Inventory and Cost of sales

Overall

Despite its claim, the guidance on inventory is not about inventory.

IAS 2 | ASC 330 also shows accounting guidance can be succinct.

Inventory comprises:

• Merchandise

Merchandise is any item acquired for resale without modification.

While minor modifications, such as dealer-installed options in automobiles, may occur, merchandise is generally sold in the same condition in which it was bought.

The primary value added by the retailer or distributor lies in logistics and market access: relocating merchandise to a suitable sale point, locating potential buyers, facilitating transactions, and above all, providing a satisfying buying experience.

Consequently, the accounting for merchandise goes from simple and even simpler.

For entities that have invested in automation such as barcode, QR code or RFID tag scanners, the MIS takes care of itself, with practically no human involvement necessary.

For entities that prefer the old school, hands-on method, adding beginning inventory to purchases and subtract ending inventory cannot be considered challenging accounting.

True, a physical inventory needs to be taken at least once per period, but that is someone else's job.

The accounting for material is thus simple. When acquired merchandise is recognized with a debit to inventory / credit to a cost (cash, accounts payable, etc.). When control passes to the customer, merchandise is derecognized with a debit to cost of goods sold / credit to inventory.

• Material

Like merchandise, material is acquired to be re-sold.

Unlike merchandise, it must be converted into or added to a product first.

US GAAP has been recently updated (ASC 220-40-50-6) introducing the term "purchases of inventory."

This item comprises raw material and merchandise if taken together. However, if an entity engages solely in manufacturing, it would continue to use the raw materials/direct material labels. Similarly, a retailer would continue to refer to its inventory as merchandise. While an entity that does both could use a "purchases of inventory" label in its reports, such an entity would likely report its cost of products sold separately from its cost of merchandise sold. So, in practice, "purchases of inventory" is neither an appropriate accounting title nor financial statement line item. It is simply the term the standard setter uses to refer to material and merchandise with a single descriptor.

Note: IAS 1 and IFRS 18 refer to "raw material" expense as a component of cost of sales. It is also uncommon for entities reporting under IFRS to disaggregate cost of sales into detailed component parts for presentation or disclosure purposes. While materiality can overcome this practice, a detailed breakdown of cost of goods sold is fairly rare in the IFRS context.

Also note: materials or supplies consumed during the manufacturing process would also fall into the "purchases of inventory" | "raw material" categories. However, good practice is recognizing these items as production supplies and reporting them in the manufacturing overhead (indirect costs) component of cost of sales (if cost of goods sold is reported on a disaggregated basis).

Material falls into two general categories:

1. It becomes part of the product being produced.

2. It is consumed by the production process.

Unlike raw material, production supplies do not become a physical part of products. Instead, they are consumed during the manufacturing process.

From an accounting perspective, while they are rarely material enough to be reported as a separate balance sheet line item, when a product is sold, production supplies are included in cost of sales as variable indirect costs (production overhead), separate from material. This distinction is important when cost of sales is reported in granular detail.

Production supplies generally comprise consumables, such as lubricants, and often small parts like fasteners, capacitors, or resistors. The key accounting difference between a raw material and a production supply is that manufacturers typically track raw material through production, recognizing it first as raw material, then in work in process, and later in finished goods. Finally, when the finished goods are sold and revenue recognized, the raw material is derecognized from the balance sheet and recognized on the profit and loss | income statement as part of cost of sales. Production supplies, in contrast, generally bypass these intermediate steps, moving directly from inventory to cost of sales as they are consumed.

This also means the definition of production supplies is entity-specific. While many companies may calculate their screw expense by simply summing a period's screw purchases (making sure to subtract beginning screw inventory and add back ending screw inventory), others may meticulously track every single screw, especially if those screws involve expensive materials, specialized tooling, and highly skilled workers.

At the other end of the spectrum, some companies treat low-value (a.k.a. small assets) like production supplies. While it is fairly common to expense wrenches or spanners as if they were screws, some companies will apply the same policy to any asset costing less than $5,000 even if that asset is a portable drill press or PC.

National GAAPs, particularly if they are legalistic, set explicit monetary limits for asset capitalization. While neither IFRS nor US GAAP set such limits, this issue did come up during the deliberation process of IFRS 16 | ASC 842 where the boards addressed the staff's concerns regarding "small assets," the way many national GAAP refer to low-value items.

This issue was considered sufficiently important that the IASB decided to include a low-value (small) asset exception in IFRS 16. While the standard itself does not provide a quantification, in the basis for conclusions $5,000 was mentioned as a reasonable threshold.

As this is the only guidance that provides a similar quantification, even though it cannot be considered authoritative, it has become the basis for common practice when evaluating (by analogy) any "small asset."

Since ASC 842 does not include a 'small asset' exception similar to IFRS 16, analogizing from ASC 842 is not an option under its guidance. Nevertheless, since the ASC 842 Basis for Conclusions mentions the same $5,000, $5,000 is commonly used as a rule of thumb for "small" in US GAAP as well.

Thus, when applying this guidance, a company would need to test whether its aggregate "small assets" (not just those acquired in the accounting period but) do not cross a materiality threshold. If, for example, it can be reasonably assumed the company actually has "small assets" exceeding 1% of total assets, some of those assets will need to be capitalized to make sure that no material misstatement is being made.

Note: the same test would also need to be performed in IFRS because the $5,000 threshold only applies to small assets being leased, not small assets in general.

Thus, while not widely used common practice, this guidance is used to justify expensing items, such as personal computers or light machinery and equipment such as compressors, welders, portable drill presses, provided the per item cost does not exceed 5,000 USD. This issue is discussed in more detail in the Consumables (small, low-value assets) section of this page and Small assets section of this page.

As the guidance provided by IAS 2 | ASC 330 is rudimentary, it leaves significant room for professional judgment, and imagination, to be applied.

However, the accounting for material is equally as simple as the accounting for merchandise.

Technically, strict adherence to the guidance would result in a different. Rather than being derecognized with a debit to cost of goods sold, it would be derecognized with a debit to WIP. However, as running costs through inventory can be more work than it is worth, simply expensing it as it is consumed (perpetual method) or once per period (periodic method) is usually close enough. A more detailed discussion of why it is usually good enough is provided above.

• Products

The accounting for products is somewhat more involved than the accounting for merchandise and material.

The default method of accounting for production is full absorption costing.

While IAS 2 | ASC 330 does not use the term "full absorption costing" but does require it. Specifically:

Black letter IAS 2.23 states: The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs.

While similar, ASC 330-10-30-10 is not nearly as categorical stating (edited): ... While in some lines of business specific lots are clearly identified from the time of purchase through the time of sale and are costed on this basis, ordinarily the identity of goods is lost between the time of acquisition and the time of sale.

Nevertheless, under both, if an entity is capable of clearly identifying inventory costs as a product moves from raw material to finished good, it shall do so, reinforcing full absorption costing as the default accounting method.

