What is the lower of cost or market inventory cost method LCM?

Definition of Lower of Cost or Market

Lower of Cost or Market is also known as LCM, followed by USGAAP to value the Inventory of a company. USGAAP is an accounting standard. Every company needs to reflect the value of the inventory in their books. If the value of the inventory that the firm plans to sell is different in books and markets, then the LCM methods directly reflect the lower value.

Explanation

At the purchase of an inventory, the cost that is reflected in the book is the same as the price prevailing in the market. If the value of the inventory in the market decreases with the passage of time, then stakeholders would like to have the true picture of the financial statements. For this reason, the lower value between cost and market is reflected.

Example of Lower of Cost or Market

Company XYZ has purchased inventory at $400. The market price of the inventory is $300. What should be the value of inventory in the financial statement?

Solution:

In the financial statement, as per the lower of cost or market method, the value of the inventory will be recorded at $300. Comparing the market price and purchase price, the market price is less, so the value of the inventory will have to be reduced by $100 and recorded at $300 instead of $400.

Factors to Applying Lower of Cost or Market

• If there is evidence that supports that the fall in the market price of the inventory is temporary, then there is no need to write down the inventory. As the inventory price will correct automatically in the market
• When inventories are raw materials and the management is sure that the selling price of the finished goods is going to be more than the cost of raw material, so in that case, the write-down of inventory may be avoided.
• When derivatives are being used to hedge the price fluctuation of inventory in the market, then the LCM rule is not required as the fall in value is hedged by the rise in the value of the derivative.
• Mostly LCM method is applied to individual items, but in some cases, the entire category of inventory can follow the LCM method.

Recording of Lower of Cost or Market

It may sound simple that the lower of the cost of the market will have to be recorded. The market value, which is also known as the replacement cost, should follow certain parameters.

The parameters have set upper bound and lower bound for the replacement cost:

• Replacement Cost shouldn’t be more than Net Realizable Value
• Replacement Cost shouldn’t be less than (Net Realizable value – Normal Profit Margin)

Net Realizable value refers to the value of the good that the company will get after sell. So there is always a selling cost involved in any sell.

Net Realizable Value = Selling Price – Selling Cost

Example:

• Purchase price of Inventory = $500
• Replacement Cost (Market Price) = $400
• Net Realizable Value = $350

Solution:

Here in this example, as the inventory’s replacement cost is more than the Net Realizable Value, Net Realizable Value will be used.

The Inventory in the book is currently reflecting at $500; actually, it should be $350, which is market value. So $150 will have to be written down.

The recording will be:

Write down of Inventory … Dr    $150

To Inventory …. Cr    $150

As Inventory carries a debit balance, so crediting it will reduce the value of the Inventory account.

Challenges of Lower of Cost or Market Method

• It is difficult to estimate the correct Market price. Market price keeps on changing, and proper estimation is difficult.
• If the change is temporary and the write-down is done, then it will reflect the loss in the accounts, which is not true.

Application of Lower of Cost or Market

The Lower of Cost or Market rule can be applied in industries that face the difficulty of losing the inventory value quickly. Mainly mobile phones lose their value within months of their launch. So this method will be really helpful in the mobile phone industry, and it will help stakeholders to estimate the true picture of inventory that the company is carrying.

If there is a market crisis that is not predicted to reverse in the short term, the rule will also help to estimate the correct value of the inventory.

Uses of Lower of Cost or Market

Companies use the Lower of Cost or Market rule-following USGAAP. This rule is applicable in many industries and helps to portray the true picture of the company in front of stakeholders.

Advantages

Some of the advantages are given below:

• The correct value of the inventory is shown in the financial statements, which help stakeholders to analyse the statements properly.
• As the inventories reflect correct value, so research analyst can predict the sale more accurately.
• The loss from revaluation reduces the taxable income, which decreases the tax burden of the company.

Disadvantages

Some of the disadvantages are given below:

• Companies may try to reduce the profit in order to escape from the tax burden.
• If the change in market price is temporary and the inventory is written down accordingly, then it may lead to the incorrect recording of loss.

Conclusion

The lower of Cost or Market method is useful for proper recording of inventory. The method is followed by USGAAP and helps to portray a true picture to the stakeholders. Proper analysis regarding the correct market price should be done before writing down the value of inventory.

Recommended Articles

This is a guide to Lower of Cost or Market. Here we also discuss the definition and factors to applying lower of cost or market along with an example. You may also have a look at the following articles to learn more –

1. Cost Recovery Method
2. Activity-Based Costing
3. Period Costs
4. Explicit Cost

Definition: Lower of cost or market, often abbreviated LCM, is an accounting method for valuing inventory. It assigns a value to inventory at the lesser of the market replacement cost or the amount it was recorded at when it was initially purchased. This price is then used on the balance sheet at the end of an accounting period.

