There are two basic issues involved in inventory accounting:

1. Determine the cost of goods available for sale: Beginning Inventory + Purchases.

2. Allocate the cost of total inventory costs (cost of goods available for sale) between two components: COGS on the income statement and the ending inventory on the balance sheet. Note that COGS = (Beginning Inventory + Purchases) - Ending Inventory.

IFRS and US GAAP allow companies the choice of using either of the following inventory valuation methods: specific identification; first-in, first-out (FIFO); and weighted average cost. US GAAP also allows LIFO, which is banned by IFRS. This topic is discussed in "Expense Recognition" of Analyzing Income Statement.

Determination of Inventory Cost

IFRS and SFAS No. 151 provide similar treatment of the determination of inventory costs. The cost of inventories, capitalized inventory costs, includes all costs incurred in bringing the inventories to their present location and condition. It includes production costs, invoice price (net of discount), transportation costs, taxes, part of fixed production overhead, etc.

Companies must use the same inventory valuation method for all items that are similar in nature and use.

IFRS Valuation

Under IFRS, inventories are reported at the lower of cost or net realizable value (NRV).

• If inventory declines in value below its original cost for whatever reason (obsolescence, price-level changes, damaged goods, etc.), the inventory should be written down to reflect this. If the NRV is lower than the cost, the ending inventory is written down to the NRV. The loss then is charged against revenues as an expense in the period in which the loss occurs, not in the period in which it is sold. However, if the NRV is higher than the cost, nothing is done. The increases in the value of the inventory are recognized only at the point of sale.

• A reversal (up to the amount of original write-down) is required if the inventory value goes up later. The amount of any reversal is recognized as a reduction in the cost of sales.

• This rule can be applied either directly to each inventory item, to each category, or to the total of the inventory. The most common practice is to price inventory on an item-by-item basis.

IFRS does not apply to the measurement of inventories held by producers of agricultural and forest products, mineral products, or commodity brokers and dealers. Their inventories are measured at net realizable value (above or below cost) in accordance with well-established practices in those industries.

GAAP Valuation

Similarly, GAAP requires the use of the lower-of-cost-or-market valuation basis (LCM) for inventories, with market value defined as replacement cost. Reversal is prohibited, however. The LCM valuation basis follows the principle of conservatism (on both the balance sheet and income statement) since it recognizes losses or declines in market value as they occur, whereas increases are reported only when inventory is sold.

In the U.S., firms that use LIFO must report a LIFO reserve. The LIFO reserve is the difference between the inventory balance shown on the balance sheet and the amount that would have been reported had the firm used FIFO. That is:

Inventory_FIFO = Inventory_LIFO + LIFO Reserve

It represents the cumulative effect over time of ending inventory under LIFO vs. FIFO.

When adjusting COGS from LIFO to FIFO: COGS_FIFO = COGS_LIFO - Change in LIFO Reserve

Here are some relevant terms:

• Net realizable value: Estimated selling price less estimated costs of completion necessary to make the sale.
• Historical cost: The cash equivalent price of goods or services at the date of acquisition.
• Market value (Replacement cost): The cost that would be required to replace an existing asset.
• Fair value: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Example

Historical cost: $5,000
Market cost: $2,000
Estimated selling price: $4,000
Estimated costs to complete sale: $1,000
Net realizable value: $4,000 - $1,000 = $3,000

• Inventory Valuation under IFRS: $3,000 (the lower of historical cost and NRV).
• Inventory Valuation under U.S. GAAP: $2,000 (the lower of historical cost and market cost).

Now assume NRV increases from $3,000 to $4,000 and the market cost increases from $2,000 to $3,000.

• Under IFRS, $1,000 of original write-down may be recovered to bring NRV up from $3,000 to $4,000. Note that reversals are limited to the amount of the original write-down ($2,000).
• Under U.S. GAAP, the value of inventory is $2,000 even though the new market value is $3,000. No adjustment is made and reversal is prohibited.