Issue No Accounting for Purchases and Sales of Inventory with the Same Counterparty

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1 EITF Issue No The views in this summary are not Generally Accepted Accounting Principles until a consensus is reached and it is FASB Emerging Issues Task Force Issue No Title: Accounting for Purchases and Sales of Inventory with the Same Counterparty Document: Issue Summary No. 1, Supplement No. 1 Date prepared: March 1, 2005 FASB Staff: Geary (ext. 211)/Oakley (ext. 284)/Belcher (ext. 226) Date previously discussed: November 17 18, 2004 Previously distributed EITF materials: Issue Summary No. 1, dated November 8, 2004 References: FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133) FASB Statement No. 153, Exchanges of Nonmonetary Assets (FAS 153) APB Opinion No. 29, Accounting for Nonmonetary Transactions (APB 29) AICPA Technical Practice Aids, Section , "Nonmonetary Exchanges of Software (Part 1)" (TPA ) AICPA Technical Practice Aids, Section , "Nonmonetary Exchanges of Software (Part II)" (TPA ) SEC Regulation S-X 5-02 (Regulation S-X 5-02) The alternative views presented in this Issue Summary Supplement are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination and it is EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 1

2 Background 1. The EITF Agenda Committee was presented with a request to add an issue to the EITF agenda that would interpret APB 29 for instances in which an entity purchases inventory from another entity to which it also sells inventory. These purchase and sale transactions may be pursuant to a single contractual arrangement or separate contractual arrangements and the inventory purchased or sold may be in the form of raw materials, work-in-process (WIP), or finished goods. The following questions were raised in Issue Summary No. 1: a. Under what circumstances should two or more transactions with the same counterparty (counterparties) be viewed as a single nonmonetary transaction within the scope of APB 29? b. If nonmonetary transactions within the scope of APB 29 involve inventory, are there any circumstances under which the transactions should be recognized at fair value? 2. These questions arose from the diverse accounting that exists in the oil and gas industry for certain buy/sell arrangements. However, application of this Issue is more broad than to just the oil and gas industry. 3. In Issue Summary No. 1, the Task Force was asked to address only the second question. Therefore, Issue Summary No. 1 only addressed purchases and sales of inventory within the same line of business that are deemed nonmonetary transactions within the scope of APB This Supplement continues the discussion on the second question (Issue 1) and does not address the first question. The Task Force may be asked to address the first question at a future meeting. Previous Discussion 4. At the November 17 18, 2004 EITF meeting, the Task Force discussed the issue of whether there are circumstances under which nonmonetary exchanges of inventory within the same line of business should be recognized at fair value but did not reach a consensus. The Task Force focused on whether paragraph 21(a) of APB 29 was intended to apply to exchanges of all types 1 APB 29 is applicable to buy/sell arrangements that are not accounted for as derivatives under FAS 133 (for example, because the entity has designated the contracts as normal purchases and normal sales pursuant to paragraph 10(b) of FAS 133 and related interpretations). EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 2

3 of inventory (that is, raw materials, WIP, and finished goods) or only finished goods. Certain Task Force members agreed to provide the FASB staff with examples of nonmonetary exchanges of inventory that are found in practice, including transactions accounted for both at fair value and at recorded amounts, and the basis for the measurement attribute selected. The Task Force requested that the FASB staff further explore alternative views as to whether there are circumstances under which nonmonetary exchanges of inventory in the same line of business should be recognized at fair value. A Board member had also asked the FASB staff to explore, as an alternative view, the use of the commercial substance criteria provided for in FAS 153. Issuance of FAS FAS 153 was issued subsequent to the November 17 18, 2004 EITF meeting and is effective for asset exchanges occurring in fiscal periods beginning after June 15, FAS 153 amends paragraphs 20 and 21 of APB 29 to now read: 20. A nonmonetary exchange shall be measured based on the recorded amount (after reduction, if appropriate, for an indicated impairment of value) of the nonmonetary asset(s) relinquished, and not on the fair values of the exchanged assets, if any of the following conditions apply: a. Fair Value Not Determinable. The fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits. b. Exchange Transaction to Facilitate Sales to Customers. The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than parties to the exchange. c. Exchange Transaction That Lacks Commercial Substance. The transaction lacks commercial substance. [Footnote and paragraph references omitted.] Commercial Substance 21. A nonmonetary exchange has commercial substance if the entity's future cash flows are expected to significantly change as a result of the exchange. The entity's future cash flows are expected to significantly change if either of the following criteria is met: a. The configuration (risk, timing, and amount) of the future cash flows of the asset(s) received differs significantly from the configuration of the future cash flows of the asset(s) transferred. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 3

