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

IAS 2 is the IFRS standard that tells companies how to put a value on inventory and report it. It requires inventory to sit on the balance sheet at the lower of cost and net realizable value, limits the cost formulas you can use to FIFO, weighted average, or specific identification, and prohibits LIFO outright.¹ Those choices feed directly into cost of goods sold, reported profit, and the strength of the balance sheet, which is why the detail of IAS 2 inventories accounting matters so much in practice.

What Counts as Inventory

IAS 2 defines inventory as assets held for sale in the ordinary course of business, assets being produced for 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-built units on the shop floor, and raw steel waiting to be cut all qualify.

Some assets are outside the standard entirely. Financial instruments fall under IAS 32 and IFRS 9. Biological assets tied to agricultural activity, and agricultural produce at the point of harvest, sit under IAS 41 and use fair value less costs to sell rather than cost.² After harvest, produce becomes ordinary inventory and returns to IAS 2.³ Contract work in progress is handled through IFRS 15’s contract asset framework rather than through an IAS 2 exclusion.

Two groups stay in scope but escape the measurement rules. Commodity broker-traders measure their holdings at fair value less costs to sell, with changes going straight to profit or loss, because those stocks exist to generate short-term trading profit. Producers of agricultural, forest, and mineral products may measure inventories at net realizable value where industry practice supports it. Both still have to meet IAS 2’s recognition and disclosure requirements.²

How to Build the Cost of Inventory

Initial measurement is at cost, defined as everything spent to bring the items to their present location and condition. IAS 2 splits that into purchase costs, conversion costs, and other directly attributable costs.⁴

Purchase Costs

Include the price paid, import duties, non-recoverable taxes, and the transport, handling, and other costs directly tied to acquiring the goods. Deduct trade discounts, rebates, and similar reductions.⁴ The word to watch is “non-recoverable.” Taxes you can reclaim from the authority, like recoverable VAT, never enter inventory cost.

Conversion Costs

These are the costs of turning raw materials into finished goods: direct labor, direct production expenses, and a systematic allocation of fixed and variable production overheads. Variable overheads are allocated on actual facility usage. Fixed overheads are allocated based on normal capacity, meaning the average output expected over several periods under ordinary conditions, with planned maintenance factored in.⁵

Normal capacity solves a real problem. When production drops temporarily, dividing total fixed overheads by fewer units would send cost per unit soaring and overstate inventory. Under IAS 2 you keep allocating at the normal rate and expense the unallocated portion immediately. When production runs abnormally high, the per-unit allocation goes down so inventory is not carried above actual cost.⁵

Joint products share conversion costs. If costs cannot be identified individually, allocation methods include relative sales value at the split-off point or when production is complete. By-products are often immaterial, and IAS 2 allows measuring them at net realizable value and deducting that figure from the cost of the main product.

Other Costs and Borrowing Costs

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

Borrowing costs can be capitalized only in narrow circumstances. Under IAS 23, borrowing costs directly attributable to acquiring, constructing, or producing a qualifying asset form part of that asset’s cost. A qualifying asset takes a substantial period of time to get ready for its intended use or sale, such as aged spirits or large custom-built equipment. Inventories manufactured in large quantities on a repetitive basis are explicitly excluded.⁶

What Stays Out

IAS 2 is explicit about costs that must be expensed in the period incurred rather than capitalized into inventory:⁵

Abnormal amounts of wasted materials, labor, or other production inputs. Normal scrap is part of conversion cost; abnormal waste is not.
Storage costs, unless storage is a necessary step between production stages, such as aging whiskey before bottling.
Administrative overheads that do not contribute to getting inventory into a saleable state.
Selling costs, including marketing, advertising, and distribution.

If a cost did not help get the inventory to where it is and in the condition it is, it does not belong on the balance sheet.

Choosing a Cost Formula

Once you know what inventory costs, a cost formula decides which costs flow to cost of goods sold and which stay in ending inventory. That choice directly affects reported profit and carrying value. IAS 2 requires the same formula for all inventories with a similar nature and use, including across subsidiaries and countries within a group.¹

FIFO

First-in, first-out assumes the oldest inventory sells first. The earliest purchase costs flow to cost of goods sold; ending inventory reflects the most recent purchase prices. This mirrors the physical reality for most businesses, especially those handling perishable or time-sensitive goods. When prices rise, FIFO reports higher profit because older, cheaper costs flow through the income statement, and the balance sheet shows inventory close to current replacement value.

