Inventory Under US GAAP vs IFRS: LIFO, Lower of Cost or Market, and the FAR Questions Built on the Difference

IAS 2 prohibits LIFO. ASC 330 permits it, and the US tax code goes further: a company that uses LIFO on its tax return must use it in its financial statements too, the conformity rule that explains why a method the rest of the world abandoned survives in the United States. For a candidate trained under IFRS in Riyadh or Dubai, LIFO is the first inventory topic in FAR that has no home equivalent, and it is the one FAR examines most.

The second divergence is quieter and catches more people. US GAAP measures inventory at the lower of cost and net realisable value for FIFO and average-cost inventory, but at the lower of cost or market for LIFO and retail-method inventory, with a ceiling and a floor around the replacement cost. IFRS uses net realisable value for everything, and, unlike US GAAP, reverses a write-down when the value recovers. Which measurement rule applies depends on which cost method the company chose, and a question that names the method is telling you which test to run.

The cost flow assumptions

Inventory cost has to be assigned to units sold and units on hand, and unless each unit is identified individually the assignment is a convention.

Method	Units sold are costed at	US GAAP	IFRS
Specific identification	Their actual cost	Permitted	Required for non-interchangeable items
FIFO	The oldest costs; ending inventory holds the newest	Permitted	Permitted
Weighted average	The average cost of goods available; moving average if perpetual	Permitted	Permitted
LIFO	The newest costs; ending inventory holds the oldest	Permitted	Prohibited

In a period of rising prices the direction of every effect follows from the table. LIFO charges the newest, highest costs to cost of goods sold, so it reports the lowest gross profit, the lowest taxable income and the lowest ending inventory; FIFO does the reverse. Falling prices flip every sign. FIFO ending inventory is the same whether the system is periodic or perpetual, because the newest costs end up on hand either way; LIFO and average cost give different answers under the two systems, and a question that says "perpetual" is asking you to apply the method sale by sale.

The LIFO reserve and LIFO liquidation

Because LIFO inventory can carry costs from decades ago, US GAAP requires a LIFO company to disclose the difference between its LIFO inventory and what the inventory would be under FIFO or current cost. That difference is the LIFO reserve, and its change during a year is the amount by which LIFO cost of goods sold exceeded FIFO cost of goods sold. Analysts add the reserve back to compare a LIFO company with a FIFO competitor, and BAR questions on ratio analysis expect that adjustment.

The danger in the method is LIFO liquidation. If a company sells more than it buys, it dips into old layers carried at old, low costs, and the profit on those units is inflated by the gap between an old cost and a current price. The effect is disclosed, and a question that gives you layers from several years and a year in which units fell is asking you to find the liquidation profit.

Dollar-value LIFO

Tracking LIFO layers unit by unit is unworkable for a company with thousands of products, so the layers are measured in dollars of a base year, using a price index. The procedure has four steps: restate the year-end inventory to base-year prices by dividing by the index; compare with the prior year's base-year inventory to find the new layer in base-year dollars; multiply the new layer by the current index; add it to the prior layers.

A company adopts dollar-value LIFO with inventory of 100,000 when the index is 1.00. A year later inventory at current prices is 132,000 and the index is 1.10. At base-year prices the inventory is 120,000, so the new layer is 20,000 in base-year dollars, or 22,000 at the current index. Ending inventory is 100,000 plus 22,000: 122,000, not 132,000. If in the following year base-year inventory falls to 110,000, the second layer is reduced to 10,000 base-year dollars at 1.10, and nothing is added at the new index: that is a liquidation, and the layer is consumed most recent first.

The LIFO conformity rule

The reason LIFO survives is tax. In rising prices it defers income, and the US tax code allows it only on the condition, in section 472, that the taxpayer uses no other method "in ascertaining the income, profit, or loss" reported to shareholders and creditors. A company cannot report LIFO to the IRS and FIFO to its investors. That is why a company's move to IFRS, or a foreign parent's requirement to report under IFRS, forces a change away from LIFO, and why the change is accounted for prospectively in the other direction: a change to LIFO is applied from the opening inventory of the year of change, because reconstructing prior layers is impracticable. The accounting for that change is set out in Change in Accounting Principle vs Estimate vs Error.

