Top 10 differences related to inventory accounting
From the IFRS Institute – December 3, 2021
Inventory represents a significant part of the balance sheet for many companies. In accounting for inventory determining and capturing the costs to be recognized as an asset through the inventory lifecycle is key, because it affects a company’s KPIs such as gross profit margin. Despite similar objectives, IAS 21 differs from ASC 330 in a number of areas2. Here we summarize what we see as the main differences on inventory accounting between the two standards.
Inventories are assets that are:
Commercial samples, returnable packaging or equipment spare parts typically do not meet the definition of inventories, although these might be managed using the inventory system for practical reasons.
Inventories are generally measured at the lower of cost and net realizable value (NRV)3. Cost includes not only the purchase cost but also the conversion and other costs to bring the inventory to its present location and condition. If items of inventory are not interchangeable or comprise goods or services for specific projects, then cost is determined on an individual item basis. Conversely, when there are many interchangeable items, cost formulas – first-in, first-out (FIFO) or weighted-average cost – may be used. Techniques for measuring the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate cost.
| Cost formula | Requirement |
| First in, first out | The FIFO formula assumes that items of inventory that were purchased or produced first are sold first. Therefore, the items remaining in inventory at the end of the period are those most recently purchased or produced. |
| Weighted average | Under the weighted-average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. |
| Last in, first out | The LIFO formula assumes that items of inventory that were purchased or produced last are sold first. Therefore, the items remaining in inventory at the end of the period are made up of many periods of purchased or produced inventory (inventory layers). This formula is prohibited under IAS 2. |
| Costing technique | Requirement |
| Standard costing | Inventory is measured at the standard cost of each unit reflecting predetermined rates for the material, labor and overhead expenses at normal level of output and efficiency. |
| Retail method | Inventory is measured based on its selling price reduced by the relevant profit margin. |
NRV is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. It is based on the most reliable evidence available at the time the estimate is made, of the amount expected to be realizable from the inventories. When the NRV of an item of inventory falls below its cost or current carrying amount, the item is written down to its NRV and the associated loss is recognized immediately in the income statement. In our view, writedowns of inventory, as well as any reversals, should be presented in cost of sales. The amount of inventories and writedowns recognized as an expense in the period are disclosed.
While both IAS 2 and ASC 330 share similar objectives, certain differences exist in the measurement and disclosure requirements that can affect comparability. Here we summarize what we see as the top 10 differences in measurement of inventories under IFRS Standards and US GAAP.
Unlike US GAAP, IAS 2 prohibits LIFO as a cost formula. The International Accounting Standards Board (IASB® Board) eliminated the use of LIFO because of its lack of representational faithfulness of inventory flows.
Unlike US GAAP, inventories are generally measured at the lower of cost and NRV3 under IAS 2, regardless of the costing technique or cost formula used.
US GAAP comparison Like IAS 2, US GAAP companies using FIFO or the weighted-average cost formula measure inventories at the lower of cost and NRV. Unlike IAS 2, US GAAP companies using either LIFO or the retail method compare the items’ cost to their market value, rather than NRV. ‘Market value’ can differ from NRV. It is equal to current replacement cost (i.e. the amount that would be required currently to replace the inventory item), except that it cannot:
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Under IAS 2, the cost of inventories measured using the retail method is reviewed regularly, in our view at least at each reporting date, to determine that it approximates cost in light of current conditions. The percentage of gross profit margin is revised, as necessary, to reflect markdowns of the selling price of inventory.
US GAAP comparison Unlike IAS 2, in our experience with the retail inventory method under US GAAP, markdowns are recorded as a direct reduction of the carrying amount of inventory and are permanent. There is no requirement to periodically adjust the retail inventory carrying amount to the amount determined under a cost formula. |
IFRS Standards define an onerous contract as one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received. Unavoidable costs are the lower of the costs of fulfilling the contract and any compensation or penalties from the failure to fulfill it. If a contract can be terminated without incurring a penalty, it is not onerous.
If a company has a contract to sell inventory for less than the direct cost to purchase or produce it, it has an onerous contract. A provision may be necessary if the write down to net realizable value is insufficient to absorb the expected loss – e.g. if inventory has not been purchased or fully produced.
