IPO Case: Is it in line with industry practice for the issuer to make full provision for inventory obsolescence only for raw materials and work-in-progress with inventory age exceeding three years?

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Inquiry Question

Please issue:

Explain whether the practice of fully provisioning for inventory write-downs on raw materials and semi-finished products with a shelf life exceeding three years is in line with industry practices.

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Response to Inquiry

1. Inventory Write-down Policy of the Issuer

At the end of each reporting period, the issuer recognizes or adjusts inventory write-downs for all categories of inventory based on the lower of cost and net realizable value.

For specialized parts in raw materials and semi-finished products, the issuer adopts a “sales-driven production and procurement” model. These specialized parts have specific contracts associated with them, and their net realizable value exceeds the inventory cost, so there is no inventory impairment. For some more general materials in raw materials, to meet future orders and production needs, the issuer maintains certain stock levels during the reporting period. Some raw materials are processed into semi-finished products through machining, welding, and assembly, which are somewhat versatile. These raw materials and semi-finished products cannot be linked to specific final products or customer orders. Therefore, the company estimates the selling price of finished products based on the most recent sales prices on the balance sheet date, subtracting further processing costs, estimated selling expenses, and related taxes to determine net realizable value. The calculated net realizable value exceeds the inventory cost, so no impairment is recognized. However, due to product updates and technological advancements, raw materials and semi-finished products with longer shelf lives may become obsolete and less likely to be used. Based on prudence, the issuer fully provisions for inventory write-downs on raw materials and semi-finished products with a shelf life exceeding three years. Additionally, the issuer also fully provisions for raw materials and semi-finished products with a shelf life within three years but with low usage likelihood.

For work-in-progress and inventory goods, because the issuer adopts a “sales-driven production and procurement” model, products are usually customized according to customer requirements. Procurement is based on production plans, inventory levels, and raw material market supply and demand. At each reporting period’s end, inventory goods are supported by orders, with order coverage exceeding 95%, indicating high order fulfillment. The issuer determines net realizable value by subtracting estimated costs, sales expenses, and related taxes from the expected selling price. The difference between net realizable value and cost is provisioned accordingly. When accepting project orders, the issuer ensures a certain profit margin through a cost-plus pricing model and mainly adopts staged payments with customers—prepayments upon order placement and progress payments before delivery. At each reporting period’s end, the issuer inspects each item of work-in-progress and inventory goods. For inventory with longer shelf life and signs of impairment, net realizable value is determined by deducting estimated costs, sales expenses, and taxes from the expected selling price. For projects expected to proceed normally and with receivables based on contract prices, the contract price is used as the expected selling price. For projects with contractual defects or abnormal customer operations, where collection risks exist, actual received payments are used as the basis for expected selling price. The issuer recognizes impairment provisions for inventory where book costs exceed net realizable value, following a cautious policy.

2. Comparison with Industry Peers’ Inventory Write-down Policies

The inventory write-down policies of comparable companies in the industry are as follows:

As shown in the table above, during the reporting period, the company’s inventory write-down policy is generally consistent with that of comparable industry companies. For example, Xinbang Intelligent only provisions for raw materials based on shelf life, while other categories of inventory are measured at the lower of cost and net realizable value, similar to the issuer’s policy. Additionally, many manufacturing companies in the equipment industry also provision for inventory write-downs of raw materials or semi-finished products based on shelf life. For other inventory categories supported by orders, net realizable value is calculated based on order prices, and provisions are made accordingly.

In summary, the company’s inventory write-down policy conforms to industry practices.

Note: This case pertains to AutoShares’ listing on the Beijing Stock Exchange.