However, given the practical difficulties of applying this method in the real world, particularly in serial manufacturing, both IFRS | US GAAP (specifically IAS 2.21 | ASC 330-10-30-12) explicitly allows standard costing, which is considerably simpler from an accounting methodology perspective. Similarly, IAS 2.21 | ASC 330-10-30-13 allows retailers to use a simplified, retail method.

In practice, entities often use other methods not explicitly mentioned in or allowed by the guidance. A good example is direct costing but various other hybrid methods are also used.

Direct costing is a common, internal method not generally appropriate for IFRS | US GAAP reporting purposes. However, if adjustments reflecting indirect costs are made, it could be used. As these adjustments need only be made periodically, it would be considerably simpler than tracking these costs as products move through the manufacturing process.

Examples include activity-based costing (ABC), throughput accounting, marginal costing, lean accounting , resource consumption accounting (RCA), target costing, etc.

However, for any method to be acceptable from an IFRS | US GAAP perspective, the result must be consistent with full absorption costing, ensuring that reported cost of sales includes direct material, direct labor and indirect production costs, both fixed and variable.

The costs fully absorbed to inventory comprise:

In US GAAP financial reports, a granular breakdown of cost of sales (cost of goods sold if only products are involved) in the footnotes is required.

ASC 220-40-55-11 includes the following illustration of how to apply ASC 220.



As this example clearly illustrates, the guidance requires a granular disclosure of various expense components. For example, a disaggregation of cost of goods sold is required (from December 16, 2026).

This reporting approach is less common in IFRS. Nevertheless, if the individual components of cost of sales are material, an auditor may require this granular information due to Practice statement 2.

However, PS 2.4 states: The Practice Statement provides non‑mandatory guidance; therefore, its application is not required to state compliance with IFRS Standards.

This implies that an auditor cannot insist on a granular breakdown of cost of goods sold, or any larger expense item, if a standard or interpretation does not require it, which neither does.

• Direct costs
• Direct material

Material out of which a product is manufactured or that becomes a physical part of a product.

Direct material is what becomes of raw material when it moves from inventory to cost of goods sold.

• Direct labor

Employee benefits accruing to employees directly involved in the production of product (rendering of services: below).

These typically include wages and costs such as overtime, social security taxes, health insurance, safety and hazard insurance, meals, clothing, work aids, etc. They may not, however, include any employee benefits for any activity besides production as discussed in the excluded items section further down this page.

• Indirect costs (manufacturing overhead)
• Fixed

Commonly, depreciation, amortization and rent. Fixed costs may also include, for example, royalty payments, supervisor salaries and other costs that do not change with production volume.

Note: costs do not need to be linear to be fixed. For example, depreciation determined using a diminishing balance method would be a fixed cost even though it is not a straight line expense. The key distinction between fixed and variable costs is that the former are not correlated with production volume while the latter are.

• Variable

Variable costs change together with production volume. The correlation need not be exact, but it must exist. If it does not, they the costs are fixed, not variable.

variable costs most often comprise factory (production) supplies, consumables (small tools not capitalized), repairs and maintenance (MRO), quality control and inspection, utilities (electricity, fuel, water, sewage, waste removal, etc.) or setup and re-tooling.

As outlined in IFRS 18.80 | ASC 220-40-50-6, an entity should recognize "raw material" | "purchases of inventory," which generally includes materials or supplies consumed during the manufacturing process. Nevertheless, it is good practice to classify material consumed in the production process as manufacturing overhead (indirect costs) instead of including it in direct material.

While this distinction is not explicitly mandated by IFRS | US GAAP, it is widely accepted and appropriate for accurate cost allocation and reporting.

Some entities treat low-value (also known as small) assets like production supplies, expensing them as they are acquired. This practice is particularly common in jurisdictions where national GAAP sets explicit monetary limits for asset capitalization. While neither IFRS nor US GAAP sets explicit universal thresholds for capitalization, the concept of "low-value" assets was discussed during the development of IFRS 16 | ASC 842, with a value of approximately $5,000 cited as a practical benchmark in the Basis for Conclusions of both standards. Although this amount is not a formal capitalization limit under either framework, it has become a widely accepted practical threshold when making capitalization versus expense judgments.

This site does not recommend expensing assets solely based on acquisition value. Instead, it recommends capitalizing such low-value assets using group or composite depreciation methods, as discussed on this page.

Quality control generally refers to the overall process of ensuring that products meet quality standards, while quality inspection specifically involves examining products or processes to detect defects. Both activities are typically classified as indirect production costs.

As a rule, setup and tooling costs are included in the acquisition cost of the item(s) of PP&E when those items are initially recognized. Once such item(s) have been initially set up, any subsequent setup and retooling costs cannot be capitalized to PP&E but should instead be capitalized to inventory and allocated to the related production run.

Depending on how production is organized and personnel compensated, they may or may not include costs such as supervisor or production manager salaries. However, regardless of their composition, care must be taken that variable costs never include any of the excluded items discussed further down this page.

As such, this page addresses both the accounting for receivables and revenue recognition simultaneously.

With respect to revenue recognition, the two key issues are timing and amount.

Both of these are discussed on this page.

However, as the timing of revenue recognition coincides with the timing of inventory derecognition, an additional discussion of this issue is provided on the inventory page.

• Services

Including services on this list always raises eyebrows. But it does have, albeit tenuous, support in the guidance.

IAS 2.6.c (edited, emphasis added): Inventories are assets: ... in the form of materials or supplies to be consumed in the production process or in the rendering of services | c To be currently consumed in the production of goods or services to be available for sale.

ASC 330.20.c states: Inventory: The aggregate of those items of tangible personal property ... c To be currently consumed in the production of goods or services to be available for sale.

While this IAS 2 specifically refers to materials or supplies IFRS 15.91 to 98 specify that both incremental costs of obtaining a contract and costs to fulfill a contract must be capitalized. This guidance applies all entities manufacturers and service providers alike.

Similarly, those ASC 330 specifically discusses items of tangible personal property, ASC 606-10-15-5 mentions and ASC 340-40-25-1 to 8 provides comparable guidance.

Given that revenue guidance is considerably more modern than inventory guidance, a more flexible interpretation of the latter is justified.

More importantly, the argument that accrued service costs may not be included in inventory because services lack physical substance misses the point.

As discussed above, inventory is not the point. Cost of sales is the point.

Put less simply, giving due consideration to the materiality constraint, coupled with the incontrovertible fact that all costs related to the provision of services are ultimately subsumed within cost of sales, service providers may, with a degree of justifiable latitude, elect to construe the antiquated and arguably obsolete guidance pertaining to inventory through the interpretative prism afforded by the contemporaneously updated revenue recognition standard, namely IFRS 15 | ASC 606. Determined by analogy, the policy of capitalizing all costs directly related to revenue into a single asset item—rather than dispersing them among various disjointed assets—thereby eschewing the historically arbitrary bifurcation predicated upon the archaic goods versus services dichotomy, the abrogation of which constituted one of the principal objectives of the comprehensive project culminating in the issuance of IFRS 15 | ASC 606, a standard promulgated expressly as a wholesale replacement for IAS 18 | ASC 605, rather than as a mere incremental amendment, reflecting the broader recognition that antiquated accounting infrastructure frequently necessitates wholesale demolition and replacement, not mere cosmetic renovation or superficial rebranding, would be justifiable.

