A retailer holding 10,000 units bought at $50 each faces a market crash: replacement cost falls to $38, but the holding period ties up $500,000 of capital. How that inventory is measured, costed, and disclosed reshapes gross margin, current ratio, and inventory turnover across every reporting period that follows.
Inventory sits on the balance sheet at the smaller of two numbers: historical cost or net realisable value (NRV). NRV is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.
When NRV drops below cost, the write-down hits COGS (or a separate loss line) and reduces ending inventory. Current ratio, gross margin, and inventory turnover all move.
KEY: IFRS uses NRV for all inventory and permits reversals up to the original write-down. US GAAP uses NRV for FIFO and weighted-average but uses lower of cost or market (where market is replacement cost bounded by NRV ceiling and NRV-minus-normal-profit floor) for...
Common mistakes
- Reversing the inflation table. Under rising prices, LIFO produces higher COGS and lower ending inventory, not the opposite. Trap: candidates flip the direction when half-remembering the rule.
- Forgetting that LIFO produces higher operating cash flow. Lower taxes mean more cash retained. The cash flow direction is opposite to the gross margin direction. Trap: assuming the lowest-margin method also gives the lowest cash flow.
- Using LIFO reserve incorrectly. The reserve is added to LIFO inventory to get FIFO inventory, and the change in reserve is subtracted from LIFO COGS to get FIFO COGS. Trap: subtracting the reserve from inventory or adding the change to COGS.
Bottom line
- IFRS = lower of cost and NRV (write-down reversals allowed up to original cost). US GAAP non-LIFO = lower of cost and NRV; LIFO = lower of cost or market, no reversals.
- IFRS prohibits LIFO entirely; only US GAAP firms may use it.
- Rising prices + FIFO = highest ending inventory, lowest COGS, highest gross margin, highest taxes.
- Rising prices + LIFO = lowest ending inventory, highest COGS, lowest gross margin, lowest taxes, highest operating cash flow.
Exam shortcut
For the direction table, memorise one line, "FIFO highest inventory, LIFO highest COGS in inflation," and derive the rest. For LIFO reserve conversion, remember "Add reserve to inventory, subtract change from COGS." For write-down reversals, IFRS yes, US GAAP no, and reversals never exceed original cost. When a LIFO firm shows a margin jump with falling inventory, your first answer is LIFO liquidation, not operational improvement.
The full lesson (about 2,077 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- analysis of inventories
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