Accounting for Inventory and Cost of Goods Sold (COGS): IAS 2 / ASC 330

Introduction

Companies involved in manufacturing or selling of physical goods will need to record inventory as an asset in their books. When the goods are purchased, they are recorded as an asset in the books, and expensed only when they are sold (matching concept). If you like to understand more about matching concept, please read the section on basic accounting principles in the previous article on Introduction to financial statements.

For manufacturing companies, the cost of manufacturing will be part of the cost of inventory. Inventory should include finished goods, raw materials for manufacturing, as well as work in progress (WIP). The accounting standards that are relevant for inventory accounting are IAS 2 Inventories for IFRS, ASC 330 on inventory for US GAAP.

 

What goes into the cost of inventory?

Inventory cost should include the following costs:

  • Cost of direct labour (number of labour hours x hourly cost per employee)
  • Indirect costs or overhead costs, which include depreciation, factory maintenance, cost of factory management, electricity, etc. Overheads are allocated to inventory based on production levels. Overheads are usually allocated based on direct labour hours or number of machine hours.

For example, if the company has total indirect costs of $1000 and allocates based on number of direct labour hours incurred. The company incurred a total of 100 hours. The overhead allocation rate is calculated by dividing the total indirect costs by number of direct labour hours, which will yield $10 per hour. In other words, for every labour hour to manufacture the product, the company needs to apply $10 worth of overhead to the product. The amount of overhead to be applied to each product can then be determined by multiplying the overhead allocation rate ($10 per hour) by the number of direct labour hours required to make each product.

  • Borrowing costs. Certain inventory products may require longer manufacturing time. Under both IAS 23 and US GAAP (ASC 835-20), borrowing costs should capitalised as part of inventory cost, if it meets the criteria of a qualifying asset, i.e. asset requires significant period of time to get ready for its intended use.

 

Inventory costing

Inventory is usually bought and sold at different times at different prices. How should companies then record the cost of inventory?

Under IFRS, companies can either use first-in-first-out (FIFO), special identification, or weighted-average cost to value inventory. Last-in-first-out (LIFO) is not allowed under IFRS. Under US GAAP, companies can choose between all 4 inventory costing formula – first-in-first-out (FIFO), special identification, weighted-average cost, or last-in-first-out (LIFO). 

  • FIFO

FIFO, or First-in-first-out, as the name implies, means that oldest inventory items are recorded as sold first. This does not necessarily mean that oldest inventory is sold first.

  • LIFO

LIFO, or Last-in-first-out, means that the newest inventory items are recorded as sold first. In an environment with rising prices, which is usually the case due to inflation, using LIFO will result in lower cost of inventory in the balance sheet, and higher cost of goods gold. i.e. lower net income recorded in the P&L, as compared to FIFO.

  • Weighted-average

The weighted-average cost of inventory uses the average of costs of goods to assign costs. Weighted cost of inventory is equal to total cost divided by total number of units of inventory. It is most commonly used when different inventory units are mixed together, and the company’s inventory system is not sophisticated enough to track FIFO or LIFO inventory layers.

  • Special identification

The special identification method refers to the situation where each item of inventory can be individually tracked and identified. There is a high degree of accuracy, and the inventory system can track each item when it is bought, which will be charged to cost of goods sold when it is sold. This method is normally used for unique high-value items, where differentiation of items in the inventory is absolutely necessary.

 

Example of inventory costing

To explain the different inventory costing methods, let’s look at the following example. A company has the following inventory:

Date of Purchase Number of units Unit Cost Total Cost
1 June 4 units $1.00 $4
10 June 5 units $2.00 $10
20 June 5 units $2.50 $12.50
Total units 14 units   $26.50

 

The company sells 6 units on 30 June. We will explore how the accounting will differ under FIFO, LIFO and weighted-average inventory costing.

Under FIFO, if there is a sale, the units bought first at $1 per unit will be recorded as sold, followed by those bought at $2 per unit and lastly those bought at $2.50 per unit.

cost of goods sold (FIFO) = 4 units x $1 + 2 units x $2 = $8

cost of inventory after sale (FIFO) = 5 units x $2.50 + 3 units x $2 = $18.50

Under LIFO, if there is a sale, the units bought last at $2.50 will be recorded as sold, followed by those bought at $2 per unit and lastly, those bought earliest at $1 per unit.

cost of goods sold (LIFO) = 5 units x $2.50 + 1 unit x $2 = $14.50

cost of inventory after sale (LIFO) = 4 units x $1 + 4 units x $2 = $12

In the above example, we can see that in an environment of rising costs, using LIFO accounting for inventory, cost of goods sold will be higher, while cost of inventory will be lower as compared to FIFO accounting. Under US GAAP, if the company chooses to use LIFO, it will also need to report its LIFO Reserve to reflect the difference between FIFO and LIFO cost of inventory.

In this case, LIFO reserve = FIFO inventory – LIFO inventory = $18.50 - $12 = $6.50

With the LIFO reserve, we can easily convert from COGS (LIFO) to COGS (FIFO) using this formula:

COGS (FIFO) = COGS (LIFO) – change in LIFO reserve

$8 = $14.50 - $6.50, in the above example

If the company decides to use weighted-average cost of inventory, the cost of inventory can be calculated as follows:

Weighted-average cost of inventory = $26.50 / 14 units = $1.89 per unit

Cost of goods sold = $1.89 x 6 units = $11.36

Cost of inventory after sale = $1.89 x 8 units = $15.14

 

Subsequent measurement of inventory cost

There are some differences between US GAAP and IFRS on write-downs on inventory. Under IFRS, cost of inventory is measured at the lower of cost and net realizable value. Net realizable value is defined as the selling price less estimated cost of sale. Under US GAAP, cost of inventory is measured at lower of cost or market. “Market” generally means current replacement cost, except that replacement cost should not exceed net realizable value or be lower than net realizable value less normal profit margin.

Inventory write-downs under US GAAP may not be subsequently reversed, whereas inventory write-downs under IFRS can be reversed later, if there is an increase in inventory value later on.

Companies with inventories will usually maintain an inventory ageing report and estimate slow-moving inventory, and apply a small amount of inventory provision based on the ageing report. This is a general provision – an amount set aside in anticipation of the inventory going bad. When the company subsequently identifies inventory that it cannot sell, for example spoilt items or outdated computer parts, it can then write-off these items, using up a portion of the inventory provision.