Be that as it may, the juice is probably not worth the squeeze?

While the above argument should be sufficient to convince even the most pedantically inclined auditor to accept the policy, is it worth the effort?

As a general rule, practitioners only have so many matches. Is it worth burning one just to prove a point?

Put another way, is tilting against the pedantic predilection to apply irrational and outdated guidance verbatim worth the time and, since auditors often bill by the hour, expense?

As a wise man once said: Más vale buen acuerdo que buen juicio.

So if the auditor balks at including accrued service costs in inventory and would rather see them recognized as accruals, why not make them happy and acquiesce?

Note: the above only applies to basic, point-of-time services or those measured cost-plus. More complex services, accounted for as projects, fall into the contract asset category outlined in IFRS 15 | ASC 606. A more detailed discussion of this issue is provided in the Percentage of completion (over time) section of this page.

On the balance sheet inventory is classified:

• Merchandise

The balance sheet recognition of merchandise generally aligns with the description of merchandise (above).

However, additional points need to be made:

• While the cost of merchandise is always capitalized, the costs associated acquiring merchandise (locating sellers, shipping, handling, storage, etc.) are often expensed (as cost of goods sold) as incurred, even though this policy would not be consistent with the letter of the guidance (as discussed above).

• While neither the IASB nor FASB XBRL taxonomy considers merchandise sufficiently material to be included on a standard balance sheet, both include it in the footnotes as Merchandise and RetailRelatedInventoryMerchandise respectively.

• Since merchandise is specifically mentioned in the guidance (IAS 2.8 and 37 | ASC 330-20), if it represents 5% or more of total assets, it would need to be presented as a separate, balance sheet line item. A supplement discussion on how to determine materiality is provided on this page.

• As the accounting for merchandise is practically indistinguishable from the accounting for raw material, the two are often reported as a single line item even though they would be recognized in separate COA accounts.

• Raw material

The balance sheet recognition of raw material generally aligns with the description of material (above).

However, additional points need to be made:

• While the cost of raw material is always capitalized, the costs associated acquiring raw material (locating sellers, shipping, handling, storage, etc.) are often expensed (as cost of goods sold) as incurred, even though this policy would not be consistent with the letter of the guidance (as discussed above).

• While the FASB XBRL taxonomy considers raw material sufficiently important to be included as in item on a standard balance sheet (InventoryRawMaterialsAndSupplies) and reported in the footnotes (InventoryRawMaterials), IASB XBRL only reports it in the footnotes (RawMaterials).

• Since material is specifically mentioned in the guidance (IAS 2.8 and 37 | ASC 330-20), if it represents 5% or more of total assets, it would need to be presented as a separate, balance sheet line item under both IFRS | US GAAP. A supplement discussion on how to determine materiality is provided on this (page).

• As the accounting for raw material is practically indistinguishable from the accounting for merchandise, the two are often reported as a single line item even though they would be recognized in separate COA accounts.

• Raw material transforms into the direct material component of cost of goods sold when finished goods are transferred to a customer. An additional discussion of this issue is included in the following sub-section.

ASC 220-40-55-11 illustrates how the guidance provided by ASC 220 would be applied to various income statement items. Although an illustration, unlike IFRS where illustrations are not considered core guidance, the ASC makes no distinction between illustrations and its remaining guidance. This implies that the disaggregation outlined below is mandatory. What is not, however, mandatory are the exact line ites that will comprise the disaggregation. Obviously, as each entity will have different material expenses or groups of expenses, a one size fits all list is not possible. Which is also the reason the guidanc is presented as an illustration rather than a comprehensive list.



IFRS provides no specific guidance requiring a detailed level of disaggregation similar to that found in ASC 220-40-55-11. Nevertheless, since all material items must be disclosed as outlined in IFRS Practice Statement 2, auditors may require comparable disaggregation. Auditors also have the authority to issue a qualified opinion if material disclosures are omitted.

Note: research conducted by the author of this page for an auditor client indicated that this level of granular disclosure is relatively rare among entities subject to EC 1606/2002. This observation suggests inconsistency in how auditors interpret and apply IFRS Practice Statement 2 in the EU context.

Also note: the engagement mentioned in the previous note did not require a statistically representative sample nor academic rigor. Therefore, the conclusions presented here should not be given the credence reserved for peer-reviewed research. Specifically, readers of this page are advised to either repeat the research for themselves or seek out peer-reviewed research.

• WIP

Interestingly, ASC 330 uses the term work in process, which accurately describes the manufacturing process of transforming raw materials and supplies into finished products.

In contrast, IAS 2 uses work in progress, which more suitably describes the progress a building makes from foundations to finished structure.

In practice, the acronym WIP solves the problem with little fuss.

At the risk of belaboring the point, a small subset of practitioners delight in often gratuitously nuanced disputations regarding the precise semantic fidelity and philological exactitude of arcane and highly specialized terminological constructs, particularly when interacting with similarly inclined cohorts who manifest an almost compulsive fixation upon the literal and verbatim phraseology enshrined within extant authoritative guidance. There concurrently exists a divergent faction of professionals who consciously eschew such lexical fastidiousness in favor of concentrating their intellectual and practical energies upon matters of substantive import and pragmatic consequence.

The former argue about whether to call it work in process or work in progress. The latter simply say WIP.

• Finished goods

The term finished goods is self-explanatory. It denotes goods that are finished.

On the profit and loss statement inventory becomes:

Previously just good practice, US GAAP requires a granular breakdown of cost of sales .

Reinforcing previous best practice, from 12/16/2026 ASC 220-40-55-11 mandates a disaggregation of expenses consistent with the following illustration:

IFRS, in contrast, does not provide specific guidance on the level of disaggregation required.

As a general rule, a line item is disaggregated if its constituent parts can be separately recognized and are material.

For example, if an entity only sells merchandise, it would only report a single cost of merchandise sold line item even if merchandise represented 70% of total expenses.

In contrast, if the entity sold products, it should disaggregate cost of sales and report, for example, direct material, direct wages, depreciation and other production overhead.

However, IFRS does not mandate the detailed disaggregation required by US GAAP (above).

Instead, materiality, as defined in IFRS 18 (A), guides overall presentation while additional guidance on making materiality assessments, including decisions about disaggregation, is found in practice statement 2.

However, PS 2.4 states: the Practice Statement provides non-mandatory guidance; therefore, its application is not required to state compliance with IFRS Standards. Consequently, auditors may recommend disaggregation based on materiality considerations, but cannot insist on it unless a specific standard or interpretation explicitly requires it.

