There are three common methods for inventory accountability: weighted-average cost method; first in, first out (FIFO), and last in, first out (LIFO). Companies in the United States operate under the generally accepted accounting principles (GAAP) which allows for all three methods to be used. Most other countries use the International Financial Reporting Standards (IFRS) which forbids the use of the LIFO method. GAAP and IFRS also differ on inventory reversal write-downs and costing formulas.
While these two systems are different in many ways, they have some similarities for 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.
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 since both entities use the phrase "net realizable value" to mean slightly different things. The GAAP version of net realizable value is equal to the estimated selling price less any reasonable costs associated with a sale. For the IFRS, 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; 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. Under IFRS, paragraph 23 of IAS 2, certain inventory items are required to use a separate and unique costing method.
Accounting bodies in the U.S. and elsewhere have expressed a desire to converge accounting rules between the IFRS and GAAP. 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.