US GAAP comparison In general, US GAAP does not permit recognizing provisions for onerous contracts unless required by the specific recognition and measurement requirements of the relevant standard. However, if a company commits to purchase inventory in the ordinary course of business at a specified price and in a specified time period, any loss is recognized, just like IFRS Standards. |
A company may have a decommissioning or restoration obligation to clean up a site at a later date, which must be provided for. Under IFRS Standards, decommissioning and restoration costs (i.e. from the accrual of the corresponding liability) incurred as a consequence of the production of inventory in a particular period form part of the cost of that inventory. Accordingly, these decommissioning and restoration costs are recognized in profit or loss when items of inventory have been sold.
US GAAP comparison Unlike IAS 2, US GAAP does not allow asset retirement obligation costs incurred as a consequence of the production of inventory in a particular period to be a part of the cost of inventory. Instead, such costs are added to the carrying amount of the related property, plant and equipment. The subsequent depreciation of the cost is included in production overheads in future periods over the asset’s estimated remaining useful life. |
Items of property plant and equipment that a company holds for rental to others and then routinely sells in the ordinary course of its activities are reclassified to inventory when they cease to be rented and become held for sale.
US GAAP comparison US GAAP does not provide specific guidance around accounting for assets that are rented out and then subsequently sold on a routine basis, and practice may vary. Proceeds from the sale would be accounted for in a manner consistent with the nature of the asset, which may be different from IFRS Standards. |
In some cases, NRV of an item of inventory, which has been written down in one period, may subsequently increase. In such circumstances, IAS 2 requires the increase in value (i.e. the reversal), capped at the original cost, to be recognized. Reversals of writedowns are recognized in profit or loss in the period in which the reversal occurs.
US GAAP comparison Unlike IAS 2, under US GAAP, a write down of inventory to NRV (or market) is not reversed for subsequent recoveries in value unless it relates to changes in exchange rates. |
IAS 2 requires the same cost formula to be used for all inventories with a similar nature and use to the company, even if they are held by different legal entities in a group or in different countries. In practice, for an acquired business this often requires rapid realignment to its new parent’s group methodologies and systems.
US GAAP comparison Unlike IAS 2, US GAAP allows use of different cost formulas for inventory, despite having similar nature and use to the company. Therefore, each company in a group can categorize its inventory and use the cost formula best suited to it. |
Under IAS 2, storage costs are expensed as incurred unless:
The costs necessary to bring the inventory to its present location – e.g. transport costs incurred between manufacturing sites are capitalized. The accounting for the costs of transporting and distributing goods to customers depends on whether these activities represent a separate performance obligation from the sale of the goods.
US GAAP comparison Like IAS 2, transport costs necessary to bring purchased inventory to its present location or condition form part of the cost of inventory. Unlike IAS 2, US GAAP does not contain specific guidance on storage and holding costs, which may give rise to differences from IFRS Standards in practice. Unlike IFRS Standards, the accounting for shipping and handling activities undertaken after the customer has obtained control of the related goods is subject to a policy choice. Read KPMG article Revenue: Top 10 differences between IFRS 15 and ASC 606. |
Under IAS 2, inventory may include intangible assets that are produced for resale – e.g. software.
US GAAP Comparison Unlike IAS 2, US GAAP inventory does not include intangible assets and differences from IFRS Standards may arise in practice – e.g. software inventory includes only the costs incurred for duplicating, documenting and producing materials from the product masters and for physically packaging them for sale. |
The significance of inventory for certain industries makes accounting and valuation a pertinent focus area. The differences around costs and measurement between IFRS Standards and US GAAP can be difficult for companies to tackle as they switch between the two standards or conform acquired businesses to group costing policies. This is because changing inventory costing methodologies often requires systems and process changes. These GAAP differences can also affect the composition of costs of sales and performance measures such as gross margin.
Dual preparers should carefully assess all differences to prepare a model that is efficient to maintain, most representative of their inventory values and compliant with all applicable requirements under both GAAPs.
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