What cost formulas are permitted under IAS 2 and why is LIFO prohibited?

Under IAS 2 Inventories, entities must measure the cost of inventories using either the First-In, First-Out (FIFO) or weighted average cost formula; the Last-In, First-Out (LIFO) method is explicitly prohibited because it does not reliably represent actual inventory flows and can materially distort reported profit and balance sheet carrying amounts. - Permitted cost formulas (IAS 2.25): Two methods are allowed — FIFO and the weighted average cost formula (either periodic or perpetual). Both must be applied consistently to all inventories of a similar nature and use; different formulas may be used for inventories with different natures or uses (IAS 2.25). - FIFO mechanics: Assumes the oldest units purchased are sold first. In rising price environments, FIFO produces a higher closing inventory value on the balance sheet and a lower cost of goods sold (COGS), which inflates reported gross profit. - Weighted average cost (IAS 2.27): Cost is determined by dividing the total cost of similar items at the beginning of a period, plus costs incurred during the period, by the total number of units. The moving weighted average recalculates after each receipt; the periodic weighted average uses end-of-period totals. - LIFO prohibition (IAS 2.BC9–BC11): The IASB eliminated LIFO in the 2003 revision on the grounds that it is inconsistent with the actual physical flow of goods for most businesses, produces a balance sheet figure (the LIFO reserve) that understates the current economic value of inventory, and creates an incentive to manipulate earnings through intentional LIFO liquidations. This remains a significant IFRS vs US GAAP divergence — US GAAP (ASC 330) still permits LIFO.

Under IAS 2.25, can an entity apply FIFO to raw materials and weighted average to finished goods simultaneously, and what justification is required?

- Specific identification (IAS 2.23): For inventories that are not ordinarily interchangeable, or goods produced for specific projects, specific identification of actual costs is required. This is not a free choice — it is mandated where items are individually identifiable (e.g., bespoke machinery, art inventory). - Net realisable value (NRV) write-down (IAS 2.28–2.33): Whichever cost formula is used, inventory must be written down to NRV when NRV falls below cost. Reversals of prior write-downs are recognised in the period the reversal occurs (IAS 2.33), capped at original cost. A retailer holds 1,000 units. Purchases during the period: | Batch | Units | Unit Cost | Total Cost | |-------|-------|-----------|------------| | Opening stock | 300 | €10 | €3,000 | | Purchase 1 | 400 | €12 | €4,800 | | Purchase 2 | 300 | €14 | €4,200 | | Total | 1,000 | | €12,000 | FIFO COGS: 300 × €10 + 300 × €12 = €6,600. Closing inventory: 100 × €12 + 300 × €14 = €5,400.

How does the prohibition of LIFO under IAS 2 affect deferred tax calculations under IAS 12 when a US GAAP entity converts to IFRS?

Weighted Average COGS: Average cost = €12,000 ÷ 1,000 = €12.00/unit. COGS = 600 × €12 = €7,200. Closing inventory = 400 × €12 = €4,800. | Account | Dr (€) | Cr (€) | |--------------------------------|--------|--------| | Cost of Goods Sold | 6,600 | | | Inventory | | 6,600 | Under FIFO, gross profit is €5,400 (€12,000 − €6,600) versus €4,800 under weighted average — a €600 difference driven purely by cost formula choice in this rising-cost environment. - Inconsistent formula application: Applying FIFO to one product line and weighted average to another within the same class of inventory violates IAS 2.25. The method must align with the nature and use of the inventory, not management's profit preference. - Confusing weighted average periods: Using a periodic weighted average for external reporting while running a perpetual system internally creates reconciliation errors. The perpetual moving average recalculates after every receipt, producing different unit costs than the period-end calculation — this is a common audit finding.

When inventory is written down to NRV under IAS 2.28, how is the reversal recognised if selling prices subsequently recover, and is there a ceiling on the reversal amount?

- LIFO legacy adjustments for IFRS converters: Entities transitioning from US GAAP to IFRS (under IFRS 1) must restate LIFO inventories to FIFO or weighted average from the opening IFRS balance sheet date. The cumulative catch-up adjustment hits retained earnings, often creating a significant tax-timing difference requiring IAS 12 deferred tax recognition. - IAS 2.23 — Specific identification required for non-interchangeable inventories. - IAS 2.25 — FIFO and weighted average are the only permitted cost formulas; consistent application by inventory class. - IAS 2.27 — Definition and mechanics of the weighted average cost formula. - IAS 2.28 — Requirement to write inventory down to NRV when below cost. - IAS 2.33 — Reversal of NRV write-downs permitted, limited to original cost. - IAS 2.BC9–BC11 — Basis for Conclusions explaining why LIFO was eliminated from IFRS.