4 b. The entity-specific value of the asset(s) received differs from the entity-specific value of the asset(s) transferred, and the difference is significant in relation to the fair values of the assets exchanged. [Footnote references omitted.] 6. While FAS 153 moved the guidance in paragraph 21(a) to paragraph 20(b) of APB 29, it did not affect the guidance in APB 29 for nonmonetary exchanges of inventory. Paragraphs A5 and A6 of FAS 153 indicate that the Board only considered the elimination of APB 29's similar productive assets exception in its scope as part of its short-term conversion project with the International Accounting Standards Board. Additionally, the premise stated in paragraph 19 of APB 29 was not changed. It states that "certain modifications of the basic principle [fair value] are required to accommodate problems of measurement and questions about the conditions for recognizing revenue." Therefore, APB 29 will continue to require a company to only recognize nonmonetary exchanges of inventory at fair value if a culmination of an earnings process has occurred. Reference throughout the remainder of this document will be to paragraph 20(b), as amended. Current Discussion 7. This Supplement provides alternative views as to whether there are circumstances under which nonmonetary exchanges of inventory in the same line of business should be recognized at fair value. As part of formulating these alternative views, certain Task Force members provided the FASB staff with examples of nonmonetary exchanges of inventory. The FASB staff observed that only a limited number of those examples (that were considered to be within the scope of APB 29) were accounted for at fair value. The basis for the fair value measurement primarily was associated with a company exchanging different classes of inventory (for example, relinquishing finished goods for inventory that needed further processing) or inventory in different lines of business. 8. The FASB staff believes that applying APB 29 to nonmonetary exchanges of inventory based on the class of inventory presents difficulties because the type of inventory (raw material, WIP, or finished goods) may not be clear in some industries. For example, in certain industries, the inventory may consist of products that are routinely sold "as is" and that also may be further EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 4

5 processed and then sold as a different product. Additionally, these companies sell or exchange this inventory at various stages in the production process to customers and competitors. Accounting Issues and Alternatives Issue 1: Whether there are circumstances under which nonmonetary exchanges of inventory within the same line of business should be recognized at fair value. 9. The FASB staff believes that relinquishing raw materials or WIP in an inventory-forinventory exchange, by its nature, is not a culmination of an earnings process and therefore the exchange should not be recognized at fair value. Additionally, the FASB staff believes that nonmonetary exchanges of finished goods for finished goods within the same line of business is addressed in paragraph 20(b) of APB 29 and therefore should not be considered the culmination of an earnings process or accounted for at fair value. Therefore, as it relates to APB 29, the FASB staff will ask the Task Force only to consider whether the exchange of finished goods for a component of inventory that will be used in internal production (raw material/wip) should be accounted for at fair value. Accordingly, Views A and B are in the context of finished goods for raw material/wip exchanges within the same line of business from the perspective of the entity that is relinquishing the finished goods. The FASB staff believes that the class of inventory involved in the exchange must be analyzed by each party to the exchange independently. It is presumed that these exchanges meet the criteria in paragraphs 20(a) and 20(c) of APB 29, as amended by FAS 153; that is, fair value is determinable and the exchanges have commercial substance. 10. As noted earlier, a Board member asked the FASB staff to explore the use of the commercial substance criteria provided for in FAS 153. As a result, the FASB staff included View C to address the use of the commercial substance criteria in FAS 153 to determine whether nomonetary exchanges of inventory should be accounted for at fair value. A consensus on View C would be an amendment to APB 29. View A: There are no circumstances under which the exchange of finished goods for raw material/wip within the same line of business should be recognized at fair value. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 5

