA E ER IA
FI US TH TER
For instance, a retailer with several retail locations may allocate a portion of the rent and other direct
TE D R A
IT AN FU M
expenses associated with the retail location as disposal costs but would not include expenses
LO SS BE RY
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associated with corporate overhead such as officer’s compensation, rent associated with the corporate
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headquarters, and other general corporate overhead items.

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• For additional information on disposal costs, refer to the US Technical Library:

o Item f. of ASC 820-10-55-21 (formerly paragraph A24 of FASB Statement 157)
Step 4 – Subtract holding costs
• You may also consider the time required to dispose of the inventory. This would represent the holding
costs associated with the acquired inventory. Holding costs may be measured by considering the
amount invested in the inventory, the time needed to dispose of the inventory, and the available
finance rate for the period.
Step 5 – Subtract a reasonable profit allowance for the post-acquisition completion effort and the selling
effort.
A reasonable profit allowance for the selling effort needs to match the amount of investment in the assets and
the degree of risk assumed. The reasonable profit allowance needs to reflect the company’s profit margin after
the costs associated with acquiring or manufacturing the finished goods inventory and any necessary disposal
and holding costs.
The following chart depicts the contribution of profit by activity or asset for a general or generic manufacturer
and a pharmaceutical company. The illustrative example below is not intended to be all inclusive and is
presented to provide insight into the various items for consideration when estimating the reasonable profit
allowance between the seller and buyer.
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SE A TR U
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OR T , D N
IS MA ED TER
DV SE AT IN
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IA TH IRC , FO
NC OF C LS
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FI US TH TER
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As depicted in the previous chart, numerous items such as the conversion process, developed or core
technology, brand and distribution activities contribute to the operating profit margin of a business and in-turn
the expected or anticipated reasonable profit to be allocated between the seller and the buyer.
Due to the profit split nature of the valuation methodology for inventory, the economic benefits of the
intangible assets that are used to produce the products are incorporated in the value of the inventory.
Incorporating contributory asset charges for the aforementioned intangible assets is typically not appropriate in
estimating the value of the inventory. Refer to the Nestle Holdings, Inc. v. Commissioner of Internal Revenue
US Tax Court case for further guidance on this topic.
• Factors to consider include:

o The company’s own historical or expected profit margins
o Industry statistics for normal profit allowances and turnover rates
o The nature of the selling network and marketing techniques the acquiree used (or the acquirer
will use, if significantly different)
o Risks of possible changes in style or design
o Potential changes in price levels
o Competitive environment and the likelihood of different levels of competition
o Possible adverse economic conditions
o The quantity of inventory acquired relative to the normal trading volume
• One approach for allocating expected profit associated with inventory between the seller (for pre-
acquisition activities) and the buyer (for post-acquisition activities) is to allocate the expected profit
based on the ratio of costs to be incurred by each party relative to the total manufacturing and selling
costs.
See the following example for an allocation of the expected profit associated with WIP and finished goods
inventory using this approach:
OF
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TO SC
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SE A TR U
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OR T , D N
IS MA ED TER
DV SE AT IN
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IA TH IRC , FO
NC OF C LS
NA E ER IA
FI US TH TER
TE D R A
IT AN FU M
LO SS BE RY
DE CE TO TA
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P
OF
•
ON
A modification of the ratio-of-expenses approach to allocate the profit described above would be to
TI
ZA
adjust the expenses to include only value-added activities in the computation. For example, the raw
O RI
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material costs might be excluded from the manufacturing costs shown in the computation, and the
AU
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E SED
manufacturing expenses that would be included in the computation would reflect the conversion costs
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TH LO
in transforming the raw materials to their current state. See the following example for an allocation of
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the expected profit associated with WIP inventory using this approach:
P. EC R
IC IS UT O
RV LS IB SE
SE A TR U
Y ERI IS AL
OR T , D N
IS MA ED TER
DV SE AT IN
L A E UL R
IA TH IRC , FO
NC OF C LS
NA E ER IA
FI US TH TER
TE D R A
IT AN FU M
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• An alternate approach is to estimate the profit margin on the disposal activities (i.e., the buyer’s profit)
based upon the operating profit margin of guideline companies that are principally distributors. The
buyer’s profit margin on the disposal activities is calculated based upon the selected guideline
distribution companies’ operating profit margins as the floor for the buyer’s profit margin on the
disposal activities. The calculated buyer’s profit is subtracted from the total expected profit and the
remainder of the expected profit is allocated to the seller.
Income method
The income method, as described in Rev. Proc. 2003-51, recognizes that finished goods must generally be
valued in a profit-motivated business. In using this method, the value is based on the amount that could be
attributed to finished goods to pay all costs of disposition and provide a return on the investment during the
period of disposition.
OF
ON
The income method is similar to the comparative sales method, but approaches the valuation from a different
TI
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point of view. The comparative sales method examines the inventory from the buyers’ perspective, considering
O RI
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the expected selling proceeds, the expected expenses related to the disposition of the inventory, and the
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PR .
E SED
estimated profit attributable to the completing and selling effort. But the income method examines the
IO
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inventory from the seller’s perspective, considering the efforts completed and what an appropriate return may
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be on these efforts.
P. EC R
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RV LS IB SE
The income method has two main steps:

SE A TR U
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IS MA ED TER
Step 1 – Determine the replacement or reproduction cost of the individual items. This will be the base
DV SE AT IN
L A E UL R
amount.
IA TH IRC , FO
NC OF C LS
NA E ER IA
FI US TH TER
• The replacement or reproduction cost needs to be based on prevailing market conditions existing as of
TE D R A
IT AN FU M
LO SS BE RY
the valuation date.