Weighted Average Cost

Weighted average recalculates a single average unit cost after each purchase by dividing total cost of goods available by total units available. That blended cost applies to units sold and units remaining. Price swings on individual purchases get smoothed across the pool, which requires continuous tracking of cumulative costs and quantities.

Specific Identification

For items that are not interchangeable, IAS 2 requires specific identification, tracking the actual cost of each individual unit. It is the only acceptable method for unique or high-value items such as custom-built machinery, individually commissioned artwork, or specific real estate developments, and for goods or services produced and segregated for a particular project. It breaks down for large volumes of fungible goods, which is where FIFO and weighted average take over.²

Why LIFO Is Banned

Last-in, first-out is prohibited. LIFO assumes the newest inventory sells first, which can leave ending inventory on the books at costs from years or decades earlier. The IASB eliminated LIFO because those stale balance sheet values lack representational faithfulness and tell readers almost nothing useful about the economic value of what the company holds.² It remains one of the most visible divides between IFRS and US GAAP.

Alongside the cost formulas, IAS 2 permits two practical measurement techniques when they approximate actual cost: standard costing, which uses predetermined costs for materials, labor, efficiency, and capacity utilization and must be reviewed and revised when conditions change, and the retail method, which derives cost by reducing selling price by an appropriate gross margin percentage and is common where large volumes of fast-moving items with similar margins make unit-level costing impractical.⁵

The Lower of Cost and Net Realizable Value

Cost is only the starting value. IAS 2 then applies a ceiling test: inventory must be carried at the lower of cost and net realizable value, so assets never sit on the balance sheet at amounts the entity cannot recover through sale.²

What NRV Is

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, such as commissions and shipping.¹ It is entity-specific, based on what this company expects to realize, not a generic market quotation.

When to Write Down

Whenever NRV falls below cost, inventory must be written down to NRV. Common triggers are physical damage, obsolescence, and declining selling prices. An increase in completion or selling costs that pushes NRV below cost has the same effect. The write-down is expensed in the period it occurs; losses are not deferred until the goods actually sell.²

The assessment is normally item by item, so gains on one line do not 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 evaluation is impractical. Raw materials get a useful shortcut: they do not need to be written down if the finished products they feed into are expected to sell at or above cost. When the finished product’s NRV sits below cost, the raw materials are written down to their replacement cost as the best available proxy for NRV.²

Reversing a Write-Down

If the conditions that caused a write-down no longer exist, IAS 2 requires reversal. Carrying amount increases, but never above original cost, and the reversal reduces cost of goods sold in the period it happens.² Inventory values move in both directions with current conditions, rather than locking in a one-way impairment.

Expense Recognition and Disclosures

When inventory sells, its carrying amount is recognized as cost of goods sold in the same period as the related revenue. Write-downs to NRV are expensed immediately; reversals reduce expense when they occur.⁵ Those three elements together make up the total inventory expense on the income statement.

The notes have to cover:

The accounting policies used, including the cost formulas and any measurement techniques such as standard cost or the retail method.
The total carrying amount of inventory, broken into classifications appropriate to the entity, typically raw materials, work in progress, and finished goods.
The carrying amount of any inventories measured at fair value less costs to sell, such as broker-trader stocks.
The amount of any write-down recognized as an expense in the period.
The amount of any reversal of a prior write-down, with the events or circumstances that caused 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 one preparers sometimes miss. If inventory backs a loan or credit facility, the carrying amount has to be shown separately so lenders and investors can see what is encumbered.

Where IAS 2 Parts Ways From US GAAP

Multinationals that prepare dual reports, or any company weighing a framework switch, run into several differences between IAS 2 and ASC 330:

US GAAP permits LIFO, which many US companies use because it reduces taxable income during inflationary periods. IAS 2 bans it.
Under IAS 2, every inventory uses the lower of cost and NRV. US GAAP applies lower of cost and NRV for FIFO and weighted average, but for LIFO or retail method it compares cost to “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; the written-down 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 entire 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 are added to that inventory’s cost and expensed on sale. US GAAP adds them to the related property, plant, and equipment instead.

The LIFO prohibition and the write-down reversal rule drive the most reconciliation work. A company converting from US GAAP that has used LIFO for years can face a sizeable one-time adjustment to unwind its LIFO reserve, and entities used to treating write-downs as permanent need to build 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. IAS 41 Agriculture
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IFRS Foundation. IAS 2 Inventories
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IFRS Foundation. IAS 2 Inventories
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IFRS Foundation. IAS 23 Borrowing Costs