IAS 2 Inventories: Cost, NRV, and US GAAP Differences

IAS 2 Inventories is the IFRS standard that tells companies how to cost, measure, and disclose inventory. It requires inventory to be carried at the lower of cost and net realizable value, restricts cost formulas to FIFO, weighted average, or specific identification for non-interchangeable items, and prohibits LIFO outright.¹ Get these rules right and reported profit, cost of goods sold, and balance sheet strength all fall into place; get them wrong and each one distorts.

What Counts as Inventory

IAS 2 defines inventory as assets held for sale in the ordinary course of business, assets in the process of production for that sale (work in progress), and materials or supplies to be consumed in production or in delivering a service.² Finished goods in a warehouse, half-assembled units on a factory floor, raw steel awaiting fabrication — all inventory.

Service businesses hold inventory too. An unbilled consulting engagement or an audit in progress qualifies, measured at the cost of the personnel directly delivering the service plus attributable overheads. Profit margin, general administration, and selling costs stay out.³

What Sits Outside the Standard

Financial instruments are governed by IAS 32 and IFRS 9 rather than IAS 2. Biological assets tied to agricultural activity and agricultural produce at the point of harvest fall under IAS 41, which uses a fair-value-less-costs-to-sell model.² Once harvested, though, the produce becomes ordinary inventory under IAS 2.⁴

Two other categories stay within IAS 2 for recognition and disclosure but escape its measurement rules. Commodity broker-traders measure their commodity inventories at fair value less costs to sell, with changes running through profit or loss. Producers of agricultural, forest, and mineral products may measure inventories at net realizable value where industry practice supports it.²

What Goes Into Cost

Inventory is initially measured at cost, which captures everything spent to bring the items to their present location and condition. IAS 2 groups those costs into purchase costs, conversion costs, and other directly attributable costs.⁵

Purchase Costs

Purchase costs include the price paid to the supplier, import duties, non-recoverable taxes, and transport, handling, and other costs directly tied to acquiring the goods. Trade discounts, rebates, and similar concessions are deducted.⁵ Taxes that can later be reclaimed from the authority, such as recoverable VAT, don’t belong in inventory cost.

Conversion Costs

Conversion costs cover turning raw materials into finished goods: direct labor, direct production expenses, and a systematic allocation of both fixed and variable production overheads. Variable overheads are allocated on actual usage. Fixed overheads (factory depreciation, plant management salaries) are allocated based on normal capacity, meaning the average output expected over several periods under ordinary conditions, taking planned downtime into account.³

Normal capacity matters because it stops a common distortion. When production drops temporarily, you don’t spread fixed overheads over fewer units and inflate the per-unit cost; you keep allocating at the normal rate and expense the unallocated overhead in the period. When production runs abnormally high, the per-unit allocation is reduced so inventory isn’t carried above actual cost.

When a process yields more than one product at once, conversion costs are allocated across the joint products, typically using relative sales value at the split-off point or when production is complete. By-products are often immaterial and can be measured at net realizable value, with that amount deducted from the main product’s cost.

Other Directly Attributable Costs

Other costs enter inventory only where they were incurred bringing the items to their present location and condition. Design costs for a custom order or non-production overheads tied to a specific project are typical examples.

Borrowing costs can be capitalized in narrow circumstances. Under IAS 23, borrowing costs directly attributable to acquiring, constructing, or producing a qualifying asset — one that takes a substantial period to get ready, such as aged spirits or large custom-built equipment — form part of that asset’s cost. Inventories produced in large quantities on a repetitive basis are explicitly excluded from this treatment.⁶

Costs That Never Enter Inventory

IAS 2 draws hard lines around what must be expensed in the period incurred:³

Abnormal amounts of wasted materials, labor, or other production inputs. Normal scrap belongs in conversion cost; abnormal waste does not.
Storage costs, unless the storage is a necessary step between production stages (aging whiskey before bottling, for instance).
Administrative overheads that don’t contribute to getting inventory into a saleable state.
Selling costs, including marketing, advertising, and distribution.

If a cost didn’t help get the inventory to where it is and the state it’s in, it doesn’t sit on the balance sheet.

Assigning Costs to Units

Cost measurement produces a pool of costs; a cost formula decides which of those costs flow to cost of goods sold and which stay in ending inventory. The same formula must be used for all inventories with a similar nature and use, including across different subsidiaries and countries within a group.¹

Specific Identification

For items that are not ordinarily interchangeable, and for goods produced and segregated for specific projects, IAS 2 requires specific identification — the actual cost of each unit is tracked and expensed when that unit is sold. This is the only acceptable approach for unique or high-value items such as custom machinery, commissioned artwork, or individual real estate developments.²

FIFO

First-in, first-out assumes the oldest units are sold first. Cost of goods sold reflects earlier purchase prices; ending inventory reflects the most recent. For most businesses this mirrors the physical flow, particularly where goods are perishable or time-sensitive. When prices are rising, FIFO produces higher reported profit and a balance sheet closer to current replacement values.