6 11. View A proponents believe that all nonmonetary exchanges of inventory within the scope of this Issue should be accounted for based on recorded amounts because the exchange is within the scope of paragraph 20(b) of APB 29. View A proponents note that paragraph 16(a) of APB 29 refers to the exact wording in paragraph 20(b) and further clarifies that the characterization of the type of exchange described in paragraph 20(b) is developing economical ways to acquire inventory for resale to customers rather than on marketing inventory to obtain revenue from customers. Therefore, "swapping" inventories between enterprises is merely an incidental early stage of an earnings process, and revenues should not be recognized until the time of sale of the exchanged products (in the same or another form) to a customer of the enterprise. View A proponents believe that inventory, regardless of its class, if exchanged for inventory within the same line of business, does not reflect the culmination of an earnings process. 12. View A proponents observe that the conclusion above is consistent with the analysis in TPA and TPA regarding nonmonetary exchanges of software. TPA addresses nonmonetary exchanges of software when the software received will be either resold or embedded in the entity's product and then resold. TPA concludes that the transaction is within the exception to fair value in paragraph 20 of APB 29. TPA further clarifies that the way in which the entity plans to "resell" the software (so long as it is in the same line of business) is not relevant in the analysis. Specifically, footnote 2 to TPA states: A software vendor that receives any of the following would be receiving inventory: a. a product to resell, sublicense, or sublease, b. a right to embed the technology received into a product, or c. a right to further develop the technology received into a product. 13. Opponents of View A believe that guidance for exchanges of nonmonetary inventory in the software industry should not be applied to other industries because the software industry accounting guidance is unique. Revenue recognition in the software industry has its own EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 6

7 separate guidance that in many circumstances is not applied to transactions outside of the software industry. View B: A company should recognize an exchange of finished goods for raw material/wip within the same line of business at fair value. 14. View B proponents believe a culmination of an earnings process has occurred in a nonmonetary exchange of inventory when a company exchanges a finished good for a component of inventory that is used in internal production (raw material/wip). View B proponents support this view by looking at the substance of the transaction; the company sold a product that it sells and markets to customers in the normal course of business and, in return, the company received materials that it uses in its production process that it would normally need to purchase or manufacture. 15. To illustrate a nonmonetary exchange of inventory that would be accounted for at fair value, consider the following example: Company A produces two products (Product X and Product Y), both of which originate from the same basic raw material and are considered within the same line of business. Once each of the products is processed beyond the original raw material neither could be substituted in the production process for the other. Company A exchanges Product X for Product Z (which is used to produce Product Y) with Company B (one of its competitors but also one of its customers). 16. Under View B, Company A would account for this transaction at fair value because there is an exchange of finished goods for inventory that will be used in its internal production. Proponents of View B believe that Company A has sold a finished good, culminating an earnings process, and will begin a separate earnings process as it produces Product Y. 17. Opponents of View B believe that accounting for an exchange of inventory at fair value is inconsistent with paragraph 16(a) of APB 29, which addresses an exchange of a similar product EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 7

8 as an accommodation to satisfy inventory needs and is not the culmination of an earnings process. Opponents of View B also believe that paragraph 16(a) emphasizes "same or in another form," which would include raw materials/wip, and that such exchanges should be accounted for based on recorded amounts. 18. Proponents of View B acknowledge that it may be difficult to determine whether a nonmonetary exchange of inventory is the culmination of an earnings process in some industries because of the nature of the inventory and the customer/competitor relationship. For instance, in the chemical industry it is common to have a number of products that are derived from one another and can be processed through a number of different cycles into different products that are both routinely sold to customers/competitors at different stages in the production process and used in the company's production cycle for other products. 19. If the Task Force reaches a consensus on View B, then the FASB staff will ask the Task Force to consider whether additional guidance on the classification of inventory should be provided. (Refer to Issue 2 below.) 20. The FASB staff believes that if a consensus is reached on View B, transparent disclosure of nonmonetary exchanges of inventory that were recognized at fair value should be provided. A consensus on View B would require disclosures of revenue and costs associated with exchanges recognized at fair value as well as the characteristics of these types of arrangements within a company's accounting policy footnote. View C: All nonmonetary exchanges of inventory should be recognized at fair value if fair value is determinable and the transaction has commercial substance. 21. Proponents of View C believe that a company could utilize the framework in FAS 153 for commercial substance to determine whether nonmonetary exchanges of inventory should be accounted for at fair value. Under FAS 153, a nonmonetary exchange of assets has commercial substance if (a) the configuration (risk, timing, and amount) of the future cash flows of the asset(s) received differs significantly from the configuration of the future cash flows of the EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 8