Thus, unlike under US GAAP, IFRS entities often present considerably less granular cost breakdowns. Reflecting this, the IASB XBRL taxonomy does not include detailed cost components such as direct material (CostDirectMaterial), direct labor (CostDirectLabor) and overhead (CostOfGoodsAndServicesSoldOverhead), like the FASB taxonomy. Interestingly, it does include the cost of merchandise sold item (CostOfMerchandiseSold), even though it omits the broader cost of goods sold item.

• Direct material

Material that has become a physical part of a product (above).

Instead of direct material, a retailer would report merchandise (above).

• Direct labor

Employee benefits | wages accrued to workers engaging in production activity.

This issue is discussed in direct labor subsection above.

• Indirect production costs (overhead)

In an IFRS or US GAAP context, overhead is generally taken as a synonym for indirect production costs and comprises costs such as depreciation of manufacturing facilities or electricity consumed by production machinery.

In a national GAAP context, it is occasionally an arbitrarily determined portion of administrative or general expenses classified as cost of sales at management discretion. While it may be possible to justify allocating some or a portion of some, for example, managerial salaries to production overhead, care must be taken so the guidance provided by IAS 2.16.c | ASC 330-10-30-8 properly and rigorously applied. This is especially important if an international subsidiary primarily applies local GAAP and only makes adjustments to arrive at an IFRS | US GAAP reporting package for its parent.

ASC 330-10-30-8 provides clear and succinct guidance stating (edited): ...under most circumstances, general and administrative expenses shall be included as period charges, except for the portion of such expenses that may be clearly related to production and thus constitute a part of inventory costs (product charges)...

While marginally less direct, IAS 2.16 does specify that administrative overheads that do not contribute to bringing inventories to their present location and condition are excluded from inventory and expensed in the period.

Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which they are incurred are: (a) abnormal amounts of wasted materials, labour or other production costs; (b) storage costs, unless those costs are necessary in the production process before a further production stage; (c) administrative overheads that do not contribute to bringing inventories to their present location and condition; and (d) selling costs.
• Fixed

Production related costs that are not correlated with production volume.

This issue is discussed in fixed cost subsection above.

• Variable

Production related costs that are correlated with production volume.

This issue is discussed in variable cost subsection above.

Inventory excludes:

• Administrative and general expenses

As outlined in IAS 2.16.c | ASC 330-10-30-8, administrative expenses may not be included in inventory or, more importantly (above), cost of sales.

Also discussed above, the brevity of the guidance means it limits itself to a simple prohibition without outlining any criteria to be used to distinguish costs that may be included versus costs that may not.

Using employee benefits as a proxy, the conservative approach would be to include only wages paid to production workers. This guarantees that only costs clearly associated with production are included.

Next most conservative: including direct wages and supervisor salaries. As work and the supervision of work are inseparable, this is the most common and best approach.

While not particularly popular with management, auditors love this approach.

In contrast, any attempts to include any management compensation will raise eyebrows.

Specifically, to paraphrase ASC 330-10-30-1, is the compensation paid to this member of management directly or indirectly necessary in bringing an article of inventory to its existing condition and location? Are you sure it is?

To quote ASC 330-10-30-8: Also, under most circumstances, general and administrative expenses shall be included as period charges, except for the portion of such expenses that may be clearly related to production and thus constitute a part of inventory costs (product charges).

Are you really sure this compensation qualifies as an exception to this general rule? Are you prepared to prove this compensation qualifies as an exception to this general rule? Are you sure you are not risking a qualified audit opinion just to make management happy? Really, really?

Well then, OK, go ahead.

While comparable, in a seeming role reversal, IFRS is stricter. Instead of being couched as a discussion of a principle, the guidance is a rule:

Black IAS 2.10 (emphasis added) states: the cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Grey IAS 2.16 (edited) clarifies: ... excluded from the cost of inventories ... c) administrative overheads that do not contribute to bringing inventories to their present location and condition.

More adventurously: production manager salaries could be included. However, auditor skepticism should be anticipated and sufficient documentation to justify this policy prepared and presented.

The pinnacle: not only intermediate management but the plant manager is included. However, as one ascends the hierarchy, the higher a manager the broader his or her responsibilities, which makes both the justification and bifurcation more onerous. While tools such as the IDI Time Bank can aid the process, but auditors will invariably scrutinize any allocation scheme to ensure that only costs demonstrably associated with production-related tasks are recognized. Developing documentation that provides auditors with irrefutable evidence that the chosen policy complies with both the letter and spirit of IAS 2.16.c and ASC 330-10-30-8 is often so onerous, many entities simply desist.

With the complexities of management compensation duly addressed, applying the same to the remaining costs becomes markedly more straightforward. For example, the fuel, depreciation or repairs associated with a vehicle used to both will-call materials and deliver finished goods would be determined and bifurcated, the former could be capitalized to inventory (or simply expensed, above, to cost of sales) while the latter expensed as selling or distribution.

• Selling (distribution) expenses

As outlined in IAS 2.16.d | ASC 330-10-30-8, distribution | selling expenses may not be included in the cost of inventory or, more importantly (above), cost of sales.

Also discussed above, the brevity of the guidance means it limits itself to a simple prohibition, without outlining any criteria to be used to distinguish costs that may be included versus costs that may not.

Fortunately, put colloquially, interpreting this guidance is a no-brainer.

No accountant would ever consider including, for example, salespersons' commissions, distributor rebates, trade show costs, travel, entertainment, or any demonstrably selling expenses in either inventory or cost of sales.

When it comes to distribution or selling costs tied to delivery or shipping, the distinction becomes less clear-cut. But, fortunately, double freight and rehandling have their own, stand-alone guidance.

• Double freight

While not explicitly mentioned by the guidance, double freight is commonly understood to mean the cost of shipping goods to a customer.

IAS 2.11 provides the more understandable guidance stating (edited): the costs of purchase of inventories comprise ... transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services.

While it does suggest services may need to be shipped (perhaps by truck or train), the guidance makes clear that double freight, as it is not directly attributable to the acquisition of finished goods or materials but rather their sale, cannot be included.

In contrast, ASC 330-10-30-7 only discusses abnormal freight and handling costs. Nevertheless, ASC 330-10-30-1 also discusses expenditures or charges directly or indirectly incurred in bringing an article to its existing condition and location, so the guidance is comparable.

The result of applying each guidance is thus comparable: double freight is a selling or distribution expenses and may not be capitalized to inventory or, more importantly (above), expensed through cost of sales.

• Rehandling

Like double freight (above), rehandling is a term commonly used in practice rather than by the guidance.

In IFRS rehandling falls under both the general guidance provided by IAS 2.11 and the specific guidance provided by IAS 2.16.b.

In US GAAP, it is not specifically addressed, but falls under same (ASC 330-10-30-7 and ASC 330-10-30-1 ) guidance as double freight.

However, this is just a formality and has no palpable influence on the accounting so it would be treated the same under both sets of guidance.

In general, two types of rehandling occur.

