While companies in the United States operate under the generally accepted accounting principles (GAAP), most other countries use the International Financial Reporting Standards (IFRS). There are many differences between both systems, particularly in how they treat inventory accounting.
One of the most basic differences is that GAAP permits the use of all three of the most common methods for inventory accountability—weighted-average cost method; first in, first out (FIFO); and last in, first out (LIFO)—while the IFRS forbids the use of the LIFO method. GAAP and IFRS also differ on inventory reversal write-downs and costing formulas.
Though these two systems are different in many ways, they have some similarities in their approach to inventory costing. For example, inventory expenses must include all direct costs to ready inventory for sale, including overhead, and must exclude selling costs and most general administrative costs.
Let's take a look at some of the key differences between GAAP and IFRS's treatment of inventory accounting.
- Companies in the United States operate under the generally accepted accounting principles (GAAP), while most other countries use the International Financial Reporting Standards (IFRS).
- GAAP permits the use of all three of the most common methods for inventory accountability; the IFRS forbids the use of the LIFO method.
- IFRS requires that inventory is carried at the lower of cost or net realizable value; U.S. GAAP requires that inventory is carried at the lower of cost or market value.
- IFRS allows for some inventory reversal write-downs; GAAP does not.
Under GAAP, inventory is recorded as the lesser of cost or market value. According to the Financial Accounting Standards Board (FASB), the organization responsible for interpreting and modifying GAAP, market value is defined as the current replacement cost as limited by net realizable value.
The IFRS lays down slightly different costing rules. It states that inventory is measured as the lesser of cost or net realizable value.
This is a subtle distinction because both entities use the phrase "net realizable value" to mean slightly different things. The IFRS's definition of net realizable value is equal to the estimated selling price minus any reasonable costs associated with a sale. For GAAP, net realizable value is the best approximation of how much "inventories are expected to realize."
Reversal of Inventory Write-Downs
Both systems require that inventory be written down as soon as its cost is higher than its net realizable value. In a sense, this means the inventory is "underwater."
Sometimes the net realizable value changes and adjusts back up; meaning, for some reason, the inventory assets have appreciated in value. The IFRS allows for reversals to be made and subsequent increases in value to be recognized in financial statements. These reversals must be recognized in the period in which they occur and are limited to the amount of the original write-down. In contrast, GAAP prohibits reversals altogether.
Accounting Methods for Inventory Costs
According to accounting standards Code 330-10-30-9 under GAAP, a company should focus on the accounting method that best and most clearly reflect "periodic income." This provides considerable leeway for companies to maximize their after-tax revenues based on inventory costs.
International standards are very different. Unless specifically exempted as "not ordinarily interchangeable for goods and services produced," all inventory must be accounted for using the FIFO or weighted-average cost method. The method selected must remain consistent. According to IAS 2, "the same cost formula should be used for all inventories with similar characteristics as to their nature and use to the entity."
Because of the confusion that can arise between the differences between the IFRS and GAAP, accounting bodies in the U.S. and elsewhere have expressed a desire to converge accounting rules between the two systems It is likely that such convergence efforts will remove the use of LIFO costing in the U.S. and create a more consistent definition of net realizable value, among other significant accounting changes.