Lower of Cost or Market: Inventory Accounting Method

An asset is recorded at its historical cost but the amount is written down to market if this becomes lower than the original cost. Market value is determined by replacement cost but not greater than net realizable value (NRV) nor less than NRV minus a normal profit.

The Lower of Cost or Market (LCM) is an inventory valuation method typically used in financial accounting. This method requires businesses to report the value of inventory at the lower amount between the original purchase cost of the inventory and its current market value. This aligns with the conservatism principle in accounting, which ensures that businesses do not overstate the value of their assets.

Calculation of Lower of Cost or Market§

Historical Cost§

Historical cost refers to the original purchase price of the inventory. This includes all costs necessary to acquire the inventory and prepare it for sale, such as purchase price, transportation costs, and any other directly attributable costs.

Market Value§

Market value, in this context, is interpreted as the replacement cost of the inventory. However, it must adhere to the following constraints:

• Not greater than Net Realizable Value (NRV): NRV is the estimated selling price in the ordinary course of business minus any costs of completion, disposal, and transportation.

  $$\text{NRV} = \text{Estimated Selling Price} - \text{Costs to Complete and Sell}$$

• Not less than NRV minus a normal profit margin: This ensures that the market value used for LCM does not fall below what is considered reasonable after accounting for typical profit margins.

  $$\text{NRV - Normal Profit Margin} = \text{Estimated Selling Price} - \text{Costs to Complete and Sell} - \text{Normal Profit Margin}$$

LCM Calculation Example§

Assume a company holds an inventory item with the following values:

• Historical Cost: $50
• Replacement Cost: $45
• Net Realizable Value (NRV): $48
• NRV minus Normal Profit: $44

The replacement cost of $45 is evaluated against the NRV ceilings and floors:

• Ceiling (NRV): $48
• Floor (NRV minus Normal Profit): $44

Hence, the market value is $45, as it lies between the ceiling and the floor.

Using the Lower of Cost or Market method:

$$\text{LCM} = \min(\text{Historical Cost}, \text{Market Value}) = \min(50, 45) = 45$$

Comparison with Other Methods§

FIFO and LIFO§

Unlike LCM, First-In-First-Out (FIFO) and Last-In-First-Out (LIFO) are inventory valuation methods that primarily affect cost flow assumptions and income statements. LCM focuses on the balance sheet, ensuring the inventory is not overstated under the circumstances of declining market values.

NRV Alone§

Net Realizable Value is another inventory valuation method that only considers the potential selling price minus costs to complete and sell the inventory. NRV can often lead to higher inventory values compared to LCM, which introduces a conservative constraint by capping replacement value considerations.

FAQs§

Why is the Lower of Cost or Market Method Important?

The LCM method is important because it helps businesses align their inventory valuations with the current market conditions, preventing them from overstating assets and future profits.

When Should a Business Use LCM?

Businesses generally use the LCM method at the end of their accounting periods to ensure that their inventory is valued conservatively. It is particularly necessary in industries with volatile market prices.

What Are the Implications of Using LCM on Financial Statements?

Using LCM can reduce the value of inventory on the balance sheet, leading to reported losses in the income statement if the market value falls below the historical cost.

Historical Context of LCM§

The LCM method has been a part of GAAP (Generally Accepted Accounting Principles) for many years, reflecting conservative accounting practices developed to protect investors and stakeholders from inaccurate financial reporting.

Summary§

The Lower of Cost or Market accounting method ensures that inventory is reported at the lesser of its original cost or its current market value. This practice is rooted in conservatism, safeguarding against overestimating inventory values. By considering both historical cost and a constrained market value, LCM provides a prudent approach to inventory valuation, ensuring that financial statements reflect a more accurate value of a company’s assets.

References§

1. Financial Accounting Standards Board (FASB). (n.d.). Accounting Standards Codification (ASC) Topic 330: Inventory.
2. International Financial Reporting Standards (IFRS). (n.d.). IAS 2: Inventories.
3. Horngren, C. T., Harrison, W. T., & Oliver, M. S. (2017). Financial Accounting. Pearson Education.

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