When applying the lower of cost or market method which way can cost and replacement cost be determined?

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

.tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end}.wpv-block-loop-item[data-toolset-views-view-template-block="047508472259182c5094e69ff2c0425b"] { padding: 1em; } .tb-image{position:relative;transition:transform 0.25s ease}.wp-block-image .tb-image.aligncenter{margin-left:auto;margin-right:auto}.tb-image img{max-width:100%;height:auto;width:auto;transition:transform 0.25s ease}.tb-image .tb-image-caption-fit-to-image{display:table}.tb-image .tb-image-caption-fit-to-image .tb-image-caption{display:table-caption;caption-side:bottom} .tb-image[data-toolset-blocks-image="936dbbdb743e9f8c140af17bc4e7a77a"] { max-width: 100%; } .tb-image[data-toolset-blocks-image="936dbbdb743e9f8c140af17bc4e7a77a"] img { border-radius: 100px;margin-right: 2em; } .tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end}.tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end} .wp-block-toolset-blocks-grid.tb-grid[data-toolset-blocks-grid="7a6d9a349db84e4063a8a60e8db2e6a8"] { grid-template-columns: minmax(0, 0.665fr) minmax(0, 0.335fr);grid-auto-flow: row } .wp-block-toolset-blocks-grid.tb-grid[data-toolset-blocks-grid="7a6d9a349db84e4063a8a60e8db2e6a8"] > .tb-grid-column:nth-of-type(2n + 1) { grid-column: 1 } .wp-block-toolset-blocks-grid.tb-grid[data-toolset-blocks-grid="7a6d9a349db84e4063a8a60e8db2e6a8"] > .tb-grid-column:nth-of-type(2n + 2) { grid-column: 2 } .wp-block-toolset-blocks-grid-column.tb-grid-column[data-toolset-blocks-grid-column="5a3296b3bb3691d8c29956e47e905aca"] { display: flex; } .wp-block-toolset-blocks-grid-column.tb-grid-column[data-toolset-blocks-grid-column="3034fbe886c11054e95b46b09d3e4112"] { display: flex; } .tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end}@media only screen and (max-width: 781px) { .tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end}.tb-image{position:relative;transition:transform 0.25s ease}.wp-block-image .tb-image.aligncenter{margin-left:auto;margin-right:auto}.tb-image img{max-width:100%;height:auto;width:auto;transition:transform 0.25s ease}.tb-image .tb-image-caption-fit-to-image{display:table}.tb-image .tb-image-caption-fit-to-image .tb-image-caption{display:table-caption;caption-side:bottom}.tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end}.tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end} .wp-block-toolset-blocks-grid.tb-grid[data-toolset-blocks-grid="7a6d9a349db84e4063a8a60e8db2e6a8"] { grid-template-columns: minmax(0, 0.5fr) minmax(0, 0.5fr);grid-auto-flow: row } .wp-block-toolset-blocks-grid.tb-grid[data-toolset-blocks-grid="7a6d9a349db84e4063a8a60e8db2e6a8"] > .tb-grid-column:nth-of-type(2n + 1) { grid-column: 1 } .wp-block-toolset-blocks-grid.tb-grid[data-toolset-blocks-grid="7a6d9a349db84e4063a8a60e8db2e6a8"] > .tb-grid-column:nth-of-type(2n + 2) { grid-column: 2 } .wp-block-toolset-blocks-grid-column.tb-grid-column[data-toolset-blocks-grid-column="5a3296b3bb3691d8c29956e47e905aca"] { display: flex; } .wp-block-toolset-blocks-grid-column.tb-grid-column[data-toolset-blocks-grid-column="3034fbe886c11054e95b46b09d3e4112"] { display: flex; } .tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end} } @media only screen and (max-width: 599px) { .tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end}.tb-image{position:relative;transition:transform 0.25s ease}.wp-block-image .tb-image.aligncenter{margin-left:auto;margin-right:auto}.tb-image img{max-width:100%;height:auto;width:auto;transition:transform 0.25s ease}.tb-image .tb-image-caption-fit-to-image{display:table}.tb-image .tb-image-caption-fit-to-image .tb-image-caption{display:table-caption;caption-side:bottom} .tb-image[data-toolset-blocks-image="936dbbdb743e9f8c140af17bc4e7a77a"] img { margin-right: 1em; } .tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end}.tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end} .wp-block-toolset-blocks-grid.tb-grid[data-toolset-blocks-grid="7a6d9a349db84e4063a8a60e8db2e6a8"] { grid-template-columns: minmax(0, 1fr);grid-auto-flow: row } .wp-block-toolset-blocks-grid.tb-grid[data-toolset-blocks-grid="7a6d9a349db84e4063a8a60e8db2e6a8"]  > .tb-grid-column:nth-of-type(1n+1) { grid-column: 1 } .wp-block-toolset-blocks-grid-column.tb-grid-column[data-toolset-blocks-grid-column="5a3296b3bb3691d8c29956e47e905aca"] { display: flex; } .wp-block-toolset-blocks-grid-column.tb-grid-column[data-toolset-blocks-grid-column="3034fbe886c11054e95b46b09d3e4112"] { display: flex; } .tb-grid,.tb-grid>.block-editor-inner-blocks>.block-editor-block-list__layout{display:grid;grid-row-gap:25px;grid-column-gap:25px}.tb-grid-item{background:#d38a03;padding:30px}.tb-grid-column{flex-wrap:wrap}.tb-grid-column>*{width:100%}.tb-grid-column.tb-grid-align-top{width:100%;display:flex;align-content:flex-start}.tb-grid-column.tb-grid-align-center{width:100%;display:flex;align-content:center}.tb-grid-column.tb-grid-align-bottom{width:100%;display:flex;align-content:flex-end} } 

