IFRS states that inventories shall be measured (and carried on the balance sheet) at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale. The assessment of net realisable value is typically done item by item or by groups of similar or related items. In the event that the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realisable value and the loss (reduction in value) recognised as an expense on the income statement. This expense may be included as part of cost of sales or reported separately.
In each subsequent period, a new assessment of net realisable value is made. Reversal (limited to the amount of the original write-down) is required for a subsequent increase in value of inventory previously written down. The reversal of any write-down of inventories is recognised as a reduction in cost of sales (reduction in the amount of inventories recognised as an expense).
Analysts should consider the possibility of an inventory write-down because the impact on a company’s financial ratios may be substantial. The potential for inventory write-downs can be high for companies in industries in which technological obsolescence of inventories is a significant risk. Analysts should carefully evaluate prospective inventory impairments (as well as other potential asset impairments) and their potential effects on the financial ratios when debt covenants include financial ratio requirements. The breaching of debt covenants can have a significant impact on a company.
Companies that use specific identification, weighted average cost, or FIFO methods are more likely to incur inventory write-downs than companies that use the LIFO method. Under the LIFO method, the oldest costs are reflected in the inventory carrying amount on the balance sheet. Given increasing inventory costs, the inventory carrying amounts under the LIFO method are already conservatively presented at the oldest and lowest costs. Thus, it is far less likely that inventory write-downs will occur under LIFO — and if a write-down does occur, it is likely to be of a lesser magnitude.