In the first type, a retailer first acquires merchandise from its manufacturer then ships it to a central distribution center, then a regional distribution center, then a local warehouse and finally a retail outlet.

Only the first cost, acquiring the merchandise, would qualify as inventory, or more importantly (above), cost of sales. The remaining costs, transportation, warehouse depreciation (or rent), warehouse staff, etc., are associated with the distribution channel, so recognized as distribution or selling expenses, even if substantial.

In the second type, a manufacturer first acquires material from its producer in country A then ships it to country B where some production steps are taken. It then ships the WIP to country C, where production is finalized. It then ships the finished goods, in bulk, to country D where the finished goods are packaged so they can be offered for sale in country D's language.

As with merchandise, the initial cost is included in inventory or cost of sales. So is the cost of shipping from A to B, and B to C. However, the cost from C to D is expensed. On the basis of what criterion?

The two most commonly used criteria are physical functionality and intended-use.

If the first is applied, the accountant determines where the product becomes physically capable of serving its purpose.

As the packaging in country D has no effect on physical functionality, and is merely done to facilitate the product's sale, the C to D leg is a selling or distribution expense.

However, what if the product produced in C were a television?

It may be possible to mail a memory card in an envelope. However, if a TV is shipped with protective packaging, it will have physical functionality only at the beginning of its journey.

Thus, in this situation, the repackaging is essential to maintaining physical functionality so the C to D leg would be included in inventory or cost of sales.

The question is, why would any accountant, if not an expert on assessing physical functionality, apply this criterion?

In another example, the item produced at C was a car door. This door could either be shipped to country D where production would continue to finished automobile. It could also be shipped to country E, where it would replace a door damaged in a collision.

In this, recognition takes care of itself: the cost of shipping WIP falls into inventory or cost of sales, while the cost of shipping finished goods is a selling or distribution expense. Simple.

Besides requiring no judgment, the intent criterion carries the added benefit of being fully consistent with the logic behind IFRS | US GAAP, even if it leaves some accountants, especially those just starting out with IFRS | US GAAP, shaking their head in disbelief.

IFRS | US GAAP focus on the financial. IFRS even goes so far as to include this word in its title.

In contrast, many national GAAPs focus on the physical. For example, many have an additional "semi-finished goods" inventory category that reflects this perspective.

Specifically, these GAAPs draw a distinction between partially manufactured goods and fully manufactured items. For example, an electric motor would be a semi-finished good, while the washing machine, once the motor (and all the other semi-finished goods) was installed, would be the finished product.

This reflects the assumptions that are the foundation for the guidance.

Under the labor theory of value, economic value is created by combining labor and material with the help of physical capital.

Under the exchange theory of value, economic value is created not by creating a physical thing but by creating something someone wants to buy.

Under the labor theory of value, the distinction between partially created value and fully created value has to be given accounting recognition during the production process.

Under the exchange theory of value, this is irrelevant because no value is created until the moment of sale.

Unfortunately, theory can also influence behavior.

For example, in accounting based on the labor theory, a change in inventory is recognized by debiting inventory/crediting revenue.

This may, and has, led careless managers to assume they are creating value even though they are only producing goods no one will ever buy.

It can also lead to warehouses full of unwanted goods lingering for years, even decades, because, since physical existence has value, testing for net realizable value has no economic foundation.

Under the labor theory of value, accountants also have to examine, for example, where in the production process a product achieves its physical functionality after which no additional value can be added.

In contrast, under the exchange theory of value, the only issue an accountant has to consider is whether the cost was associated with the exchange or not.

To accountants moving from a national GAAP environment to IFRS | US GAAP, it may seem as if something is missing.

It is not. It really is that simple.

• Abnormal waste

As outlined in IAS 2.16.a | ASC 330-10-30-7, abnormal amounts of wasted materials (also known as wastage, spoilage or shrinkage) may not be included in the cost of inventory or, more importantly (above), cost of sales.

Also discussed above, the brevity of the guidance means it limits itself to a simple prohibition, without providing detail to help identify abnormal waste or distinguish it from normal waste. In practice, this gap is filled by the "reasonably preventable" criterion in that, simply being able to avoid wastage does not, in and of itself, make it abnormal.

Thus, being absolutely preventable is not sufficient to tip the scales. The operating procedures, business policy or management technique also needs to be reasonably applicable rather than counterproductive.

For example, consider a manufacturer using steel pipes in its production. The pipes come in a standard length which the manufacturer cuts into usable portions. Each pipe yields five usable portions. The sixth portion is too short and scrapped.

In the real world, scrap is sold. However to keep this illustration straightforward, in its simplified world, scrap has no market value.

To assess whether the waste was normal or abnormal, the manufacturer compares the cost of a standard length pipe (100) with the price (120) of a non-standard length pipe. Assuming the scrap is 10% of the whole, spending 20 to save 10 would not be reasonable so the wastage is normal.

While I have never had a pipe manufacturer as a client, during a training, I discussed this with accountants from a pipe manufacturer. They confirmed that their company hated special orders, which required stopping production, resetting the cutting length and restarting production. While they did do special orders, they only did them for repeat customers and always at a premium (unless the customer happened to order a very unusually large run).

However, the real world is rarely this straightforward.

What if the pipe's producer only wants 110. Placing a special order to save zero is not reasonable: normal.

What if the pipe's producer only wants 109. Annoying suppliers for marginal savings is not reasonable: normal.

In my spare time, I am MD at a company providing programming and support services. Most customers are easy to work with, require reasonable delivery times, are happy even if we use mostly off-the-shelf modules, rarely request rework, and pay on time. Troubleshooting is also straightforward because they clearly identify their bugs.

However, one customer was not like this. Never satisfied, always making special requests, always haggling on price, incapable of identifying problems, and consistently paying late. A nightmare.

As I am merely charged with managing a national branch of a larger entity, I do not have the authority to terminate customers without approval. And this approval is practically never given. But what I do have authority over is the project queue (except for in-house support; that always comes first). I made sure this customer's requests were always at the end of the line. Even if other projects had flexible timeframes, this customer's projects were always last. And if they did happen to get done quickly, I made sure they were tested and retested; unless the programmers had better things to do, in which case they could wait to be tested.

When it came time to negotiating price, I always started with a 50% annoyance premium. Sometimes I would settle for just 25%, but they always paid extra. After all, a reasonable price has to reflect both the aggravation they caused and my time they wasted. When the customer finally decided to switch suppliers, the team cheered.

What if the pipe's producer only wants 105. Special orders do not upset us; 5% is a significant relative to the cost of pipe; no reasonable explanation: abnormal.

To save the effort of quantitative analytical techniques, many administrative workers default to the simplest of all criteria: historical experience.

The argument goes: it was 10% last year; it was 10% the year before that; 10% is normal.

While the historical experience criterion does have its place, for example in estimating future returns and warranty provisions or uncollectible accounts receivable, it is not appropriate for evaluating whether wastage is normal or abnormal.

