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The lower of cost or market rule states that a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price. This situation typically arises when inventory has deteriorated, or has become obsolete, or market prices have declined. The rule is more likely to be applicable when a business has held inventory for a long time, since the passage of time can bring about the preceding conditions. The rule is set forth under the Generally Accepted Accounting Principles accounting framework. The “current market price” is defined as the current replacement cost of the inventory, as long as the market price does not exceed net realizable value; also, the market price shall not be less than the net realizable value, less the normal profit margin. Net realizable value is defined as the estimated selling price, minus estimated costs of completion and disposal.
Additional factors to consider when applying the lower of cost or market rule are:
A recent update to the rule simplifies matters somewhat, but only if a business is not using the last in, first out method or the retail method. The variation states that the measurement can be restricted to just the lower of cost and net realizable value. Example of the Lower of Cost or MarginMulligan Imports resells five major brands of golf clubs, which are noted in the following table. At the end of its reporting year, Mulligan calculates the lower of its cost or net realizable value in the following table:
Based on the table, the market value is lower than cost on the Hi-Flight and Iridescent product lines. Consequently, Mulligan recognizes a loss on the Hi-Flight product line of $3,000 ($27,000 - $24,000), as well as a loss of $144,000 ($336,000 - $192,000) on the Iridescent product line. Accounting for the Lower of Cost or MarginIf the amount of a write-down caused by the lower of cost or market analysis is immaterial, then charge the expense to the cost of goods sold; this is usually the case. If the loss is material, then you may want to track it in a separate account (especially if such losses are recurring), such as “Loss on LCM adjustment,” in order to separately report on this information. To use the information in the preceding example, the journal entry would be:
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Rationale Behind Lower of Cost or Market (LCM)When inventory is purchased by a company, it sits on the balance sheet at cost. However, over time, the value of the inventory may depreciate or appreciate. To increase the reliability of financial statements, the changing value of inventory, to an extent, must be accounted for. For example, if a company purchased inventory at the cost of $100,000 but the market value of the inventory is $20,000, users of financial statements would want the lower value to be reflected in the books. If the inventory value were not reassessed to the appropriate value, it would overstate the company’s assets and mislead users. However, as will be discussed below, the lower of cost or market inventory valuation method is not as simple as just comparing cost and market. Valuing Inventory at Lower of Cost or Market (LCM)In the lower of cost or market inventory valuation method, the company’s inventory purchased at cost is compared against the market value of that inventory. The market value of inventory is essentially the replacement cost of that inventory or the amount of money it would take to replace the inventory in the open market. However, there are some caveats for understanding replacement value:
Net realizable value is the sale price of the inventory minus any costs incurred to prepare the inventory for sale. A normal profit margin is the average spread between the cost and sale price of the inventory. Such caveats for replacement cost establish a floor and ceiling for replacement cost. It is illustrated as follows: Here are the steps to valuing inventory at the lower of cost or market: 1. First, determine the historical purchase cost of inventory. 2. Second, determine the replacement cost of inventory. It is the same as the market value of inventory. 3. Compare replacement cost to net realizable value and net realizable value minus a normal profit margin. If:
4. Compare the cost of inventory to replacement cost. Lastly, if:
To fully understand the concepts, a comprehensive example is prepared below. Examples of Lower of Cost or Market (LCM)Example 1ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:
In this example, replacement cost falls between net realizable value and net realizable value minus a normal profit margin. Therefore, the replacement cost used is $150. Comparing the amount to the purchase cost of $250, a $100 write-down is necessary. Example 2ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:
In this example, replacement cost falls below the net realizable value minus a normal profit margin. Therefore, the replacement cost used is $140. Comparing the amount to the purchase cost of $250, a $110 write-down is necessary. Example 3ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:
In this example, replacement cost is above net realizable value. Therefore, the replacement cost used is $160. Comparing the amount to the purchase cost of $250, a $90 write-down is necessary. Recording Lower of Cost or MarketIf the market cost is lower than the cost, a write-down is necessary. The journal entry would be as follows:
The loss from the decline in inventory value would be reflected in the income statement and reduce net income. Inventory would be reflected in the balance sheet and reduce the value of inventory. The journal entry for the three examples above would be: Example 1
Example 2
Example 3
More ResourcesThank you for reading CFI’s guide to Lower of Cost or Market. To keep advancing your career, the additional CFI resources below will be useful:
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