Lower of Cost or Market: Accounting Valuation Rule

August 25, 2024 3 min read Accounting Finance Inventory Valuation Accounting Principles GAAP Historical Cost Market Value

An accounting rule requiring inventory to be recorded at the lower of its historical cost or market value.

On this page

The “Lower of Cost or Market” (LCM) is an accounting principle used in the valuation of inventory. It mandates that inventory be reported at the lower of its cost or its current market value. This rule is designed to ensure that inventory valuations reflect losses due to market decreases or obsolescence, safeguarding against overstated asset values.

Importance in Accounting

Inventory Valuation and Financial Statements

Inventory is a significant asset for many businesses, and its valuation can considerably affect financial statements. Accurate inventory valuation ensures that financial reports present a true and fair view of financial health, impacting decisions made by investors, creditors, and other stakeholders.

Compliance with GAAP

The LCM rule adheres to the Generally Accepted Accounting Principles (GAAP), ensuring consistency and reliability in financial reporting. Thus, all publicly traded companies in the U.S. must follow this rule for inventory valuation.

Calculating Lower of Cost or Market

Cost

The historical cost of the inventory includes all costs incurred to bring the inventory to its present location and condition, such as purchase price, freight-in, direct labor, and production overhead.

Market Value

Under the LCM rule, “market value” generally refers to the current replacement cost of the inventory, subject to certain constraints:

It should not exceed a ceiling (net realizable value).
It should not be lower than a floor (net realizable value less a normal profit margin).

Example Calculation

Imagine a company has inventory items that cost $100 each but currently can only be replaced for $80 each. According to the LCM rule, the inventory should be recorded at $80 per unit, as it is the lower figure.

Historical Context

Development of LCM

The concept of LCM emerged to address the subjective nature of inventory valuation and provide a consistent method for reporting inventory. Over time, it was embedded into accounting standards to enhance reliability and transparency in financial reporting.

Applicability

Businesses and Industries

The LCM rule is particularly relevant in industries with rapidly changing product values, such as technology, fashion, and consumer electronics. It ensures inventory costs are not overstated in such volatile markets.

Net Realizable Value (NRV)

NRV is the estimated selling price of inventory minus any costs required to complete the sale. NRV acts as the ceiling for the market value under the LCM rule.

Replacement Cost

Replacement cost is the current cost to replace an inventory item, serving as the basis for determining the market value under LCM practices.

FAQs

Why is the LCM rule important?

The LCM rule prevents the overstatement of assets and income by ensuring that inventory is not valued higher than its recoverable amount.

How is LCM linked to conservatism in accounting?

LCM reflects the conservative approach in accounting, which prioritizes recognizing potential losses over unrealized gains, thereby providing a cautious and prudent valuation of inventory.

Are there exceptions to the LCM rule?

LCM primarily applies under GAAP for inventory valuation, but some exceptions exist, such as commodities brokers who may value inventory at market price if it’s the primary activity.

References

“Accounting Standards Codification (ASC) 330-10-35”, Financial Accounting Standards Board (FASB).
“Understanding the Lower of Cost or Market Rule”, Journal of Accountancy, 2019.
“Inventory Valuation Methods: Rules and Regulations”, AICPA, 2020.

Summary

The Lower of Cost or Market rule is a cornerstone of conservative accounting practices, ensuring that inventories are valued prudently. By mandating that inventories be reported at the lower of their historical cost or current market value, the LCM rule provides a safeguard against inflated asset valuations and ensures that financial statements present a truthful depiction of a company’s financial position.