Inventory impairment is the write-down you take when the cost recorded on your books is higher than the amount you realistically expect to recover from selling the goods. Under US GAAP, the measurement rule depends on whether you use FIFO or weighted-average cost (lower of cost and net realizable value) or LIFO or the retail method (lower of cost or market). IFRS applies a single lower-of-cost-and-NRV test to all inventory. Getting the number right matters because an overstated inventory balance inflates both assets and net income.
When a Write-Down Is Required
Any condition that pushes recoverable value below recorded cost should trigger an assessment. Physical damage from water, heat, or mishandling is the clearest case: dented or spoiled goods will not sell at full price. Obsolescence is the next, and it moves fastest in electronics and fashion, where last season’s product can lose most of its value in weeks.
A drop in selling prices from competition, oversupply, or a broader slowdown reduces what you will collect on a future sale. The same thing happens from the cost side when the amounts needed to finish work-in-process or to ship and sell finished goods rise, because those extra costs come out of the eventual cash inflow. Overstocking compounds every one of these problems, since inventory held well past current demand tends to move only at deep discounts.
On the quantitative side, a persistently low inventory turnover ratio (cost of goods sold divided by average inventory) relative to your industry is a warning that some portion of the stock may be impaired.
Measuring Impairment Under US GAAP
ASC 330 splits inventory into two groups based on cost flow method. Both groups aim for the same result, that inventory is carried at no more than the amount you expect to recover, but the mechanics are different.
FIFO and Weighted-Average: Lower of Cost and Net Realizable Value
Inventory measured under FIFO or weighted-average cost uses the simpler rule. Compare recorded cost to net realizable value and write the inventory down to NRV if NRV is lower. NRV is the estimated selling price in the ordinary course of business minus reasonably predictable costs of completion, disposal, and transportation.1Financial Accounting Standards Board. Inventory (Topic 330) Simplifying the Measurement of Inventory
LIFO and Retail Method: Lower of Cost or Market
Inventory measured under LIFO or the retail inventory method uses lower of cost or market. Here, “market” is not the future selling price. It is the current replacement cost, constrained between a ceiling and a floor.1Financial Accounting Standards Board. Inventory (Topic 330) Simplifying the Measurement of Inventory
- The ceiling is net realizable value. Replacement cost cannot be used if it exceeds what you expect to collect net of completion and selling costs.
- The floor is net realizable value minus a normal profit margin. This prevents a write-down so deep that an artificially high profit appears when the goods eventually sell.
Designated “market” is replacement cost unless it falls outside these boundaries. If replacement cost exceeds the ceiling, the ceiling becomes market; if it drops below the floor, the floor becomes market. Compare that constrained figure to original cost and write the inventory down to whichever is lower. The three-way comparison exists because LIFO layers can produce book values that diverge sharply from current economics, and the ceiling and floor keep the result anchored to both today’s replacement pricing and realistic profit expectations.
Measuring Impairment Under IFRS
IAS 2 uses one rule for all inventory regardless of cost flow method: lower of cost and net realizable value. There is no separate LCM test and no ceiling-and-floor analysis. NRV carries the same meaning as under US GAAP.
The most consequential difference from US GAAP is reversal. If the conditions that caused an earlier write-down disappear, say a rebound in market prices or a drop in completion costs, IAS 2 requires you to reverse some or all of the loss. The reversal is capped at the amount of the original write-down, so carrying value never climbs back above original historical cost. The reversal reduces cost of goods sold in the period the recovery occurs.
US GAAP takes the opposite position. Once inventory is written down, the reduced figure becomes the new cost basis, and recovery of value in a later fiscal year cannot be recognized. There is a narrow interim-reporting exception: a write-down taken in one interim period can be reversed in a later interim period of the same fiscal year, up to the amount previously written down. Once the annual books close, the write-down is permanent.2KPMG. Inventory Accounting: IFRS Standards vs US GAAP
What Level to Test At
You do not have to test every SKU individually, though you can. Under ASC 330, the comparison can be applied item by item, by category of similar items, or across the entire inventory. The choice matters because testing at a higher level lets gains on some items offset losses on others, potentially masking impairment. Item-by-item is the most conservative and captures every loss.
Under IAS 2, the comparison is generally item by item. Items from the same product line may be grouped only if they share a similar purpose and end use, are produced and marketed in the same geographic area, and cannot practicably be evaluated separately. Whatever method you choose, apply it consistently from period to period.
