By: Linda Cavanaugh, CPA The purpose of Proposed FSP ARB 43-a - Amendment to the Inventory Provisions of Chapter 4 of ARB No. 43 (FSP) is to address the inconsistency between the AICPA Audit and Accounting Guide, Brokers and Dealers in Securities and Investment Companies and ARB No. 43, Chapter 4, Inventory Pricing. ARB 43 requires that inventory be accounted for at lower of cost or market while the AICPA Audit Guide requires brokers and dealers to account for their inventory at fair value.
If adopted the FSP would be effective for fiscal years beginning after November 2008. It would be applied as a cumulative effect of a change in accounting principle and the offsetting adjustment would be to the opening balance of retained earnings.
The proposed FSP states “an entity shall determine “trading inventories” based on its specific facts and circumstances and guidance in current GAAP that describes or defines trading activities.” Therefore, the first thing to consider is what is “trading inventory”.
ARB 43, Chapter 4, Statement 1defines inventory as: “the aggregate of those items of tangible personal property which (1) are held for sale in the ordinary course of business, (2) are in process of production for such sale, or (3) are to be currently consumed in the production of goods or services to be available for sale.” These items would include finished goods, work in process and raw materials.
The term “trading” is defined in several places in US accounting standards. Most sources refer to FAS 115, Accounting for Certain Investments in Debt and Equity Securities, which defines trading securities as: “debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.” The FASB Q&A for FAS 115 defines “near term” and “a short period of time” as being “generally measured in hours and days rather than months or years. However, at acquisition an enterprise is not precluded from classifying as trading a security it plans to hold for a longer period.”
Footnote 2 of EITF 02-3: Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities states “the determination of what constitutes “trading purposes” is based on the intent of the issuer or holder and shall be consistent with paragraph 12(a) of Statement 115 which characterizes trading as “active and frequent buying and selling with the objective of generating profits on short-term differences in price.”
EITF 99-2: Accounting for Weather Derivatives gives a long discourse on trading activities and includes an Exhibit with indicators of trading activity. EITF 99-2 states that a determination of trading activities should be “based on an evaluation of the various activities of an entity rather than solely on the terms of the contracts and that inherent in that framework is an evaluation of the entity's intent for entering into a weather derivative contract.”
Based on the above, a definition of trading inventory can be discerned as finished goods, work in process, and/or raw materials that management intends to hold for a short period of time and actively and frequently buys and sells with the objective of generating profits on short-term differences in price.
Once you determine that you have “trading inventory”, this proposed FSP would require these inventories to be accounted for at fair value in accordance with FAS 157.
If you reclassify inventory from trading to non-trading or vice versa, the inventory is to be recorded at the current fair value. Once it becomes non-trading you don’t have to continue marking it to market, but the initial transfer has to be at fair value.
And of course there are additional disclosures:
1. Disclosures that enable the financial statement user to understand management’s conclusion that inventory is included in trading activities, including
• a description of those activities
• the typical holding period
• the effect of transfers between non-trading and trading categories.
2. For inventory transfers from non-trading to trading
• the carrying amount of inventory at the pre-transfer accounting policy (LIFO, ,FIFO, average cost)
• the volume of the inventory transferred
• amount of gain or loss recognized at the transfer date
3. For inventory transfers from trading to non-trading
• the fair value of the inventory transferred
• the volume of the inventory transferred
• the profit margin that would have resulted had the inventory been in the production category since its inception.
This FSP is still in the comment period. The final version may include a definition of trading inventory that is different from the one I have formulated above. Stay tuned.