Inventory Costing Under ASC 330: FIFO, Average Cost, LIFO, Overhead and Net Realizable Value

For manufacturers, distributors and retailers, inventory is often the largest current asset and the area where the audit hours go. The count is only half the job. The other half is valuation: what cost is attached to each unit, whether overhead is allocated properly, and whether any item is carried above what it can recover. The accounting rules are in ASC 330, Inventory.

This guide covers cost flow assumptions, what goes into cost, the lower of cost and net realizable value test, LIFO specifics and the procedures auditors perform on valuation. For counting and observation, see the inventory observation guide.

What counts as cost

Under ASC 330, the primary basis of accounting for inventory is cost: the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.

Purchased inventory

Includes the invoice price, less trade discounts, plus freight-in, duties, non-recoverable taxes, insurance in transit and other costs to bring the goods to the point of sale or use. Cash discounts for early payment are generally treated as a reduction of the cost of the goods purchased rather than as financial income. Rebates from vendors raise their own questions, covered in ASC 705-20, and are usually a reduction of cost of inventory and cost of sales.

Manufactured inventory

Includes direct materials, direct labor and a systematic allocation of production overhead, both variable and fixed. Points to know:

• Fixed production overhead (depreciation of the plant, factory rent, supervisory salaries) is allocated to units based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved over a number of periods under normal circumstances, taking into account the loss of capacity from planned maintenance. Some variation from period to period is expected. The actual level of production may be used if it approximates normal capacity. In a period of abnormally high production, the fixed overhead per unit is decreased so that inventory is not measured above cost, and abnormally low production does not increase it.
• Unallocated overhead in a period of abnormally low production is recognized as an expense in the period, not added to inventory.
• Abnormal costs, such as excessive spoilage, double freight and rehandling, and idle facility costs, are expensed as incurred, not capitalized.
• Selling costs are not inventory costs. General and administrative costs are generally excluded unless they clearly relate to production.
• Interest is capitalized into inventory only in narrow cases, such as discrete projects, under ASC 835-20.

An overhead absorption schedule is a standard workpaper for a manufacturer. Agree the pools to the trial balance, review the allocation base and test the rate calculation.

Cost flow assumptions

An entity chooses a cost flow assumption that most clearly reflects periodic income, consistently applied. The common methods follow.

The method does not need to match the physical flow of goods. A perishable product can be costed with average cost, and a company can use different methods for different inventory pools if applied consistently and disclosed.

LIFO specifics

• Under LIFO, in a period of rising prices, cost of sales is higher and ending inventory is lower than under FIFO. The difference is the LIFO reserve, which lenders and analysts often ask for.
• LIFO is often adopted for tax. Federal tax law (IRC section 472(c)) requires that a taxpayer using LIFO for tax also use it in financial reports to owners and creditors, commonly called the conformity requirement. This is a tax rule rather than a GAAP rule, so the entity's tax position bears on any change in method for books only. Coordinate with the tax team and the income taxes guide.
• LIFO liquidation happens when inventory quantities decrease so that older, lower costs flow into cost of sales, boosting gross profit. The effect is a disclosure matter when material. For auditors, an unexpected improvement in gross margin warrants asking whether layers were liquidated.
• LIFO is applied through pools, and there are techniques such as dollar-value LIFO and index methods. Recalculation of the index and layers is often the main audit work.
• Measurement uses the lower of cost or market model for LIFO and retail method, not net realizable value. See below.

Changing the method

A change in cost flow assumption is a change in accounting principle under ASC 250. It requires justification that the new method is preferable and, in general, retrospective application. Dropping LIFO, or adopting it for books alone, has tax consequences that should be settled before year end.

Subsequent measurement: lower of cost and net realizable value

Which test applies

ASU 2015-11 simplified measurement for most inventory. For entities other than public business entities, it is effective for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017.

• For inventory measured using FIFO or average cost (and other methods besides LIFO and the retail method): measure at the lower of cost and net realizable value.
• For inventory measured using LIFO or the retail method: continue to use the lower of cost or market, where market is replacement cost, limited by a ceiling of net realizable value and a floor of NRV less normal profit margin.

Net realizable value

NRV is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Compare cost to NRV item by item, or by groups of similar items when individual comparison is not practicable. A write-down creates a new cost basis; it is not reversed if prices recover.

