Learning Outcomes
This article explains accounting for inventory and long-lived assets, emphasizing recognition, measurement, and presentation issues under IFRS and US GAAP. It explains how different inventory cost formulas (specific identification, FIFO, weighted average, and LIFO under US GAAP) affect cost of sales, ending inventory, and gross margins, especially in periods of changing prices. It examines depreciation approaches for property, plant, and equipment, including straight-line, declining-balance, and units-of-production methods, and how estimates of useful life and residual value influence expense patterns and asset balances. It analyzes capitalization versus expensing decisions, the treatment of borrowing costs, and the effect of these policies on earnings trends, cash flows, capital structure, and return ratios. It reviews impairment testing for long-lived assets, contrasting IFRS and US GAAP requirements and the impact of write-downs and reversals. It also covers required inventory and long-lived asset disclosures and shows how analysts use them to adjust reported figures, evaluate management choices, and improve comparability across companies for exam-style questions.
CFA Level 1 Syllabus
For the CFA Level 1 exam, you are expected to understand the accounting, valuation, and analytical implications of inventory and long-lived assets, with a focus on the following syllabus points:
- Recognizing and measuring inventory under IFRS and US GAAP
- Identifying different inventory costing methods and their effects
- Accounting for and depreciating property, plant, and equipment
- Understanding capitalization versus expensing and subsequent measurement
- Analyzing the implications of choices on financial statements and ratios
- Disclosing required information for inventory and long-lived assets
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Under which conditions should a company write down inventory, and how does this affect profit margins?
- What is the primary difference between capitalizing and expensing an asset purchase?
- If a company changes its method for depreciating equipment from straight-line to accelerated, what happens to net income and operating cash flow in the first year?
- Which inventory valuation method typically produces the highest ending inventory during periods of rising costs?
Introduction
Inventory and long-lived assets (such as property, plant, and equipment) are major items in most companies’ balance sheets. For Level 1, you must know how these assets are acquired, valued, depreciated or amortized, tested for impairment, and presented in the financial statements. Treatment varies between IFRS and US GAAP, and different choices affect profit trends, ratios, and comparison across companies.
Key Term: inventory
Inventory represents goods held for sale in the normal course of business, goods in production, and materials to be consumed in production.Key Term: long-lived assets
Long-lived assets are tangible or intangible resources expected to generate economic benefits over more than one year, including property, plant and equipment, and intangible assets.
MEASURING INVENTORY
Inventory is initially recognized at cost, including all purchase costs, conversion costs, and other costs required to bring inventory to its current location and condition. Under both IFRS and US GAAP, inventory is subsequently measured at the lower of cost and net realizable value (NRV).
Inventory Cost Formulas
Companies must use a consistent inventory cost formula for inventories with a similar nature and use. Common methods include:
- Specific identification: Each item’s actual cost is assigned to that item. Suitable for unique or high-value goods.
- First-in, first-out (FIFO): The earliest goods purchased are assumed to be the first sold. Ending inventory reflects the most recent costs.
- Weighted average cost: Cost of goods available for sale is averaged across all units. Used commonly for interchangeable items.
US GAAP also allows the use of last-in, first-out (LIFO), where the most recently acquired inventory is sold first. IFRS does not permit LIFO.
Under IFRS and US GAAP, when net realizable value falls below carrying value, inventory is written down, causing an expense in the income statement. IFRS allows reversal of previous write-downs if NRV increases, but US GAAP does not.
Key Term: net realizable value (NRV)
NRV is the estimated selling price in the ordinary course of business less the estimated costs of completion and selling.
Worked Example 1.1
A manufacturer bought 1,000 units at $6 and another 1,000 at $8. By year-end, it had sold 1,200 units. What is ending inventory using FIFO?
Answer:
Under FIFO, 1,200 units sold consist of 1,000 from the $6 lot and 200 from the $8 lot. Remaining inventory: 800 units from the $8 lot at $8 = $6,400. Ending inventory is $6,400.
ACCOUNTING FOR LONG-LIVED ASSETS
Long-lived assets are recorded at historical cost, including all direct costs to acquire and prepare the asset for use. If constructed, borrowing costs may be capitalized. After initial recognition, companies can use two models under IFRS:
- Cost model: Carrying amount = cost less accumulated depreciation and impairment.
- Revaluation model (IFRS only): Asset is remeasured to fair value at the date of revaluation less subsequent depreciation and impairment. US GAAP does not allow the revaluation model.
Key Term: depreciation
Depreciation is the systematic allocation of the cost of a tangible asset over its estimated useful life.Key Term: impairment
Impairment is a reduction in the carrying value of an asset when its recoverable amount falls below its carrying amount.