IAS 2 FIFO vs Weighted Average (LIFO Banned)

IAS 2 FIFO vs Weighted Average (LIFO Banned) — Core Rule

Under IAS 2 Inventories, entities must measure the cost of inventories using either the First-In, First-Out (FIFO) or weighted average cost formula; the Last-In, First-Out (LIFO) method is explicitly prohibited because it does not reliably represent actual inventory flows and can materially distort reported profit and balance sheet carrying amounts.

How IAS 2 FIFO vs Weighted Average (LIFO Banned) Works

Permitted cost formulas (IAS 2.25): Two methods are allowed — FIFO and the weighted average cost formula (either periodic or perpetual). Both must be applied consistently to all inventories of a similar nature and use; different formulas may be used for inventories with different natures or uses (IAS 2.25).

FIFO mechanics: Assumes the oldest units purchased are sold first. In rising price environments, FIFO produces a higher closing inventory value on the balance sheet and a lower cost of goods sold (COGS), which inflates reported gross profit.

Weighted average cost (IAS 2.27): Cost is determined by dividing the total cost of similar items at the beginning of a period, plus costs incurred during the period, by the total number of units. The moving weighted average recalculates after each receipt; the periodic weighted average uses end-of-period totals.

LIFO prohibition (IAS 2.BC9–BC11): The IASB eliminated LIFO in the 2003 revision on the grounds that it is inconsistent with the actual physical flow of goods for most businesses, produces a balance sheet figure (the LIFO reserve) that understates the current economic value of inventory, and creates an incentive to manipulate earnings through intentional LIFO liquidations. This remains a significant IFRS vs US GAAP divergence — US GAAP (ASC 330) still permits LIFO.

Specific identification (IAS 2.23): For inventories that are not ordinarily interchangeable, or goods produced for specific projects, specific identification of actual costs is required. This is not a free choice — it is mandated where items are individually identifiable (e.g., bespoke machinery, art inventory).

Net realisable value (NRV) write-down (IAS 2.28–2.33): Whichever cost formula is used, inventory must be written down to NRV when NRV falls below cost. Reversals of prior write-downs are recognised in the period the reversal occurs (IAS 2.33), capped at original cost.

IAS 2 FIFO vs Weighted Average (LIFO Banned) — Practical Example

A retailer holds 1,000 units. Purchases during the period:

Batch	Units	Unit Cost	Total Cost
Opening stock	300	€10	€3,000
Purchase 1	400	€12	€4,800
Purchase 2	300	€14	€4,200
Total	1,000		€12,000

Sales: 600 units at €20 each (€12,000 revenue).

FIFO COGS: 300 × €10 + 300 × €12 = €6,600. Closing inventory: 100 × €12 + 300 × €14 = €5,400.

Weighted Average COGS: Average cost = €12,000 ÷ 1,000 = €12.00/unit. COGS = 600 × €12 = €7,200. Closing inventory = 400 × €12 = €4,800.

Journal entry — recognising COGS under FIFO

Account	Dr (€)	Cr (€)
Cost of Goods Sold	6,600
Inventory		6,600

Under FIFO, gross profit is €5,400 (€12,000 − €6,600) versus €4,800 under weighted average — a €600 difference driven purely by cost formula choice in this rising-cost environment.

IAS 2 FIFO vs Weighted Average (LIFO Banned) — Common Pitfalls

Inconsistent formula application: Applying FIFO to one product line and weighted average to another within the same class of inventory violates IAS 2.25. The method must align with the nature and use of the inventory, not management's profit preference.

Confusing weighted average periods: Using a periodic weighted average for external reporting while running a perpetual system internally creates reconciliation errors. The perpetual moving average recalculates after every receipt, producing different unit costs than the period-end calculation — this is a common audit finding.

LIFO legacy adjustments for IFRS converters: Entities transitioning from US GAAP to IFRS (under IFRS 1) must restate LIFO inventories to FIFO or weighted average from the opening IFRS balance sheet date. The cumulative catch-up adjustment hits retained earnings, often creating a significant tax-timing difference requiring IAS 12 deferred tax recognition.

IAS 2 FIFO vs Weighted Average (LIFO Banned) — Key Paragraphs

IAS 2.23 — Specific identification required for non-interchangeable inventories.
IAS 2.25 — FIFO and weighted average are the only permitted cost formulas; consistent application by inventory class.
IAS 2.27 — Definition and mechanics of the weighted average cost formula.
IAS 2.28 — Requirement to write inventory down to NRV when below cost.
IAS 2.33 — Reversal of NRV write-downs permitted, limited to original cost.
IAS 2.BC9–BC11 — Basis for Conclusions explaining why LIFO was eliminated from IFRS.