The IVSC’s newest IVS 230 Inventory Exposure Draft tackles several themes, with particular attention to changes in the top-down method. Most financial analysts would apply the top-down method ‘for the valuation of WIP and finished goods,’ says Mark Zyla in his opening analysis. He notes the need for the Exposure Draft since ‘recent guidance is moving best practices toward a more systematic and detailed approach to allocate the value creation before and after the measurement date.’
Such considerations include:
[A]ccounting for internationally generated IP in the cost structure or apportionment analysis, whether relevant intangible assets are effectively imbedded in the inventory, identification of costs that benefit future periods, the allocation of overhead expenses, etc.
Therefore, the draft sections (60.5 through 60.8 below) that suggest new guidance on how to use the top-down method should be of interest to all business valuers and analysts whose clients carry material inventory.
The Exposure Draft suggests the following steps:
60.5 The key steps in applying the Top-Down Method are to:
(a) Estimate the selling price. The valuer should rely on direct observations of selling prices when the information is available. However, such data is often not available and the selling price is often estimated by applying an appropriate gross profit margin to the net book value of finished goods at the product level or aggregate level. Typically, the projected gross profit margin in the period the inventory will be sold is used.
(b) Estimate the costs to complete (for work-in-process only). Completion costs should include all of the expenditures directly or indirectly remaining to be incurred post-valuation date in bringing the WIP inventory to its finished condition. Costs to complete should be adjusted to remove expenses benefitting future periods.
(c) Subtract the costs of disposal. Costs of disposal represent costs that would be incurred post-valuation date in order to deliver the finished goods to the end customer. Costs of disposal should be adjusted to remove expenses benefitting future periods. Disposal costs generally include selling and marketing expenses while procurement and manufacturing expenses have typically already been incurred for finished goods inventory. In order to properly determine costs of disposal, each expense in the inventory cycle (including indirect overhead) should be categorised as having been incurred and, therefore, contributed to the value of the finished goods inventory or remaining to be incurred during the disposal process.
(d) Subtract the profit allowance on the completion effort (for work-in-process only) and the disposal process. An initial starting point may be to utilise the operating profit of the company. However, this methodology assumes the profit margin would be proportional to the costs incurred. In most circumstances there is rationale to assume profit margins which are not proportional to costs (see Section 90).
(e) Consider any necessary holding costs. Holding costs may need to be estimated in order to account for the opportunity cost associated with the time required to sell the inventory. Additionally, the valuer should consider the risk born during the holding period when determining the required rate of return. Risks may be a function of the length of inventory life cycle and the contractual arrangements with end customers (e.g., manufacturer bears the risk of fluctuation in costs of completion and disposal). Holding costs may be immaterial if the inventory turnover is high and/or the borrowing rate is low.
60.6 When determining the cost to complete, costs of disposal and profit allowance, the valuer should identify and exclude any expenses that are intended to provide future economic benefit and are not necessary to generate the current period revenue. Examples of future-benefit expenses may include research and development (“R&D”) related to new product development; marketing for a new product; recruiting to increase the size of the workforce; expansion into a new territory; depreciation of an R&D facility dedicated to future research; or restructuring costs.
60.7 Internally developed intangible assets should either be modelled as 1) a cost as if they were hypothetically licensed, and therefore included in either the cost of production or disposal, or 2) considered as part of a functional apportionment when determining the appropriate profit allowance.
60.8 When utilising the Top-Down Method, valuers should consider whether sufficient data are available to appropriately apply the key steps. If sufficient data is not available, it may be appropriate to apply other methods or techniques.
The IVSC invites feedback on all matters in this Exposure Draft. Submit comments by 30 April 2020 by emailing comments to comments@ivsc.org.