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.
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.
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.
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.