Farm Supply Inventory and the Issue with Value

Many farm supply dealers are approaching a common 8/31 year end. They are also approaching some unexpected consequences of high input purchasing costs last fall/winter coupled with the steep decline in summer market pricing. Thanks to Todd Etheridge, Agribusiness Principal in our Central Illinois office, who raised this issue and provided the content of this post.

If an agronomy supplier has a financial reporting obligation under generally accepted accounting principles, they are required to report their inventory at lower of cost or net realizable value as of the date of their balance sheet. This is requirement of Generally Accepted Accounting Principles (GAAP). When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs. This loss can occur by any of the following: damage, physical deterioration, obsolescence, changes in price levels or other causes.

Cost, as expected, is defined as the price paid or consideration given to acquire an asset. As applied to inventory, cost means the sum of the applicable expenditures and charges directly or indirectly incurred in bringing inventory to its existing condition and location. Net realizable value is the estimated selling price of something in the ordinary course of business, less the costs of completion, selling, and transportation.

The accounting standards require an inventory adjustment to the lower of cost or net realizable value but nothing less than that. The accounting standards do not contemplate a potential margin on the disposition of inventory for next fiscal year or reporting period. Assume the following facts: Company A bought potash for a cost of $600 a ton (including delivery costs) in March 2022. At August 31st Company A’s Net Realizable Value for Potash was $575 a ton (including consideration for selling costs). Also at August 31st, the wholesale price for Potash was now $550. Company A would write their Potash down to $575/ton which is the lower of cost ($600 a ton) or net realizable value ($575 a ton). The wholesale price at August 31st does not factor in for Company A as it is not its cost or net realizable value even if that wholesale value would allow Company A to have a better margin next fiscal year or period. By making the adjustment to net realizable value, the company has already recognized the loss on the inventory that existed as of the balance sheet date. However, unless market pricing increases, there could be little or no margin earned on the final sale of the product, which could impact income in the following period.

Consistency in the valuation basis used is also required. While the basis of stating inventory does not affect the overall gain or loss on the “ultimate disposition” of inventory items, any inconsistency in the selection or employment of a valuation basis may improperly affect the amounts of income or loss recognized in each financial statement period.

The amount of inventory hedged and the amount covered by sales contracts at year end can also play into developing the lower of cost or net realizable value but only the quantities of inventory hedged and covered by sales contracts can be considered when using those items to determine the lower of cost or net realizable value. When using hedges, you must make sure the hedges are appropriate.

Remember, the accounting standards are not designed to allow you to “smooth” income from year to year. It is possible given current market conditions that many supply companies could have lower margins next year on the ultimate disposition of their agronomy inventory that is carried over from 8/31/22. We recommend you start talking to your board of directors now to make them aware that margins next year may be impacted. The expectation fo reduced margins may also impact planning for the current year with respect to depreciation, patronage, and other planned cash outlays.

The tax treatment of these inventory adjustments is different than how they are treated for the financial statements. We will address this in a separate post.