Unfortunately, as this is not explicitly outlined in the guidance, accountants not adept at interpreting vague instructions only find out after an auditor identifies the error and demands its correction.

The problems with auditors, they may not notice the error right away. As they test, the error may not show on the test unless it gets picked at random or until it becomes too large to ignore. By then it may be too late to fix the error in the current period so IAS 8.42 | ASC 250-10-45-23 becomes applicable. This means going back, sometimes maybe years back, identifying all the affected periods, correcting the accounts and restating the financial reports.

Oops.

Once it has been determined the wastage is abnormal, the wastage must be appropriately classified. The guidance does not specify where the abnormal wastage is recognized. It only specifies that it may not be recognized in inventory and, by implication, cost of sales. However, the waste was caused by insufficient management control over the purchasing function, it would be classified as an administrative expense.

In another situation, a retailer sells, among other items, fresh fruit and vegetables. Wednesday evening the produce purchasing manager is watching TV. The report for the weekend is hot and sunny. Rather than a standard 100 tonne order, the manager doubles down, ordering 200 tonnes. However, the weekend is cold and rainy. Instead of salad, customers stock up pork roast and dumplings.

As the extra 100 is not sold, it must be liquidated. Was this waste preventable?

Yes. If, instead of ordering 200 the manager had ordered 100, it would have been prevented.

Was it reasonably preventable?

Perhaps. If the manager had based the purchasing decision on a stochastic analysis of weather patterns, perhaps utilizing a Monte Carlo simulation to quantify a most likely outcome, while the decision may not have been fully accurate, it would have likely been less inaccurate than if based simply on a TV weather report.

As a company should reasonably expect its managers to use rigorous analysis in their decision making, the wastage was reasonably preventable.

The counter-argument: no stochastic analysis, including Monte Carlo simulations, can fully attenuate potential losses caused by variables of such inherent unpredictability as the weather. Thus, any policy that fails to balance the inherent unpredictability of future events with the need to make managerial decision whose ultimate outcome can only be evaluated in retrospect risks instilling a risk averse mindset which can be almost as destructive for shareholder value as management carelessness.

This puts the accountant in the difficult position of arbitrator. When is an erroneous managerial decision reasonably preventable and when is it not.

Fortunately, this is above the pay grade of practically all accountants. Instead, all an accountant needs to do is flag any erroneous managerial decision. This way, the decision is pushed up the chain of command to a level where its reasonableness can be evaluated by informed senior managers, who can then take corrective action.

The worst thing an accountant can do, allow themselves to be swayed by such arguments, simply classify it as normal waste and call it a day.

I once had a client, a retailer of, among other items, fresh fruit and vegetables. While we were discussing the issue at hand, the conversation turned to why I was there. The new accounting manager had to make sure the policy he was implementing was consistent with the guidance.

Why was he new? Because his predecessor allowed himself to be convinced by the argument that the purchasing department had no control over the weather. Consequently, he failed to flag the wastage as excessive. As such, it remained in cost of sales where, as cost of sales was a large number, the purchasing department hoped it would remain hidden forever. After some time, a team from internal audit arrived. Their concern was the statistically significant anomaly in the cost of sales reported by this location compared to that reported at other, comparable locations. After reviewing the pertinent documentation, the team concluded that the purchasing department had failed to use adequate stochastic analysis of weather patterns, particularly utilizing Monte Carlo simulations to precipitate the most advantageous possible outcome. As a result, the purchasing department was reorganized and newly staffed with individuals adroit in appropriate decision making techniques. Also as a result, the accounting department was reorganized and newly staffed by individuals with sufficient judgment to apply guidance, such as IAS 2.16.a | ASC 330-10-30-7, correctly.

Thus, if abnormal waste is caused by inadequate managerial decision making, it should be classified as an administrative expense allowing review at a higher administrative level.

Unfortunately, should not must, at least not under IFRS.

Specifically IAS 2.38 (edited, emphasis added) states: The amount of inventories recognised as an expense during the period, which is often referred to as cost of sales, consists of those costs previously included in the measurement of inventory ... and abnormal amounts of production costs of inventories...

Interpreted literally, this guidance indicates that including abnormal waste in cost of sales is appropriate. However, as discussed here, doing so may cause abnormal waste to be mistaken for normal, preventable waste, thereby hindering the corrective actions also discussed here.

Fortunately, if abnormal waste is material, auditors will require it to be flagged and, in all likelihood, excluded from cost of sales. Nevertheless, auditors would not be able to issue a qualified opinion solely because this exclusion was not made. Obviously, immaterial abnormal waste would not need to be flagged at all, and could be reported in cost of sales without explicitly violating any guidance.

In contrast, ASC 330 does not address cost of sales but focuses solely on inventory, requiring abnormal waste to be excluded. ASC 705 discusses cost of sales but simply refers to ASC 330. This implies that only those items explicitly includable in inventory may be included in cost of sales, and thus including abnormal waste in cost of sales would be an error and grounds for a qualified opinion.

Obviously, the above applies to, for example, an accounting manager at a subsidiary of a larger entity. In contrast, a chief accountant or chief accounting officer's task is to, in consultation with the company's independent external audit, establish adequate internal controls to make certain the guidance is applied correctly.

This is especially important at an entity applying US GAAP as, in addition to ASC guidance and SEC regulations, such entities, and the responsible member of management, are also subject to legal requirements, particularly those imposed by Sarbanes-Oxley, section 404.

Another issue. Assume the company buys 100 tonnes of fruit and vegetables. Will it sell 100 tonnes? No. Why? If the company offers the goods in a standard retail environment, allowing its customers to self-serve, a portion of the produce, commonly around 10%, will remain unsold no matter what the company does. Is it possible to prevent customers from mishandling this fragile merchandise? Is it possible to prevent them from selecting only the most attractive merchandise? Yes, it is. But this would require a specially trained employee to handle the merchandise and dispense it to customers.

Is an over-the-counter model the best model for selling fresh produce? Probably not.

However, as the wastage is not related to the acquisition of the produce, but rather its sale, it would need to be classified as selling or distribution, not inventory or cost of sales.

The same logic applies in other retail settings. While there are techniques to minimize shoplifting, preventing shoplifting requires over-the-counter sales.

While consumers accept this retail model for, for example, jewelry, watches, or sneakers (they may even accept the model where the displayed goods are not even freely sold but reserved for only "special" customers—perfected by brands such as Rolex and Ferrari), they will balk when it comes to most retail goods.

The point is, as there is no explicit criterion for distinguishing normal and abnormal wastage, judgment must be applied. As there is no guidance on how the wastage must be reported, judgment must be applied.

This also implies that auditors frequently test whether the normal/abnormal distinction is supportable, particularly internal auditors (external auditors will also test, but either at random or if the amounts are material).

• Idle or underutilized or production capacity

While subsumed by the overall guidance on normal capacity (IAS 2.13 | ASC 330-10-30-6), low production or idle plant | abnormally low production or idle plant, popularly known as underutilized production capacity, is sufficiently important to warrant a separate, stand-alone discussion.

