Inventory Accounting:US GAAP vs IFRS
Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value.
Net realizable value (NRV) is a method of evaluating an asset’s worth when held in inventory. Net realizable value is generally equal to the selling price of the inventory goods less the selling costs (completion and disposal).
Companies need to record the cost of their Ending Inventory at the lower of cost and NRV, to ensure that their inventory and income statement are not overstated. For example at a company’s year end, if an unfinished good that already cost $25 is expected to sell for $100 to a customer, but it will take an additional $20 to complete and $10 to advertise to the customer, its NRV will be $100-$20-$10=$70. In this year’s income statement, since the cost of the good ($25) is less than its NRV ($70), the cost of the good will get recorded as the cost of inventory. In next year’s income statement after the good was sold, this company will record a revenue of $100, Cost of Goods Sold of $25, and Cost of Completion and Disposal of $20+$10=$30. This leads to a profit of $100-$25-$30=$45 on this transaction.
Suppose we changed the example so that it costs $60 to advertise to the customer. Now the good’s NRV will be $100-$20-$60=$20. In this year’s income statement, since the NRV ($20) is less than the cost of the good ($25), the NRV will get recorded as the Cost of Ending Inventory. To do so, an inventory write down of $25-$20=$5 is done, and hence a decrease of $5 in this year’s income statement. In the next year’s income statement after the good was sold, this company will record a revenue of $100, Cost of Goods Sold of $20, and Cost of Completion and Disposal of $20+$60=$80. This leads to the company breaking even on this transaction ($100-$20-$80=$0).
Under US GAAP inventories are reported on the balance sheet at the lower of cost or market.
Market is usually equal to replacement cost; however market cannot be greater than the net realizable value or less than the NRV minus a normal profit margin.
A Rotman Mnemonikos
What if inventory values change?
Let’s say you can sell your inventories at higher price thus your net realizable value is higher than the historical cost of inventors. How will you record them under IFRS and US GAAP? A Rotmanie will easily remember Gordon Richardson’s thumb in this scene.
Always write-down losses. But not realize the gain until you sell it! That’s the rule of US GAAP, not applicable to IFRS.