What Does  Lower of Cost or Market Mean?

The lower of cost or market method is used to protect retailers and other businesses from fluctuations in inventory purchase prices. Since inventory is a significant number on a retailer’s balance sheet, a large fluctuation in the value of these assets could affect the company’s financial position.

For example, if a retailer purchases $100,000 worth of inventory and six months later it is only worth $10,000, the retailer actually lost money even though it didn’t sell the inventory yet. The FIFO, LIFO, and weighted average inventory systems would not recognize this loss because the inventory hasn’t been sold. The LCM method takes care of this.

Example

LCM adjusts the reported value of inventory based on the market and original cost prices. The market price is amount of money it would take to replace the inventory today. It’s the current market price. The cost is the price that the retailer originally paid for the merchandise.

The lower of cost or market method adjusts inventory to the lessor of the original cost or the current market price. In other earlier example, the recorded cost was $100,000, but the current market price was only $10,000. According to the LCM method, this $90,000 loss should be recorded by crediting the inventory account and debiting a loss account.

Here’s a simple rule of thumb when using the LCM. When the cost equals the market value, no gain or loss is recognized. When the cost is greater than the market value, a loss is recognized.

Lower of cost or market (LCM or LOCOM) is a conservative approach to valuing and reporting inventory. Normally, ending inventory is stated at historical cost. However, there are times when the original cost of the ending inventory is greater than the net realizable value, and thus the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The criterion for reporting this is the current market value. Any loss resulting from the decline in the value of inventory is charged to "Cost of goods sold" (COGS) if non-material, or "Loss on the reduction of inventory to LCM" if material.

History

The lower of cost or market concept first became part of normal accounting practices in England during the nineteenth century. Lower of cost or market was considered fair because assets were valued on a going-concern basis, rather than the price at which the assets were purchased. During the nineteenth century, lower of cost or market was not common practice for valuation of factory inventory in the United States. The concept was not easy for the Academic Accountants to accept due to its lack of logic. Despite the criticism, lower of cost or market quickly caught on in practice and by the early twentieth century was described as the most commonly accepted method for inventory valuation according to the Report of the Special Committee on Co-operation with Stock Exchanges.[1] Although it lacked accounting logic, lower of cost or market survived because of its conservative approach to valuation and because it addressed opposing principles of cost and value. Its conservatism allowed users to value the inventory at the price for which the inventory could be sold.

Challenges

Three possible values can represent the market value: the replacement cost of the inventory, the net realizable value (also known as the "ceiling"), and the "floor" (the difference between the net realizable value and the normal profit).[2][3] In the lower of cost or market approach, companies must determine these three values and find the median of the values. The companies then compare the median value, which is called the designated market value, to the inventory cost that is recorded. The lower of these two values is subsequently reported on the balance sheet.[2] Because the lower of cost or market approach requires companies to use three possible market values, the companies' financial statements can be difficult to compare.

Contemporary usage

The term "lower of cost or market" is now obsolete and is officially replaced by "lower of cost and net realizable value". According to the FASB Accounting Standards Update,

An entity should measure inventory within the scope of this Update at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.

This FASB update makes usage consistent with the IFRS wording and removes the use of "or" in a context where "and" was always the correct one.[4] However, the update does not apply to all companies. Companies that use the FIFO (first-in, first-out) and average-cost methods of inventory valuation are required to implement the changes, whereas companies that use the LIFO (last-in, first-out) and retail inventory methods are not affected by the update.[3]

See also

• Inventory valuation
• Impaired asset
• Fair market value
• Value (economics)

References

1. ^ Parker, R. H. (1965). Lower of Cost and Market in Britain and the United States: An Historical Survey. Abacus, 1(2), 156-172.
2. ^ a b Wampler, Bruce; Holt, Travis (January 2013)."Valuing Inventory at the Lower of Cost or Market." CPA Journal. 83: 34–9. ISSN 0732-8435
3. ^ a b Penner, James; Kreuze, Jerry; Langsam, Sheldon (2016). "Analysis of Simplification of Accounting Initiative for Inventory and Update of Other Simplification Proposals". Journal of Corporate Accounting & Finance. 27 (4): 9–12. doi:10.1002/jcaf.22155. ISSN 1044-8136.
4. ^ FASB Accounting Standards Update, No. 2015-11, July 2015, p. 1.

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