Inventory costs, write-downs and hidden margin effects

Learning goals

• Reconstruct FIFO, weighted-average and LIFO examples without confusing cost flow with physical flow.
• Evaluate valuation adjustments and inventory disclosure signals.

Draft · approximately 80 minutes, excluding further revision.

Build the unit ledger before choosing a method

A cost-flow assumption allocates available cost between goods sold and ending inventory; it need not describe the physical delivery order. In rising unit costs with stable quantities, FIFO tends to assign older lower costs to sales and newer higher costs to inventory; LIFO tends to do the reverse. Falling costs reverse the direction. Periodic weighted average spreads available cost over available units; perpetual moving average can differ.

IFRS does not permit LIFO. US GAAP can permit it, so reconcile method differences before interpreting margins and taxes. A reduction of old LIFO layers during inflation can release low historical costs and temporarily inflate profit. Where disclosed, FIFO inventory=LIFO inventory+LIFO reserve; a change in reserve helps bridge COGS only after considering other movements.

Test recoverability using the right framework

Under IAS 2, compare inventory cost with net realizable value, a sale-based estimate after completion and selling costs. A later recovery reverses a prior write-down only within its permitted original-cost ceiling. Recognizing a write-down reduces inventory and current profit; it can mechanically increase future gross margin when the reduced cost is sold.

US GAAP generally applies lower of cost and NRV to inventory other than LIFO or retail-method inventory; those exceptions retain a lower-of-cost-or-market model. Do not describe US inventory as one undifferentiated lower-of-cost-and-NRV rule. Subsequent recovery generally does not reverse the US write-down. State the method, standard and fact pattern before applying a classroom adjustment.

Read quantity, aging and policy together

Inventory growth faster than sales may reflect expansion, bottlenecks or obsolete goods. Compare units, price effects, turnover, aging, write-downs and purchase commitments. A write-down lowers the denominator of turnover, so apparently improved turnover can coexist with weaker stock quality. Suppliers, product cycles and seasonal build-ups can provide alternative explanations.

Check whether overhead allocations follow normal capacity and whether unusual waste or storage costs were improperly retained in inventory. For peer analysis, document the adjustment and related tax effect rather than silently rewriting reported earnings. A LIFO reserve is an analytical bridge, not extra cash held by the issuer.

Deflation and a LIFO-reserve bridge

Reverse the earlier cost layers:100 units at 14 then 100 at 10, sell 150. Periodic FIFO COGS=1,900, ending inventory 500; LIFO COGS=1,700, ending 700. With revenue 3,000, FIFO gross profit 1,100 is lower than LIFO 1,300, unlike the rising-cost case. This comparison is hypothetical and does not make LIFO permissible under IFRS.

If a US issuer’s LIFO reserve rises from 30 to 45 with no other reserve movements, COGS under FIFO is LIFO COGS minus 15. Converting ending inventory adds 45, but the income-statement bridge uses the change 15. Under a simplified 25%tax assumption, the pretax earnings increase 15 corresponds to after-tax 11.25; actual current/deferred tax and disclosure adjustments require the issuer’s facts.

A write-down changes margins and later comparisons

For an original ordinary-inventory example under IAS 2,100 units cost 12 each. Expected selling price is 13, with completion and necessary selling costs of 2 per unit. NRV per unit=11, below cost 12; write inventory from 1,200 to 1,100 and recognize expense 100. Neither the selling price 13 alone nor replacement cost supplies the specified IAS 2 comparison. These facts exclude special inventory measurement exceptions.

When comparing inventory turnover across firms, inspect the cost formula, write-down history and seasonality. A write-down reduces both profit and the inventory denominator; a later apparently faster turnover may therefore be partly accounting arithmetic. Calculate turnover on a consistent basis and read physical volume and aging information before concluding that warehouse operations improved.

Formula and assumptions

Goods available=beginning inventory+purchases; COGS=available cost−ending inventory; FIFO inventory=LIFO inventory+reserve

A two-layer inventory ledger

1. Buy 100 units at 10 and 100 at 14; sell 150 for 20 each. Periodic FIFO COGS=100 × 10+50 × 14=1,700 and ending inventory=700.
2. Periodic LIFO COGS=100 × 14+50 × 10=1,900; inventory=500. Weighted-average cost 12 gives COGS 1,800 and inventory 600. Revenue 3,000; FIFO gross profit 1,300 versus LIFO 1,100, before tax.
3. Separately, IFRS inventory cost 100, NRV 80 is written to 80; subsequent NRV 95 permits 15 reversal. A recovery to 110 cannot raise carrying value above original cost 100.

Errors to catch

• Calling LIFO permissible under IFRS.
• Treating a write-down-induced turnover increase as sales improvement.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.ifrs.org
• Reference · storage.fasb.org
• Reference · www.ifrs.org