DE CE TO TA
•
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The direct costs of replacing or reproducing the inventory may include direct material costs, direct
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labor costs and the manufacturing or conversion costs incurred in purchasing, receiving, handling, and
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converting the raw materials into work-in-process or finished goods.
Step 2 – Adjust the base amount for the estimated profit associated with the efforts completed to date.
• The estimated profit for the efforts completed to date can be arrived at through the same profit-
allocation process outlined in the comparative sales section.
BV113.5 Valuation methodologies -

asset-based lending purposes
In asset-based lending, appraisers usually use the market approach to value inventory. The question to answer
in this situation is: What amount could be realized if the lien holder takes possession of the inventory, which is
collateral for a loan? The premise of value most often is “orderly liquidation value,” measured in terms of
money that could be realized on the sale of inventory when the seller is compelled to sell over a defined period
of time. Many lenders subtract estimated costs that would be incurred while selling the inventory, resulting in a
“net orderly liquidation value.”
The first question to be asked in a collateral valuation of inventory is who will buy it. Finished goods inventory
destined for retail outlets has many potential buyers. Finished goods intended to be incorporated into other
manufactured products have fewer buyers – and may have only one.
The next question to be asked in this valuation is how motivated the buyer is. A buyer with many supply
sources may not be motivated. If the vendor is a sole supplier to a manufacturer producing at a high level, then
OF
the buyer will likely be quite motivated. Obviously, a motivated buyer is likely to pay more for an item than an
ON
unmotivated one.
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O RI
TH
Collateral valuations normally exclude WIP inventory. Issues such as lack of warranty, spare parts, and credit
AU
PR .
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terms can also affect value. Raw materials are frequently the most valuable items in this context, because they
IO
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TH LO
are more generic and appeal to a larger pool of buyers.

TO SC
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P. EC R
IC IS UT O
In an inventory valuation for asset-based lending, much effort is spent analyzing the turnover of inventory at a
RV LS IB SE
SE A TR U
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line-item or SKU level to determine whether that line item has recent sales and how long the supply on hand
OR T , D N
IS MA ED TER
might last. These factors are used to assess likely sales channels. If an item is sold through its normal sales
DV SE AT IN
L A E UL R
channels, values are likely to be based on historical selling prices. Otherwise, values are likely to be based on
IA TH IRC , FO
NC OF C LS
cost.
NA E ER IA
FI US TH TER
TE D R A
IT AN FU M
LO SS BE RY
DE CE TO TA
Valuation Standard - BV113.5.A

AC OT PRIE
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When valuing inventory for asset-based lending purposes, the traditional methods outlined in this standard
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may not apply. You need to approach the inventory valuation from the perspective of the lender or lien holder
and be aware that the premise of value is typically orderly liquidation value or perhaps even a forced
liquidation.
Accordingly, you need to a) consult with a subject matter specialist, and b) document in the engagement
working papers the various considerations in estimating the liquidation value of the inventory (whether
orderly or forced).
BV113.6 Resources
• ASC 330, Inventory (formerly Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory
Pricing
• AICPA Issue Paper, Identification and Discussion of Certain Financial Accounting and Reporting
Issues Concerning LIFO Inventories
• Gregory F. Udel, “Asset Based Finance, Proven Disciplines for Prudent Lending’,” 2004, The
Commercial Finance Association, Chapter 6, The Mechanics of Lending Against Accounts Receivable
and Inventory.
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International Accounting Standard 2 (IAS 2), Inventories
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•
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International Financial Reporting Standard 3 (2004), Business Combinations

SE A TR U
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IS MA ED TER
DV SE AT IN
L A E UL R
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•
NA E ER IA
International Financial Reporting Standard 3 (Revised 2008), Business Combinations

FI US TH TER
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• Rev. Proc. 2003-51 – United States Internal Revenue Service
• ASC 805, Business Combinations (formerly FASB Statement 141)
• ASC 805, Business Combinations (formerly FASB Statement 141(R))
• ASC 330, Inventory (formerly FASB Statement 151)
• ASC 820, Fair Value Measurements and Disclosures (formerly FASB Statement 157)
• The American Society of Appraisers, Valuing Machinery and Equipment: The Fundamentals of
Appraising Machinery & Technical Assets, 2005, Chapter 10, Technical Specialties
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SE A TR U
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IS MA ED TER
DV SE AT IN
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BV113.7 Frequently asked questions

