GAAP vs. IFRS for Inventory Accounting (#106)
/In this podcast episode, we cover the differences between how GAAP and IFRS treat the accounting for inventory. Key points are noted below.
LIFO Costing
The first item is last in, first out costing. It’s allowed under GAAP, and it’s specifically prohibited under IFRS. If you don’t know what LIFO is, it’s just like the name implies – the assumption is that the last item of inventory that you purchase is the first one to be used, which means that your inventory layers can be incredibly old, and that also means the cost of those inventory layers may be a very long ways away from their current replacement cost.
This is the number one issue if you’re currently using a LIFO costing system. No need to be alarmed just yet, but you may want to start thinking about what it will take to convert to a different costing system. If when you do convert, presumably those inventory cost layers are at really low costs, and when you recognize them, your profits will be way to high during that conversion period, and you’re going to pay a lot more than normal in income taxes.
Overall, this is a good change, though converting away from LIFO will be a pain for anyone who’s using it. LIFO has never had much basis in reality, and it was really developed to dodge taxes. So it’s better to let it go away.
Agriculture
There’s very minimal coverage of agriculture in GAAP, but under IFRS, you can recognize what they call biological assets at fair value – so, for example, if the market rate for soybeans changes, you can record the difference in income right away. So that means you are allowed to report at fair value, even if it’s in excess of cost.
And by the way, when they say you can do this for biological assets, that means more than just agriculture. They define a biological asset as a living animal or plant, so you can apply fair value to cattle or even a fish farm.
Lower of Cost or Market Accounting
Another item is lower of cost or market accounting. This is when you’re supposed to write down the value of inventory if the market value is lower than cost. Under GAAP, if you have a lower of cost or market write down, then that write down is permanent, and you cannot write it back up if market prices later go up.
Not the case with IFRS. You can reverse a write-down.
Being able to reverse lower of cost or market losses makes a lot of sense. The whole concept of lower of cost or market is based on adjusting to market, but GAAP only allows an adjustment if the market value drops, and never allows you to benefit if the market price comes back up – which is far too conservative. So, I like the IFRS approach quite a bit. It’s more common sense.
And speaking of lower of cost or market, the calculation is different. Under GAAP, it’s just as the name implies – you record the lower of inventory cost or its market value. And actually, there’s a bunch of persnickety extra rules that set up boundaries for the amount of the write down.
Under IFRS, it’s the lower of inventory cost or net realizable value. And net realizable value is defined as the estimated selling price of the inventory, minus the estimated cost of completion and any estimated cost to complete the sale.
The IFRS calculation is somewhat simpler, so I’m automatically in favor of it right there. But really, the overall concept is the same, and so it’s just not a large difference.
Presentation of Inventory Losses
And another topic is the presentation of inventory losses in interim periods. Under GAAP, if there’s an inventory loss in an interim period that’s caused by a market decline, but you expect the decline to be reversed later in the year, then you don’t have to record the loss in the interim period.
Not so with IFRS, which really sticks closer to the concept of fair value accounting. Under IFRS, you still have to record the inventory loss in interim periods, even if you expect the loss to be reversed.
The net effect of this last item is probably somewhat more variation in reported profits under IFRS, but on the other hand, it takes away any possibility of manipulating the results in interim periods.
Parting Thoughts
Taken as a whole, I think these changes are for the better. And, as we – eventually – go through some of the other differences between GAAP and IFRS, I think you’ll find that the international standards are generally better.
However, one comment on the whole issue of when IFRS will replace GAAP. I’ve just through all of the source documents for both IFRS and GAAP, because I was writing new books on both, and it really struck me that, even with the newer standards that are supposedly involving lots of input from both sides, there’re still a remarkable number of differences that are not being resolved.
It looks to me as though the staffs of both organizations are just motoring along, and churning out standards that are not quite the same. The Securities and Exchange Commission can command all publicly held companies to use IFRS, but most companies are not publicly held.
So, unless somebody higher up, like the United States Congress, finally steps in and commands that GAAP will go away, I’m not entirely sure that it ever will, and especially for non-public companies.