9 asset(s) transferred or (b) the entity-specific value of the asset(s) received differs from the entityspecific value of the asset(s) transferred, and the difference is significant in relation to the fair values of the assets exchanged. 22. Some proponents of View C believe APB 29 only addresses the measurement of nonmonetary exchanges and does not provide criteria for revenue recognition. For example, they believe that a nonmonetary exchange of inventory could be measured at fair value; however, criteria for revenue recognition may not be met. 23. Further, proponents of View C believe that neither class of inventory nor line of business is a necessary attribute for determining whether a culmination of an earnings process was achieved. Rather, they believe the commercial substance criteria above would provide enough rigor to determine whether conditions exist for determining whether a nonmonetary exchange of inventory results in an earnings process. Proponents of View C believe nonmonetary exchanges of inventory that have commercial substance create value to the company and should be recognized in a company's financial statements. 24. For instance, exchanging finished goods from the west coast of the U.S. for the same products on the east coast of the U.S. could have commercial substance because the value of the inventory received on the east coast could have significantly more entity-specific value than the west coast inventory due to the significance in transportation cost. Therefore proponents of View C believe that the exchange could be recognized at fair value. 25. Additionally, exchanging raw material of one product for raw material of another product could also have commercial substance because the configuration of the cash flows for each of the products could be significantly different. To illustrate this view, consider the following example: Company A manufactures pine and oak furniture. The manufacturing process is different for each product. The furniture produced is either 100 percent pine or 100 percent oak. Company A produces both pine and oak trees each at a cost of $1,000/ton; however Company A from time to time buys cut pine trees from the open market at $1,500/ton. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 9

10 Company A has excess oak trees and needs pine trees. One ton of cut oak trees are worth $3,000/ton on the open market. Company A exchanges 1 ton of cut oak trees for 2 tons of cut pine trees with a competitor. 26. Proponents of View C believe that Company A should recognize the exchange at fair value because this exchange of inventory has commercial substance that should be recognized in a company's financial statements. View C proponents believe this exchange has commercial substance because the risks associated with the pine material are substantially different from the risks associated with the oak material. The risk profiles of these two materials differ significantly because the (a) manufacturing processes associated with these two types of inventory are distinct from one another, (b) the production of the pine furniture results in substantially more products to be sold than the production of the oak furniture, and (c) the margins associated with the oak furniture are substantially different from the margins associated with the pine furniture. 27. Proponents of View C believe that, effectively, Company A sold cut oak trees and used the consideration to procure inventory (pine). Therefore, Company A should recognize the cut pine trees at fair value that is, $3,000, which is the cost to procure the inventory on the open market. If Company A were to account for the exchange at recorded amounts under APB 29, the cost of the 2 tons of cut pine trees would be recorded at $1,000 (cost of the 1 ton of oak trees relinquished), which is less than Company A's cost to produce cut pine trees ($2,000 for 2 tons). View C proponents believe that recognizing the transaction at recorded amounts results in inappropriately inflating the margins on the ultimate sale of the pine furniture. 28. View C proponents believe that the use of the commercial substance criteria above produces financial information that more faithfully represents the economics of the exchange and also that characteristics of inventory that should be accounted for at fair value are unnecessarily limited by APB View C proponents acknowledge that relying on the notion of commercial substance in FAS 153 for all inventory-for-inventory exchanges would require an amendment to APB 29. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 10

11 Accordingly, View C proponents believe that the Task Force should ask the Board to consider amending APB 29 to eliminate specific provisions on nonmonetary exchanges of inventory. 30. Opponents of View C believe that it would be inappropriate to recognize exchanges of inventory at fair value that may have commercial substance and that are done for supply-chain management purposes. For instance, in certain industries, companies have business relationships with competitors for supplying inventory during plant shutdowns or outages. These relationships could be in the form of supplying the same inventory or different types of inventory, neither of which are sold as end-products. Opponents of View C believe that those exchanges could have commercial substance using the criteria above, however, they do not believe that a company should recognize those exchanges at fair value because they do not represent the culmination of an earnings process. 31. Opponents of View C also believe that applying the commercial substance model to nonmonetary exchanges of inventory would be impractical because of the volume of nonmonetary exchanges in certain industries and the need to critically analyze each exchange on a fact specific basis. Issue 2: Whether additional guidance should be provided regarding the classification of inventory for purposes of determining whether a nonmonetary exchange of inventory should be accounted for at fair value. 32. If the Task Force reaches a consensus on View B of Issue 1, the FASB staff will ask the Task Force to consider Issue 2. View A: A company should use its own entity-specific criteria to classify inventory for financial reporting purposes to determine the class of inventory transferred or received in a nonmonetary exchange. 33. Proponents of View A believe that a company should utilize the same criteria it uses for identifying the class of inventory for financial reporting purposes to determine the class of EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 11

