Impairment of Inventory: A Charge on profit yet a power-booster.

Keeping Inventory in Financial Statements as per its market worth – Though it carries a charge on profit YET it is a power-booster for stakeholders confidence on Financial Statements

Impairment of Inventory improves the quality of financials

Generally, Impairment implies reduction of asset’s carrying value. Sometimes, impairment is done even when the value is reduced to zero i.e. “Full Impairment”.

As we all know, financial statements needs to provide a true and fair view of the state of affairs of an enterprise. Going by this ideology, it is important to show inventory at fair value i.e. at their net realizable value or sum of their estimated future cash flows. Same ideology even applied to the assets of an enterprise (including Goodwill or other assets). The regulations are complex, but the fundamentals are easy to understand relatively.

The inventory valuation is especially susceptible to impairment because its value is highly prone to be impacted by elements such as its ageing factor, market trends, technological changes, physical deterioration, and obsolescence. Therefore, the accounting standards such as International Accounting Standard (IAS), Generally Accepted Accounting Principles (GAAP), International Financial Reporting Standards (IFRS), Indian Accounting Standard (Ind-AS) presses the need of revaluation of inventory based on its net realizable value.

Entities using inventory valuation methods other than last-in-first-out (LIFO) or the retail inventory method are required to carry inventory at the lower of cost or net realizable value. Net realizable value (NRV) is defined as the expected selling price of an inventory item in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.

Practically, every year, inventory manager (with the help of experts advice, survey or market analysis) assesses the usage of inventory for the enterprise and re-value inventory in the books of accounts. Under the responsibility of ‘Inventory management’, Inventory manager normally perform following tasks and actions on annual basis-

1)      Scrap/Sell the inventory (where inventory is assessed as of ZERO Market Value or of no-worth for enterprise).

2)      Sell the inventory (where inventory is assessed as ‘non-moving’ or not-useful for enterprise anymore).

3)      Recognize the impairment loss and adjust the operating income accordingly with this charge in books of account. (when the inventory’s carrying value is assessed as higher than its net realizable value)

4)      Continue to hold inventory with/without impairment charge.

In this exercise, For ascertaining appropriate action to carry inventory as stated above, references can be made to the following-

~ Ageing report of Inventory,

~ Movement Report of Inventory (Slow-Moving/Fast-Moving/Non-Moving Inventory),

~ Market Trends,

~ Survey,

~ Subject Matter Experts (SME)/Consultant’s advice or certificate

If impairment charge is not provided timely in the financial statements, inventory is considered as over-inflated in the financial books or financial statements and hence analysis of enterprise gets distorted for the key stakeholders.

Action of Impairment is required to be done when an asset’s fair value is assessed as less than its carrying value on the balance sheet. by recording of an “impairment loss”. Impairment can occur because of a change in legal or economic circumstances, or as the result of a casualty loss from unforeseen hazards. Impairment can also be affected by internal factors (damage to assets, holding on to assets for restructuring, and others) or through external factors (changes in market prices, legal or economic factors etc.).

Impairment losses are very important information to all stakeholders specially for Shareholders, Investors and Creditors. They often review impairment charges to assess the financial health of company and make important decisions, such as whether to lend or invest in a particular company.

Impairment loss appears under ‘Operating Expenses’ section in the Financial Statements.

For the purpose of Impairment charge under accounting, generally net realizable value is calculated by reaching out to the most reliable sources. Hence, determining fair value is an art but more of is a science. Different sources can arrive at different valuations and best judgement should be done by an accountant in this regard.

Real Time example of Inventory Impairment:

BI-C-RIDE LTD, a bi-cycle manufacturing company re-assess its imported inventory on annual basis before the books of accounts are finalized in order to publish its financial statements. Every year, Promotors and Investors are keen to know this piece of information as it enhances their confidence in the real worth of the assets in the company.