For example, assume a manufacturer planned to manufacture 10,000 units of a product annually and thus acquired a production line with an annual capacity of 10,000 units. For simplicity, also assume the plant cost 1,000,000 and had a life of 10 years. Each time a unit was produced, depreciation of 10 would be allocated to that unit.

However, assume that once production started, annual demand was for only 5,000 units. As a result, the manufacturer could not simply allocate 20 to each unit, as this would not be consistent with IAS 2.13 | ASC 330-10-30-6. Instead, 10 would be capitalized to inventory and the remaining 10 recognized as an administrative expense.

As with abnormal waste discussed above, costs associated with underutilized production capacity should be classified as administrative expenses. Rather than repeating the reasoning here, readers are encouraged to revisit the previous section, which is more common and controversial.

This accounting treatment is, however, predicated on the depreciation period being determined using a technological or commercial obsolescence criterion.

A discussion on the criteria used to determine useful life and depreciation period is provided on this page.

If the depreciation period is determined using a physical wear and tear criterion, the manufacturer could adjust the depreciation period to reflect that the plant was used at half capacity, which would logically extend its useful life by a like percentage.

Note: IAS 16.51 requires an annual review of the useful life of assets. IAS 16.55 prohibits the cessation of depreciation unless a units-of-production depreciation method is used. Unfortunately, auditors occasionally combine this guidance to mean that unless a units-of-production depreciation method is used, an asset's depreciation period may only be adjusted once per year, in the context of an annual review. This is an overly ambitious interpretation of the actual guidance and simply reflects an option that is not actually supported by the letter of the guidance.

Also note: as US GAAP has no requirement comparable to IAS 16.51 and 16.55 annual review, this issue has never come up in a US GAAP context.

Additional Illsues:

• Cost flows
FIFO

As the name implies, first-in first-out tracks cost flows by assuming the oldest item is removed first. Picture a silo where fresh grain is placed on top and grain to be processed into flour is taken from the bottom.

Note: Of all the inventory tracking methods, FIFO is the simplest to apply, making it the most popular method among entities that keep their accounts in Excel. Conversely, although they may use this method, most entities applying IFRS | US GAAP use automated systems that are capable of calculating the preferred method, weighted average, automatically.

Weighted average

As the name implies, the weighted average method tracks cost flows at their weighted average.

Note: while IAS 2.25 specifies that the avarage must be weighted, ASC 330-10-35-1B simply discusses an average. Neverthless, as using a simple average would not yeild an accurate result, a weighted average suld be used under both IFRS and US GAAP.

LIFO

As the name implies, last-in first-out tracks cost flows by assuming the newest item is removed first. Picture a box of rocks where rocks are both added and taken from the top.

As this method can be used to create hidden reserves, LIFO is not allowed under IFRS.

As LIFO is allowed for US tax purposes only if used in financial reports, it is allowed under US GAAP.

Currently, Japan is the only other jurisdiction that allows LIFO. That said, since LIFO is not allowed under IFRS and almost no Japanese companies use US GAAP, this point is included here for completeness rather than practical importance.

Note: unlike the US, most jurisdictions disallow LIFO for taxation purposes thus dual national GAAP : IFRS filers do not need to make any adjustments. However, a dual US GAAP : IFRS filer would need to make adjustments if it elected to use LIFO for US GAAP purposes.

Also note: the tax advantage of LIFO is predicated on an inlationary envornment. As prices have been, except for a blip or three, stable for the past 40 years, it has gradually gone out of favor.

• Normal capacity

As noted above, the asset/liability model prevents the guidance from simply stating: when calculating cost of sales do not forget to adjust fixed costs so they can be treated as if variable. That would be too easy.

Instead the guidance says "... the allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities. Normal capacity refers to a range of production levels. Normal capacity is the production expected to be achieved over a number of periods or seasons under normal circumstances..."

Unfortunately, ASC 330-10-30-3 does not specify how the "range of production levels" should be calculated. Fortunately, after reading IAS 2.13 "Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances..." it is clear that it would be an average.

So what the guidance is saying, pretend as it actual capacity is fixed by calculating its average. The allocate fixed costs to that fixed average. This is done on the asset side of the coin.

On the expense side of the coin one pretends fixed costs are variable and allocates this variable cost to cost of sales made variable by variable production.

As a coin is the same regardless of which side it happens to by lying on, both approaches lead to exactly the same result. The difference, the math for one is a walk in the park while for the other it involves some strenuous calisthenics.

• Lower of cost or market

Inventory is tested for recoverability by comparing its cost and net realizable value.

While IAS 2 does not provide any specific guidance on the issue, ASC 330-10-35-14 outlines a clear preference of a one per fiscal year test. Specifically, according to the letter of this guidance, a reduction to NRV recognized at the close of a fiscal year is irreversible. This implies that while entities can test more frequently than annually, this has no consequence as fat as the financial report is concerned, because any write-down made that is not made at the end of fiscal year is reversable.

Note: ASC 270-10-45-6 does provide additional guidance for interim periods, but does not change the core guidance provided by ASC 330-10-35-14.

Technically, recoverability is only explicitly mentioned by IAS 2.28, which states (edited): The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined...

Nevertheless, ASC 330-10-35-1B (edited) states: ...When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs...

Since checking to see if net realizable value is lower than cost is what testing for recoverability means, the guidance is comparable.

Both IFRS and US GAAP compare the original cost of the inventory with its net realizable value. Both define NRV as the expected selling price in the ordinary course of business less the expected costs necessary to liquidate the inventory. If the inventory being tested is WIP, cost to complete is also deducted.

While similar, their guidance is not identical. Unlike IFRS which leaves the composition of estimated costs necessary to make the sale to judgment, US GAAP specifies they should include transportation.

More importantly, while US GAAP converged with IFRS by moving from its previous ceiling / floor approach to the simpler lower of cost and NRV, it did not do so across the board. That would have been too easy.

In line with its proclivity for eschewing clear, concise and easy to apply guidance whenever recondite, byzantine, and impenetrable guidance is possible, ASC 330-10-35-1B retains LCM for LIFO and retail method items. Also true to form, it goes into more detail.

ASC 330-10-35-1C: A departure from the cost basis of pricing inventory measured using LIFO or the retail inventory method is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to damage, physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.

ASC 330-10-35-2: The cost basis of recording inventory ordinarily achieves the objective of a proper matching of costs and revenues. However, under certain circumstances cost may not be the amount properly chargeable against the revenues of future periods. A departure from cost is required in these circumstances because cost is satisfactory only if the utility of the goods has not diminished since their acquisition; a loss of utility shall be reflected as a charge against the revenues of the period in which it occurs. Thus, in accounting for inventories, a loss shall be recognized whenever the utility of goods is impaired by damage, deterioration, obsolescence, changes in price levels, or other causes. The measurement of such losses for inventory measured using LIFO or the retail inventory method shall be accomplished by applying the rule of pricing inventories at the lower of cost or market. This provides a practical means of measuring utility and thereby determining the amount of the loss to be recognized and accounted for in the current period.

