IAS 2 Inventories: Cost, Net Realisable Value and How US GAAP Differs
What goes into inventory cost, how the lower of cost and net realisable value test works, and why IFRS allows write-down reversals while US GAAP does not.
Scope
IAS 2 applies to assets held for sale in the ordinary course of business, in the process of production for such sale, or as materials and supplies to be consumed in production or in rendering services. Some items are excluded, such as financial instruments and biological assets related to agricultural activity.
What counts as cost
| Included in cost | Excluded from cost (expensed) |
|---|---|
| Purchase price, import duties and non-recoverable taxes | Abnormal waste of materials, labour or other production costs |
| Transport and handling to bring goods to their location | Storage costs, unless necessary in the production process |
| Direct labour and production overheads (fixed overheads allocated on normal capacity) | Administrative overheads not related to production |
| Other costs to bring inventory to its present condition | Selling costs |
Trade discounts and rebates are deducted when determining purchase cost.
Fixed overheads and normal capacity
Fixed production overheads are allocated based on the normal capacity of the production facilities. If production is abnormally low, unallocated overheads are expensed in the period rather than being loaded onto fewer units. This prevents inventory from being overstated when a factory runs below capacity.
Cost formulas
| Formula | IFRS (IAS 2) | US GAAP (ASC 330) |
|---|---|---|
| Specific identification (for items not ordinarily interchangeable) | Required | Permitted |
| FIFO | Permitted | Permitted |
| Weighted average cost | Permitted | Permitted |
| LIFO | Prohibited | Permitted |
An entity uses the same cost formula for all inventories with a similar nature and use.
Lower of cost and net realisable value
Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs to make the sale. When NRV falls below cost, inventory is written down to NRV and the loss is recognised in profit or loss.
Write-downs are usually assessed item by item, although grouping similar or related items can be appropriate. Writing down an entire class, such as "all finished goods", is generally not appropriate.
Worked example: write-down and reversal
At 31 December 2025, a retailer holds a line of products that cost $50,000. Because of a price war, the estimated selling price less costs to sell is $44,000.
| Account | Debit | Credit |
|---|---|---|
| Cost of sales (inventory write-down) | 6,000 | |
| Inventory | 6,000 |
The products are still unsold at 31 December 2026, and market prices have partially recovered. NRV is now $49,000.
Under IFRS: the write-down is reversed to the extent of the recovery, but never above original cost. The new carrying amount is the lower of cost ($50,000) and the revised NRV ($49,000), so $5,000 of the earlier write-down is reversed.
| Account | Debit | Credit |
|---|---|---|
| Inventory | 5,000 | |
| Cost of sales (reversal of write-down) | 5,000 |
Under US GAAP: the written-down amount becomes the new cost basis. The inventory stays at $44,000 and no reversal is recorded, even though NRV has recovered.
US GAAP measurement differences in more detail
Since ASU 2015-11, US GAAP measures inventory using FIFO or average cost at the lower of cost and net realisable value, broadly aligned with IAS 2. Inventory measured using LIFO or the retail inventory method continues to use the older lower of cost or market test, where "market" is replacement cost bounded by a ceiling (NRV) and a floor (NRV less a normal profit margin).
Disclosures
IAS 2 requires disclosure of the accounting policies and cost formulas used, carrying amounts by classification, the amount of inventories expensed in the period, write-downs and reversals (with the circumstances that led to a reversal), and inventories pledged as security.
Application scenarios
Scenario 1: Garment factory running below capacity
Situation. A garment factory has normal capacity of 100,000 pieces a year and fixed production overheads of $500,000. Due to fewer orders, it produces only 60,000 pieces. It also discards $40,000 of fabric because of a cutting error, far above normal wastage.
Analysis. Fixed overheads are absorbed at the normal-capacity rate: $500,000 ÷ 100,000 = $5 per piece.
| Item | Amount | Treatment |
|---|---|---|
| Fixed overhead absorbed (60,000 × $5) | 300,000 | Included in inventory cost |
| Unabsorbed fixed overhead | 200,000 | Expensed in the period |
| Abnormal fabric wastage | 40,000 | Expensed in the period |
Loading the full $500,000 onto 60,000 pieces would overstate inventory at about $8.33 per piece instead of $5.
Scenario 2: Seasonal stock after the season ends
Situation. A retailer holds 1,000 winter jackets that cost $80 each. After the season, it expects to sell them at $70 each, with selling costs of $5 per jacket.
Analysis. NRV is $70 − $5 = $65, which is below cost of $80. The write-down is ($80 − $65) × 1,000 = $15,000.
| Account | Debit | Credit |
|---|---|---|
| Cost of sales (inventory write-down) | 15,000 | |
| Inventory | 15,000 |
If the jackets are still on hand next winter and their expected selling price recovers, IFRS requires the write-down to be reversed (up to original cost); US GAAP does not.
Summary
The IAS 2 rules on cost are mostly about discipline: include only what it takes to get inventory into saleable condition, and expense the rest. The most important framework difference is in the reversal of write-downs, which can make IFRS earnings recover faster than US GAAP earnings after a temporary price decline. For companies using LIFO in the US, converting to IFRS also means restating inventory to an approved cost formula.
This article is for general educational purposes and reflects the author's understanding of the standards at the date shown. Always refer to the authoritative text of the standards and seek professional advice for specific situations.