Typical indicators for write-downs: slow-moving, obsolete or excess quantities, damaged goods, discontinued products, price declines for commodity inputs, sales below cost, return rates and technological changes. An inventory reserve based on aging rules should be supported by sales history and forward demand. The inventory reserve calculator can help test a reserve formula.

Firm purchase commitments

If a company has a firm commitment to buy inventory at a fixed price and the market price falls below the contract price, a loss on the commitment is recognized in the same way as an inventory loss under ASC 330. Check long-term supply contracts for this.

Disclosure

Disclose the basis of stating inventories (cost method and the lower of cost and NRV policy), the major classes (raw materials, work in process, finished goods), significant write-downs, any material LIFO liquidation effect, the LIFO reserve where the client presents it, and pledged inventory. Use the GAAP disclosure checklist.

What auditors test

Inventory valuation is an accounting estimate area with an existence component. Risk assessment under AU-C 315 considers the complexity of costing, the number of locations, the reliability of the perpetual system and management incentives around gross margin.

Cost

• Purchases: vouch a sample of costs in the perpetual or costing records to vendor invoices, including freight and duties.
• Standard costs: if the company uses standards, test how they were set, how variances are treated, and whether the standards approximate actual cost at year end. Test the variance capitalization.
• Labor and overhead: test labor rates and hours by agreeing to payroll, and test the overhead pools and allocation base, including the normal capacity assumption.
• Cost flow method: recalculate FIFO or average cost layers for a sample, or test the software logic and data. For LIFO, recompute the index and the layers.
• Test of the extension: quantity times unit cost times count result, agreed to the final listing. See the lead schedule template for tying the listing to the trial balance.

NRV and excess and obsolete

• Obtain the aging and the reserve calculation and test its inputs.
• Compare cost to recent selling prices, using sales after year end, price lists and contracts.
• Review slow-moving and no-activity items, and test whether management considered them.
• Evaluate subsequent sales and returns. See subsequent events.

Cutoff and in-transit

Agree receipts and shipments around the date to the right period under the cutoff testing approach, including goods in transit and consignment inventory. Consider title terms (FOB shipping point or destination).

Records tie-out

Roll the count forward or back to the balance sheet date if counts were not at year end. Reconcile the perpetual to the general ledger. See AU-C 501 on inventory observation.

Document under AU-C 230.

Issues to look for

• Fixed overhead allocated on actual low volume rather than normal capacity.
• Abnormal costs capitalized.
• No NRV test because "we always sell above cost."
• Reserves based on a formula never validated against sales.
• LIFO layers not recalculated.
• Standard cost variances left in the P&L when they should partly be inventoried, or the reverse.
• Vendor rebates not reducing inventory cost.

FAQ

Which inventory costing methods are allowed under US GAAP?

Specific identification, FIFO, weighted average, LIFO and the retail method, among others. The method is a choice that should reflect periodic income and be applied consistently.

Do I use NRV or lower of cost or market?

For FIFO and average cost, use the lower of cost and net realizable value. For LIFO and the retail method, the lower of cost or market model continues to apply.

How is fixed overhead allocated to inventory?

Based on the normal capacity of the production facilities. Overhead from abnormally low production is expensed in the period, not carried in inventory.

Can a company use LIFO for tax but FIFO for books?

Generally no. Federal tax rules (IRC section 472(c)) require a taxpayer that uses LIFO for tax to use it in financial reports to owners and creditors, subject to limited exceptions.

Is a write-down of inventory reversed if prices recover?

No. A write-down to NRV establishes a new cost basis, and later recoveries are not recorded as reversals.

CORAA prepares ready-to-review audit files for US CPA firms; see /us.

Sources

• FASB ASC 330-10 (Inventory, Overall): cost, normal capacity, abnormal costs, lower of cost and net realizable value, purchase commitments
• FASB ASU 2015-11, Simplifying the Measurement of Inventory (effective dates for public business entities and other entities)
• FASB ASC 705-20 (vendor consideration); ASC 835-20 (capitalization of interest); ASC 250-10 (changes in accounting principle)
• Internal Revenue Code section 472(c) and Treas. Reg. 1.472-2(e), LIFO conformity: https://www.law.cornell.edu/uscode/text/26/472
• AICPA, AU-C Section 501, Audit Evidence: Specific Considerations for Selected Items; AU-C Section 540; AU-C Section 230

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error