Weighted Average Cost

The weighted average formula computes a single average unit cost, dividing total cost of goods available by total units available, and applies that blended cost to both units sold and units remaining. Price fluctuations get smoothed across the pool. The average is recalculated as new purchases come in.

Why LIFO Isn’t Allowed

Last-in, first-out is prohibited. Under LIFO, ending inventory can sit on the books at costs from years or decades ago, and the IASB removed the option because those stale carrying values lack representational faithfulness — they tell users almost nothing about what the entity actually holds.² This is one of the most visible IFRS/US GAAP differences, since US GAAP still allows LIFO.

Standard Cost and Retail Method

Two convenience techniques can be used to measure cost if results approximate actual cost. Standard costing sets predetermined costs for materials, labor, efficiency, and capacity utilization at normal levels, with the standard reviewed and revised as conditions change. The retail method — common among retailers with high volumes of similar-margin goods — takes selling price and reduces it by an appropriate gross margin percentage, accounting for markdowns, often calculated by department.³

The Lower of Cost and Net Realizable Value

Cost is only the starting point. IAS 2 imposes a ceiling: inventory must be carried at the lower of cost and net realizable value, so no asset sits on the balance sheet at an amount the entity cannot recover through sale.²

How NRV Is Defined

Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs to complete the goods and the estimated costs to make the sale (commissions, shipping, and similar).¹ It is entity-specific: what this company expects to realize, not a generic market price.

When to Write Down

When NRV falls below cost, inventory is written down to NRV, and the write-down is recognized as an expense immediately rather than deferred until the sale. Typical triggers are physical damage, obsolescence, and declining market selling prices; an increase in estimated completion or selling costs can push NRV below cost with the same effect.²

NRV assessment is normally done item by item so gains on one item don’t mask losses on another. Grouping is allowed for items in the same product line with similar purposes and end uses, produced and marketed in the same area, where individual assessment isn’t practical.

Raw materials and supplies get a shortcut: no write-down is needed if the finished products they’ll go into are expected to sell at or above cost. If the finished product’s NRV falls below cost, the raw materials are written down to replacement cost as the best available approximation of NRV.²

Reversing a Write-Down

When the circumstances that caused a write-down no longer exist — market prices recover, expected selling costs fall — the carrying amount is increased back, but never above original cost. The reversal reduces the cost-of-goods-sold expense in the period it happens.² Under IFRS, inventory values move in both directions rather than locking in a one-way impairment.

Expense Recognition and Disclosure

When inventory is sold, its carrying amount is recognized as cost of goods sold in the same period the related revenue is recognized. Any write-down to NRV is expensed immediately, and any reversal of a prior write-down reduces expense in the period the reversal occurs.³ Cost of goods sold, write-downs, and reversals together make up total inventory expense on the income statement.

The notes must disclose:

Accounting policies, including the cost formulas and any measurement techniques used.
Carrying amounts, broken into classifications appropriate to the entity (raw materials, work in progress, finished goods).
The carrying amount of any inventories measured at fair value less costs to sell, such as broker-trader inventories.
The amount of any write-down recognized as an expense during the period.
The amount of any write-down reversal, with the events or circumstances that led to the recovery.
The carrying amount of inventories pledged as security for liabilities.²
The total cost of inventories recognized as an expense during the period.

The pledged inventory disclosure is easy to overlook. If inventory is collateral for a loan or credit facility, that carrying amount must be separately disclosed so lenders and investors can see which assets are encumbered.

Differences From US GAAP That Matter in Practice

Groups that prepare dual reports or contemplate a switch between frameworks run into the same handful of gaps.

US GAAP (primarily ASC 330) permits LIFO; IAS 2 bans it. Many US companies use LIFO to reduce taxable income in inflationary periods.
Under IAS 2, all inventories use the lower of cost and NRV regardless of the costing method. Under US GAAP, FIFO and weighted average users apply lower of cost and NRV, but LIFO and retail method users compare cost to a “market value” constrained between an NRV ceiling and an NRV-less-normal-profit-margin floor.
IAS 2 requires reversal of write-downs when conditions improve, capped at original cost. US GAAP prohibits reversal — once written down, the new lower amount becomes a permanent cost basis, with a narrow exception for exchange rate changes.
IAS 2 requires the same cost formula for all inventories with a similar nature and use across the group. US GAAP allows different formulas for similar inventory, even within the same entity.
Under IFRS, decommissioning and restoration costs incurred as a consequence of producing inventory become part of inventory cost and flow to expense on sale. US GAAP adds those costs to the related property, plant, and equipment instead.

The LIFO ban and the reversal requirement generate the most reconciliation work. Converting from US GAAP to IFRS after years of LIFO can mean a significant one-time adjustment to unwind the LIFO reserve, and entities used to treating write-downs as permanent need processes that monitor NRV in both directions.

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IFRS. IAS 2 Inventories
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IFRS Foundation. IAS 2 Inventories
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IFRS Foundation. IAS 2 Inventories
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IFRS. IAS 41 Agriculture
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IFRS Foundation. IAS 2 Inventories
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IFRS Foundation. IAS 23 Borrowing Costs