12 inventory transferred or received in a nonmonetary exchange. For example, Regulation S-X 5-02 requires public companies to disclose classification of inventory. 34. Opponents of View A believe that View A would result in diversity in the classification of inventory and, therefore, in the application of APB 29 for inventory exchanges. View B: Additional guidance should be provided because the determination of the class of inventory in nonmonetary exchanges is not always clear. 35. If the Task Force reaches a consensus on View B, the FASB staff has provided the following alternatives (Views B1-B3) for determining the classification of inventory (on both the inventory relinquished and the inventory received) for purposes of applying the guidance in View B to nonmonetary exchanges of inventory. View B1: A company should consider the predominant use of the inventory in the exchange to determine the classification of inventory for purposes of applying APB Proponents of View B1 believe the classification of inventory for applying APB 29 should be based on the predominate use of that inventory. For example, an inventory type that is predominantly sold to customers should be considered a finished good. Similarly, a type of inventory that is predominantly used for internal production should be considered a raw material or WIP. Exchanges of inventory would not be considered sales to customers for determining the classification of inventory. View B2: A company should consider whether the inventory is sold in the normal course of business to determine the classification of inventory for purposes of applying APB Proponents of View B2 believe the classification of inventory for purposes of applying APB 29 should be based on whether the type of inventory is sold in the normal course of business. In contrast to View B1, inventory would not need to be predominantly sold to customers for it to be considered a finished good for purposes of applying APB 29. Judgment is required to determine EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 12

13 whether a type of inventory is sold in the normal course of business. If a company routinely sells that inventory item in monetary transactions, it would consider that inventory a finished good for purposes of applying APB 29. View B3: A company should consider whether the type of inventory is subject to further processing in its internal production to determine the classification of inventory for purposes of applying APB Proponents of View B3 believe that if a company further processes the type of inventory more than an incidental amount, that type of inventory should be considered raw material/wip for purposes of applying APB 29, even if this type of inventory is sold in the normal course of business. Finished goods are not subject to additional processing. 39. The following examples illustrate the effect of the above views: Example 1 Furniture Company A manufactures cut wood products, unassembled furniture products, and assembled furniture products. It sells both the unassembled and assembled products in the normal course of business and sells the cut wood products only a nominal amount of time. In addition, it further processes unassembled furniture products 30 percent of the time into assembled products (sells the unassembled furniture "as is" the other 70 percent of the time). A substantial effort is necessary to convert the cut wood into unassembled furniture products, and unassembled furniture products into assembled furniture products. Furniture Company A exchanges unassembled furniture products for cut wood products with Company B. Furniture Company A believes that all of these products are within the same line of business. Furniture Company A assumes the exchange has commercial substance and that fair value is determinable. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 13

14 Example 2 All the information is the same as in Example 1, except Furniture Company A exchanges assembled furniture products for unassembled furniture products with Company B. View B1: View B2: View B3: A company should consider the predominant use of the inventory in the exchange to determine the classification of inventory for purposes of applying APB 29. A company should consider whether the inventory is sold in the normal course of business to determine the classification of inventory for purposes of applying APB 29. A company should consider whether the inventory is subject to further processing in its internal production to determine the classification of inventory for purposes of applying APB 29. Example 1 Example 2 Exchange View B1 View B2 View B3 Finished Goods Finished Goods WIP for WIP for WIP for WIP Unassembled furniture products for cut wood products Assembled furniture products for unassembled furniture products Fair value Finished Goods for Finished Goods Recorded amount of asset relinquished Fair value Finished Goods for Finished Goods Recorded amount of asset relinquished Recorded amount of asset relinquished Finished Goods for WIP Fair value Transition 40. The FASB staff recommends that any consensus in this Issue (other than View C in Issue 1) should be applied to nonmonetary exchanges of inventory in reporting periods beginning after Board ratification of the consensus for transactions executed after that date. The carrying amount of inventory that was acquired under these types of arrangements before the initial application of the consensus should not be adjusted. Early application of the consensus should be permitted in periods for which financial statements have not been issued. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 14