ASC 330-10-35-3: The rule of lower of cost or market is intended to provide a means of measuring the residual usefulness of an inventory expenditure. The term market is therefore to be interpreted as indicating utility on the inventory date and may be thought of in terms of the equivalent expenditure which would have to be made in the ordinary course at that date to procure corresponding utility.

ASC 330-10-35-4: As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. In applying the rule, however, judgment must always be exercised and no loss shall be recognized unless the evidence indicates clearly that a loss has been sustained. There are therefore exceptions to such a standard. Replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility.

ASC 330-10-35-5: Furthermore, when the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss shall be recognized even though replacement or reproduction costs are lower. This might be true, for example, in the case of production under firm sales contracts at fixed prices, or when a reasonable volume of future orders is assured at stable selling prices.

ASC 330-10-35-6: Paragraph superseded by Accounting Standards Update No. 2015-11.

ASC 330-10-35-7: Because of the many variations of circumstances encountered in inventory pricing, the definition of market is intended as a guide rather than a literal rule. It shall be applied realistically in light of the objectives expressed in this Subtopic and with due regard to the form, content, and composition of the inventory. For example, the retail inventory method, if adequate markdowns are currently taken, accomplishes the objectives described herein. It is also recognized that, if a business is expected to lose money for a sustained period, the inventory shall not be written down to offset a loss inherent in the subsequent operations.

If NRV ≥ cost, no action taken.

If NRV < cost, the inventory is written down to NRV.

However, such a straightforward summary does mask the challenges of applying the guidance in practice.

The first issue: the decline in value may be physical or financial.

For example, if a flood destroys merchandise in a warehouse, the decline is clearly physical. If a recession erodes customer buying power or expected deflation their incentive to spend, the decline is clearly financial.

However, in most cases, the physical and the financial are like the two sides of a coin.

In the absence of a clear dichotomy, the guidance covers both possibilities, and their blend.

IAS 2.28 states (edited): The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined.

ASC 330-10-35-1B (edited) states: [Loss recognition] may be required, for example, due to damage, physical deterioration, obsolescence, changes in price levels, or other causes.

Thus if the decline in NRV was caused by the merchandise falling, or being knocked, off a shelf, the decline in value would be just as real as if it were caused by a new model that causes the sales price of older models to fall.

Just as real but not (below) necessarily accounted for in the same way.

The second, arguably more important issue, the cause of the decline.

Unfortunately, while this issue does have the power to significantly affect how a decline in value is recognized and reported (or disclosed), the guidance is not clear-cut as it could be, particularly US GAAP guidance.

For example, the inventory item in question: notebook PCs. The notebooks in stock were acquired before the newer model, with a newer generation processor, was introduced.

If the loss had been caused by a simple break-in or fire, the accounting would have been effortless. It was not.

It was caused by something preventable. True, technological obsolescence cannot be avoided or, as the Luddites learned the hard way, prevented. But managerial decisions can be made to ensure obsolescence does not drag down earnings.

Specifically, notebooks were ordered by a purchasing manager who, while experienced, had previously worked in the white goods. Not realizing the obsolescence curves of refrigerators and notebook PCs were uncorrelated, the manager placed an excessive order.

Oops.

The problem is, ASC 330-10-35-1B, the same paragraph that also discusses obsolescence, states (edited, emphasis added): ...When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs...

However, would it be acceptable accounting policy to recognize and report a clearly reasonably preventable decline in value in a way that would make it indistinguishable from a loss caused by a fire or flood or perhaps even a change in currency exchange rates?

Clearly not.

Thus, ASC 330-10-35-1B may not be applied on a stand-alone basis but must be applied together with ASC 330-10-30-7 (above) to arrive at policy that not only pedantically reflects the letter of a single paragraph, but is consistent with the topic as a whole.

Fortunately, this is mostly a US GAAP-specific complication.

IAS 2.34 (edited) states: ... The amount of any write-down of inventories to net realisable value and all losses of inventories shall be recognised as an expense in the period the write-down or loss occurs...

While not as crystal clear as it could be, the guidance does distinguish between "write-down of inventories to net realisable value" and "losses of inventories," suggesting that an evaluation of the nature of the decline in value, and particularly whether the decline was preventable or reasonable preventable (not the same thing), should be performed and used to determine how the decline in value is reported on the profit and loss statement and/or disclosed in the footnotes.

Be that as it may, as a rule of thumb, if the decline in value was not preventable, it would be recognized and reported as a loss. If the decline was preventable, it would be examined carefully (as illustrated below). If the decline was reasonably preventable, it would be an expense. Which expense? That is discussed above.

• Full absorption costing

The term full absorption costing is not specifically mentioned in IAS 2 or ASC 330. Nevertheless, it is commonly used to describe the procedure those standards require.

In short, the process starts by recognizing acquired material as raw material. When production begins, raw material (or a portion) is first derecognized then recognized in WIP. As production continues, additional costs are added to WIP. These include direct wages, and both fixed and variable indirect production costs.

Once production is complete, the costs accumulated in WIP are derecognized and recognized as finished goods. Finally, when the product is sold, the finished goods are derecognized and cost of goods sold recognized.

The accounting for services is economically identical. Costs of services incurred before services are begun, or during their rendering but before revenue is recognized, are capitalized. They remain as assets until control over the services passes to the customer and revenue recognized. At this point, the previously capitalized costs are derecognized and recognized as cost of services rendered (or simply cost of sales). However, regardless of what the above discussion implies, the accounting for services is sufficiently different to be illustrated on a separate page page.

Note: an added benefit of illustrating services separately is that it satisfies the pedantic proclivities of those who claim that, just because the guidance is called Inventory, it applies only to inventory.

• Function / nature of expense

Inventory and cost of sales (above) are two sides of the same coin, so discussing one without the other is like trying to buy candy with a one sided coin.

Kidding aside, a related but also important issue: the nature or expense / function of dichotomy.

Particularly its practical implications.

A general ledger built on a nature of expense premise is an order of magnitude easier to apply. As this issue involves delving into account structure, it is covered in more detail in this section dedicated to the COA.

This section merely emphasizes that the recent update to US GAAP makes including a nature of expense account block not just good sense, but necessary as from 12/16/2026 ASU 2024-03 added ASC 220-40-50-6, which requires entities to disclose nature of expense expenses. This in turn requires them to keep track of these expenses.

Users who have downloaded any of our charts of accounts over the years are already covered. Users that have not, are encouraged to do so now.

Note: unlike IAS 1, which not only allows but considers nature of expense format as primary (and IFRS 18, which attempts to blend the two), ASC 220-40-50-6 only outlines disclosure requirements. Thus, entities will continue to publish function of expense income statements. Nature of expense income statements will remain disallowed under US GAAP.