Recording the Write-Down
Two recording methods are common. The direct method debits cost of goods sold and credits inventory for the loss amount. This reduces the asset and increases the expense in one step, and it works well when the impaired goods are expected to sell in the near term.
The allowance method debits a separate loss account (often called “Loss on Inventory Write-Down”) and credits a contra-asset account such as “Allowance to Reduce Inventory to NRV.” The contra-asset sits on the balance sheet against gross inventory, so the reader sees both the original cost and the cumulative adjustment. This gives management a running record of how much impairment has been recognized against the original basis.
Inventory write-downs typically appear within cost of goods sold on the income statement. When the loss is material, separate disclosure or a distinct line item helps readers distinguish it from ordinary operating costs. On the balance sheet, inventory is presented at its impaired value regardless of which method you use.
Disclosure Requirements
Under US GAAP, ASC 330 requires disclosure of the basis of accounting for inventories (FIFO, LIFO, or average cost) and the valuation method (lower of cost and NRV, or lower of cost or market). Material write-downs should be disclosed by nature and amount so that investors can separate the loss from normal cost-of-goods-sold activity.
Public companies face more. Regulation S-K, Item 303 requires MD&A to address unusual events that materially affected reported income and to disclose known trends or uncertainties reasonably likely to affect future results. A significant inventory write-down falls within both, and the regulation specifically calls out inventory adjustments as an example of events that can change the relationship between costs and revenues. If NRV forecasting or completion-cost projection involves significant estimation uncertainty, the SEC treats the estimate as a critical accounting estimate, which brings its own disclosure of why the estimate is uncertain, how it has changed, and how sensitive results are to the underlying assumptions.3eCFR. 17 CFR 229.303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
Under IFRS, IAS 2 requires disclosure of the total carrying amount of inventories, the amount recognized as an expense during the period, any write-downs recognized, any reversals of previous write-downs along with the circumstances that led to them, and the carrying amount of inventories pledged as security for liabilities.
Tax Treatment
A GAAP write-down does not automatically produce a tax deduction. The IRS has its own inventory valuation rules, and the gap shows up on the return as an M-1 or M-3 adjustment.
For federal tax purposes, the accepted valuation bases are cost, and cost or market, whichever is lower. The IRS defines “market” as the aggregate current bid price of the basic cost elements reflected in the inventory, a replacement-cost concept rather than the GAAP net realizable value framework.4eCFR. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever is Lower
Damaged, out-of-style, or otherwise unsalable goods get special treatment. These “subnormal” goods must be valued at bona fide selling price minus direct costs of disposal, regardless of whether you otherwise use cost or cost-or-market. The bona fide selling price must be an actual offering price during a window ending no later than 30 days after the inventory date, and you bear the burden of proving the goods qualify. Keep records of eventual disposition so the IRS can verify the claimed value.5eCFR. 26 CFR 1.471-2 – Valuation of Inventories
The IRS does not allow a general reserve for anticipated price declines. You cannot estimate that a category of inventory will lose value and take a blanket deduction; each write-down must be tied to specific goods with identifiable impairment.5eCFR. 26 CFR 1.471-2 – Valuation of Inventories
Small businesses that meet the gross receipts test under Section 448(c) have a simpler path. Section 471(c) lets a qualifying taxpayer either treat inventory as non-incidental materials and supplies (deducting cost when consumed or sold rather than tracking it as an asset) or follow the method used in its applicable financial statements. That effectively lets many small businesses skip a separate impairment analysis for tax and align tax treatment with the books.6Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
Any change in inventory valuation method for tax purposes requires Form 3115, Application for Change in Accounting Method. Some changes qualify as automatic (no user fee, filed with the return); others need advance IRS approval and a fee.7Internal Revenue Service. Instructions for Form 3115
When Inventory Can Be Carried Above Cost
The lower-of-cost rule has a narrow set of exceptions. ASC 330 permits above-cost carrying only in exceptional cases, and the SEC has stated it will challenge mark-to-market inventory accounting except in extremely rare circumstances.
The most recognized exception is precious metals with a fixed monetary value and no substantial marketing cost, such as gold and silver held where a government-controlled market exists at a fixed price. Agricultural, mineral, and other commodity products may also qualify if units are interchangeable, a quoted market price is immediately available, and costs are difficult to determine. When inventory is stated at selling prices under these exceptions, the balance must be reduced by the costs expected to be incurred in disposing of the goods. Outside these categories, the lower-of-cost principle applies without exception, and any appreciation above recorded cost is not recognized until the goods actually sell.