Q1. Is the carrying value of raw materials a good representation of current replacement cost?
A1. It depends. If the raw materials were purchased recently and price levels have not fluctuated materially,
then it may not be unreasonable to consider carrying value as representative of current replacement cost.
But,you need to consider other factors relevant to the raw materials in this assessment, such as returns on
the effort to obtain the raw materials, slow-moving and obsolete inventory, overstocking, etc.
You also need to consider the method used to account for the inventory’s carrying value. For example,
carrying value stated on a FIFO basis would generally represent current replacement cost more closely
than carrying value stated on a LIFO basis.
Q2. What disposal costs do I need to consider when performing the comparative sales method?
A2. Disposal costs include all costs incurred in disposing of the inventory, such as:
• Selling and support service expense

• Sales promotion expenses
• Selling-related property and equipment expenses (such as depreciation, insurance, rent, and taxes)
OF
ON
• Selling-related accounting and management information expenses
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• Selling-related service and operations costs (such as security, telephone, utilities, maintenance,
O RI
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and repairs)
AU
PR .
•
E SED
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In certain circumstances, a portion of the general and administrative overhead costs associated
IO
TH LO
with a retail location based upon the facts and circumstances of the retail operations.
TO SC
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ES SU ED N
P. EC R
IC IS UT O
RV LS IB SE
SE A TR U
Y ERI IS AL
OR T , D N
IS MA ED TER
Q3. How does an inventory reserve affect a fair-value or fair-market-value measurement?

DV SE AT IN
A3. You need to determine the reason for the inventory reserve and consider that reason when determining the
L A E UL R
IA TH IRC , FO
inventory’s fair value or fair market value. For example, if the inventory reserve is an obsolescence
NC OF C LS
NA E ER IA
reserve associated with specific products that may be obsolete, then you can use this information when
FI US TH TER
TE D R A
estimating the proceeds that may be realized for the specific items when sold. If the reserve is a LIFO
IT AN FU M
LO SS BE RY
DE CE TO TA
reserve adjustment, then this information may be relevant if the carrying value is used as a proxy for
AC OT PRIE
current replacement cost, because FIFO typically results in a better representation of current replacement
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costs than LIFO.

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This standard was last updated on: 9/16/2016. Please go to {https://financialadvisory.deloitteresources.com/vkg/bval/Pages/BV113Valuation_37249.

aspx} to access the

BV113. Valuation of Inventory

In this standard, we:

BV113.1 Inventory Overview

and then sells them.

Why value inventory?

BV113.2 Inventory accounting methods

• Accounting Research Bulletin (ARB) No. 43, Inventory Pricing

Other guidance includes:

inventory on a “lower of cost or market” basis.

net realizable value (NRV).

Principal cost methods

A company may use several methods

LIFO and FIFO compared– rising price and increasing inventories

LIFO results in: FIFO results in:

• higher COGS • lower COGS

lower taxes higher taxes

• lower inventory balances • higher inventory balances

• lower working capital • higher working capital

• higher cash flows • lower cash flows

• If current replacement cost > NRV, then NRV is market

BV113.3 Regulatory guidance

significantly from those under Statement 141, as described above.

valuing finished goods inventory at a retail outlet:

Financial Reporting Guidance – IFRS

Note that LIFO is prohibited under IFRS.

Tax Guidance – Internal Revenue Service (IRS)

(A) Revenue Procedure (Rev. Proc.) 2003–51

of inventory and allocate the purchase price for tax purposes.

o The time required to dispose of the inventory

BV113.4 Valuation methodologies –

portion of the profit).

buyer’s portion of the profit).

the appropriate Standards that apply.

• Replacement cost method

Valuation Standard - BV113.4.B

Replacement cost method

inventory’s cost when it was actually purchased. R

Step 2 – Adjust the base amount for relevant factors:

inventory once it is completed.

Valuation Standard - BV113.4.C

Step 2 – Subtract the costs to complete, if applicable.

Valuation Standard - BV113.4.D

Step 3 – Subtract disposal costs

or research and development related expenses.

acquisition. However, in certain circumstances it may be necessary to allocate a portion of a retail

headquarters, and other general corporate overhead items.

• For additional information on disposal costs, refer to the US Technical Library:

Step 4 – Subtract holding costs

• Factors to consider include:

remainder of the expected profit is allocated to the seller.

The income method has two main steps:

the valuation date.

converting the raw materials into work-in-process or finished goods.

BV113.5 Valuation methodologies -

are more generic and appeal to a larger pool of buyers.

Valuation Standard - BV113.5.A

International Financial Reporting Standard 3 (2004), Business Combinations

International Financial Reporting Standard 3 (Revised 2008), Business Combinations

• Rev. Proc. 2003-51 – United States Internal Revenue Service

• ASC 805, Business Combinations (formerly FASB Statement 141)

• ASC 805, Business Combinations (formerly FASB Statement 141(R))