Inventory, Inventory, Inventory
July 29, 2012 § Leave a comment
My last blog talked about the differences between the way GAAP and IFRS step up their income statements. This blog will focus on the way GAAP and IFRS differ when it comes to how inventory should be accounted for. These two systems differ in three important areas: the allowable costing methods, how inventory is to be presented, and the reversal of market adjustments.
The first way that GAAP and IFRS differ when it comes to inventory is the allowable inventory costing methods. There are three costing methods that are widely used in accounting. Those three methods are FIFO, LIFO, and average cost. FIFO, which stands for first in first out, assumes that goods are sold in the order they are purchased. LIFO, which stands for last in first out, assumes that the last goods purchased are the first ones sold. Average cost just takes the average cost of the inventory sold. Under GAAP, a company can chose to use any three of these methods. However, IFRS has banned the use of LIFO because they believe that it allows for income manipulation.
I agree with IFRS that the LIFO method should not be allowed. The only reason that it was created was so that companies could manipulate their inventory value to pay fewer taxes. If a company reports their inventory under LIFO, they also have to report it under FIFO. However, the opposite is not true. If a company uses LIFO then they end up having to do twice the work, which is a waste of time and money, so there is no reason to allow LIFO in the first place.
Another way that GAAP and IFRS differ is how inventory is to be presented and valued on the balance sheet. There are two ways in which inventory can be valued: lower of cost or market (LCM) or net realizable value (NRV). LCM means that inventory should be recorded at the lower of either the cost to produce it, the cost to repurchase it, or the market value of the inventory. NRV is the estimated selling price minus the estimated disposal cost. GAAP requires that inventory be valued at LCM, whereas IFRS allows inventory to be valued at LCM or NRV. In this case, I agree with GAAP. Using LCM is a much more conservative approach than NRV, and conservatism is very important when it comes to accounting. Also, it is a lot simpler if there is only one way allowed.
The third way that GAAP and IFRS differ is on the reversal of market adjustments. When you buy inventory it goes on your books at a certain price. If the value of that inventory should drop for some reason, then you are allowed to write down the value of the inventory to what it is worth now. Now let’s say that after you wrote the inventory down, the value goes back up. Under GAAP, companies are not allowed to write the inventory back up. So once you write the inventory down, you can never write it back up. Under IFRS, you are allowed to write the inventory back up to the original cost you had it on your books for. IFRS’s method is better because it gives a more current value of the inventory. With GAAP, once you write the inventory down, you are stuck with that amount. Even if the inventory triples in value you can’t recognize that gain.