Lower of cost or market is a method of inventory pricing by which the inventory is priced at cost or market, whichever is lower. It is an application of conservatism in accounting.

Explanation

Under generally accepted accounting principles (GAAP), the presumption is that inventories will be recorded at cost, If however, the utility of the goods in the inventory is not as great as their cost is, the goods must be written down to the lower of cost or market. Although this is a violation of the historical cost principle, accountants feel that losses should be recorded as soon as they become evident. thus, in this case, the concept of conservatism takes precedence over historical cost convention. Approximately 90% of the 600 companies surveyed by the AICPA in 2019 reported their inventory at the lower of cost or market.

The Theory of Lower of Cost or Market (LCM)

In applying the lower of cost or market rule, cost is determined by one of the cost flow methods; market, in this case, generally means replacement cost, or the cost to purchase a similar inventory item. The use of lower of cost or market is based on the theory that if an item’s replacement cost decreases in the current period, its sales price will ultimately decrease. Because accountants feel that all losses should be recognized when they occur, this loss is recognized in the period that it occurs – that is, when the price declines – not in a later period – when the item is eventually sold.

Example

To illustrate the theory behind the LCM rule, assume the following facts:

1. During year 1 the Shanken Company purchases one item of inventory for $80. The normal selling price is $100, which represents a gross margin percentage of 20%.
2. The item is held during the entire year. However, during the current year its replacement cost falls 10%. from $80 to $72. No other transaction takes place during the year.
3. During year 2 the item is sold for $90.

The Application of Lower of Cost or Market

The application of lower of cost or market is a two-step process. In the first step, market, defined as the item’s replacement cost, is determined. This can usually be done by examining vendors’ invoices at the end of the year. In the second step, market or replacement cost is compared with cost, and if necessary, the inventory is reduced to the lower of cost or market (LCM). Under generally accepted accounting principles, the comparison can be made on (1) an item-by-item basis, (2) a group-of-items basis, or (3) the inventory as a whole. The LCM comparison on all three bases is shown in the below example.

Lower of Cost and Market and Income Taxes

The Internal Revenue Code contains specific regulations pertaining to the use of lower of cost or market for federal tax purposes. Two of these provisions differentiate the use of lower of cost or market for tax purposes from financial reporting purposes. First, for tax purposes, only FIFO (no LIFO) can be used in conjunction with lower of cost or market. For generally accepted accounting (GAAP) purposes, however, LIFO combined with lower of cost or market is a valid method. Second, for tax purposes, lower of cost or market can be applied only on an item-by-item basis. The group or total inventory method cannot be used.

Our Services