Fair value of inventory acquired in a business combination
FINANCIAL REPORTING INSIGHTS |
Topic 805, Business Combinations, of the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC or the Codification) requires the buyer in a business combination to measure the identifiable assets acquired (including inventory), liabilities assumed, and any noncontrolling interest in the target predominantly at their acquisition-date fair values. Topic 820, Fair Value Measurement, of the Codification defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
The source literature for ASC 805 was FASB Statement No. 141 (revised 2007), Business Combinations (Statement 141R). The predecessor to Statement 141R was FASB Statement No. 141, Business Combinations (Statement 141). Paragraph 37c of Statement 141 provided the following guidance on estimating the fair value of different categories of inventory:
- Finished goods: "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"
- Work in process: "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: "Current replacement costs"
When estimating the fair value of inventory under Statement 141, the reasonable profit allowance for finished goods inventory should have been less than the reasonable profit allowance for work-in-process inventory because the profit allowance for work-in-process inventory included the profit related to the effort to complete inventory production as well as the effort to sell the inventory. Also, the reasonable profit allowance used in estimating the fair value of finished goods inventory acquired in a business combination should have been less than the profit earned on the same products manufactured by the buyer to be sold in the ordinary course of its business because the estimated fair value of the acquired finished goods inventory should have only included the profit related to the selling effort whereas the profit earned on products manufactured by the buyer would have included profit related to the manufacturing effort. In addition, when estimating the fair value of work-in-process inventory under Statement 141, costs to complete should have included all inventoriable costs.
Statement 141's guidance on estimating the fair value of inventory was not carried over into Statement 141R. As a result, this guidance is not included in ASC 805. However, based on discussions held by the FASB's Valuation Resource Group, we believe the application of the guidance from Statement 141 on estimating the fair value of finished goods and work-in-process inventory generally would be consistent with the definition of fair value in ASC 820. There are, however, certain differences that may be significant, such as using market participant assumptions (instead of entity-specific assumptions) for purposes of estimating the costs to complete work-in-process inventory and the costs of disposal and reasonable profit allowances for both finished goods and work-in-process inventories. In addition, for raw materials, fair value must be measured based on the price that would be received to sell the raw materials in an orderly transaction between market participants at the acquisition date, which may be consistent in many (but not all) cases with current replacement costs as discussed in Statement 141.
Based on the guidance above, buyers will often need to consult with valuation specialists when determining the fair value of acquired inventory in a business combination. Furthermore, entities should not assume that the fair value of acquired inventory is equal to its carrying amount prior to the business combination.