Depreciable amount is allocated over the asset’s useful life using a rational and systematic method, most commonly:
- Straight-line method: Allocates cost evenly.
- Declining balance method: Accelerates expense recognition; greater depreciation early in the asset’s life.
- Units of production method: Depreciation is proportional to asset use.
Estimates of useful life and residual value should be reviewed at least annually (required by IFRS).
Worked Example 1.2
A company buys equipment for $25,000 with a 5-year useful life and $0 residual value. What is annual depreciation using straight-line and double-declining balance (DDB) methods?
Answer:
Straight-line: $25,000/5 = $5,000 per year. DDB: Year 1 = 2 × (1/5) × $25,000 = $10,000; Year 2 = 2 × (1/5) × ($25,000–$10,000) = $6,000; and so on.
CAPITALIZATION VERSUS EXPENSING
Costs providing benefits beyond the current period are capitalized as assets and amortized or depreciated. Other costs are expensed as incurred, reducing net income immediately but potentially increasing future profit trends.
Worked Example 1.3
Two identical companies acquire a $12,000 machine. Company Alpha expenses immediately; company Beta capitalizes and depreciates on a straight-line basis over 4 years. In year 1, both have $30,000 revenue and $10,000 other expenses. Tax rate is 25%.
Answer:
Alpha: Expense = $12,000, Net income lower in year 1. Beta: Depreciation = $3,000, Net income higher in year 1. Over 4 years, total accumulated net income is the same, but trends and cash flow effects differ.
Exam Warning
Many exam questions test if you recognize how capitalization vs. expensing affects profitability and ratios in early periods. Capitalizing boosts current profit but reduces future profit trends, and vice versa for expensing.
IMPAIRMENT AND REVERSALS
When events indicate an asset may not be recoverable, a company tests for impairment. Under IFRS, if carrying amount exceeds recoverable amount (higher of fair value less costs to sell and value in use), the asset is written down. IFRS allows reversal of impairment (except for goodwill) if value recovers. US GAAP is more restrictive and uses a two-step test and prohibits reversal of impairment losses.
Key Term: recoverable amount
The greater of an asset's fair value less costs to sell and its value in use.
INVENTORY AND LONG-LIVED ASSET DISCLOSURES
Financial statements must disclose:
- Inventory accounting policy, method used, and carrying amount in classifications (e.g., raw materials, work-in-progress, finished goods)
- Amount of inventory recognized as expense
- Details of any inventory write-down and reversal
- Gross carrying amount and accumulated depreciation of long-lived assets
- Methods and rates or useful lives used for depreciation
- Reconciliation of carrying amount at the beginning and end of the period
- Impairment losses and reversals
Key Term: carrying amount
The amount at which an asset is recognized in the balance sheet after deducting accumulated depreciation and impairment losses.
ANALYSING THE EFFECTS OF ACCOUNTING CHOICES
The methods used for inventory valuation (FIFO vs. weighted average vs. LIFO), depreciation (straight-line vs. accelerated), capitalization vs. expensing, and impairment affect reported profits, trends, cash flows, and key ratios:
- FIFO produces higher ending inventory and lower cost of sales in periods of rising prices versus LIFO.
- Accelerating expense recognition reduces current net income but may produce higher future profit growth rates.
- Capitalizing expenditures increases assets, earnings, and equity in the short term.
Analysts should check for changes in reported methods and estimate the impact on profit and ratios when comparing companies or periods.
Revision Tip
For ratio questions: Review how different inventory or asset accounting methods affect current and future net income, asset balances, and cash flows.
Summary
Efficient revision for Level 1 requires you to recognize how choices in inventory and long-lived asset accounting—such as cost formula, depreciation method, capitalization, and impairment—affect companies’ reported profits, financial position, and key ratios. Understand both the principles and disclosures for reliable comparison and analysis.
Key Point Checklist
This article has covered the following key knowledge points:
- Inventory and long-lived assets are recognized at cost and measured at lower of cost and NRV (inventory) or depreciated cost (long-lived assets)
- Methods include FIFO, LIFO (US GAAP), weighted average, straight-line, accelerated depreciation
- Capitalizing increases earnings and equity early; expensing reduces current income
- Inventory or asset write-downs create immediate expense; IFRS may permit reversals
- Depreciation/amortization methods and estimates crucially affect ratios and comparability
- Analysts must check policy disclosures and adjustments for comparability
Key Terms and Concepts
- inventory
- long-lived assets
- net realizable value (NRV)
- depreciation
- impairment
- recoverable amount
- carrying amount