Measurement below cost

Both frameworks write inventory down when its value falls below cost, and this is where they part.

Question	US GAAP, FIFO and average cost	US GAAP, LIFO and retail method	IFRS, all inventory
Measured at	Lower of cost and net realisable value	Lower of cost or market	Lower of cost and net realisable value
"Market" means	Not used	Replacement cost, capped at NRV and floored at NRV less a normal profit margin	Not used
Reversal if value recovers	No; the write-down is a new cost basis	No	Yes, up to the original cost
Level of application	Item by item, or by category if that better reflects income	Same	Item by item, or groups of similar items

Net realisable value is the estimated selling price less the costs of completion and disposal. The lower-of-cost-or-market rule is the older US test, and the computation FAR still asks for. Market starts as replacement cost, then is bounded: it cannot be above the ceiling, NRV, because the company would recover at most that; and it cannot be below the floor, NRV less a normal profit margin, because a lower figure would create excess profit when the item sells. The "designated market value" is whichever of the three the replacement cost lands on after bounding, and inventory is carried at the lower of cost and that figure.

The computation. Cost 100, replacement cost 80, estimated selling price 110, costs to complete and sell 15, normal profit margin 15. NRV is 95, the ceiling; the floor is 80. Replacement cost of 80 sits exactly at the floor, so market is 80, and the item is written down to 80. Change the replacement cost to 70 and the floor still holds: market is 80. Change it to 98 and the ceiling holds: market is 95. Under IFRS, and under US GAAP for a FIFO company, the answer in every case is the lower of 100 and 95: 95.

The write-down goes to cost of goods sold unless it is unusual in size, in which case it may be shown separately; either way it is not extraordinary. Under IFRS, a later recovery reverses the write-down through profit or loss, limited to the original write-down; under US GAAP the reduced figure is the new cost and stays.

What goes into cost

Both frameworks capitalise the costs of purchase, conversion and bringing inventory to its present location and condition, and both exclude abnormal waste, storage not required by production, administrative overhead and selling costs. Fixed production overhead is allocated on normal capacity, so the cost of idle capacity is expensed rather than spread over fewer units, a rule examined in the cost accounting portions of BAR and the SOCPA Cost paper as often as in FAR. One difference: IFRS requires a single cost formula for all inventories of a similar nature and use, while US GAAP lets a company apply different methods to different pools, which is how a LIFO company can hold some inventory under FIFO.

How FAR asks

Question pattern	What to do
Cost of goods sold under each method, periodic	Total goods available; apply the assumption to the ending count
Same, perpetual	Apply the assumption at each sale; LIFO and average differ from periodic
LIFO reserve given, restate to FIFO	Add the reserve to inventory; add the change in reserve to pre-tax income
Dollar-value LIFO with an index	Deflate, layer, reinflate; consume layers most recent first on a decline
Lower of cost or market with five numbers	Ceiling, floor, bound the replacement cost, compare with cost
Lower of cost and NRV	Selling price less completion and disposal costs, compared with cost
Effect of an inventory error	Ending inventory overstated overstates income this year and understates it next year

The last row is the bridge to error corrections, and the ratio questions are the bridge to BAR, where the LIFO reserve adjustment reappears in financial analysis.

Where to practise this

Inventory questions are procedural and reward repetition under time. Prepito's FAR course covers cost flow, dollar-value LIFO and both measurement tests with practice questions and simulations, each with a worked explanation. The SOCPA Financial Accounting course covers IAS 2, where the same material is examined without LIFO. For the section as a whole, see the FAR study guide, and for the other place US GAAP and IFRS diverge in ways the exam tests, impairment.

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Sources: FASB Accounting Standards Codification, Topic 330, Inventory, IFRS Foundation, IAS 2 Inventories, IRS Publication 538, Accounting Periods and Methods on the LIFO conformity requirement, AICPA CPA Exam Blueprints. Worked figures are illustrative; standards are amended periodically, so confirm the current text for a specific case.