Lower of Cost or Market Method: Why and How It Is Used

What Is the Lower of Cost or Market Method?

When valuing a company's inventory, the lower of cost or market (LCM) method states that it is recorded on the balance sheet at either the historical cost or the market value.  Historical cost refers to the cost at which the inventory was purchased.

The value of a good can shift over time. This holds significance, because if the price at which the inventory can be sold falls below the net realizable value of the item, thus triggering a loss for the company, then the lower of cost or market method can be employed to record the loss.

KEY TAKEAWAYS

• The lower of cost or market (LCM) method relies on the fact that when investors value a company's inventory, those assets shall be recorded on the balance sheet at either the market value or the historical cost.

• Historical cost refers to the cost of inventory at the time it was originally purchased.

• The LCM method takes into account that the value of a good can fluctuate. Under this scenario, if the price at which the inventory may be sold dips below the net realizable value of the item, which consequently results in a loss, the LCM method can be employed to record the loss.

• The LCM method is a tenet of the generally accepted accounting principles (GAAP).

Why Is the Lower of Cost or Market Method Used?

The lower of cost or market method lets companies record losses by writing down the value of the affected inventory items. This value may be reduced to the market value, which is defined as the middle value when comparing the cost to replace the inventory, the difference between the net realizable value and the typical profit on the item, and the net realizable value of the item. The amount by which the inventory item was written down is recorded under cost of goods sold on the balance sheet.

The LCM method is part of the GAAP rules used in the U.S. and in international commerce. Almost all assets enter the accounting system with a value equal to acquisition cost. GAAP prescribes many different methods for adjusting asset values in subsequent reporting periods.

In 2017, the FASB issued an update to their code and standards that affect companies that use the average cost and LIFO methods of inventory accounting. Companies that use these two methods of inventory accounting must now use the lower of cost or net realizable value method, which is more consistent with IFRS rules.

Application of the Lower of Cost or Market Rule

The lower of cost or market rule traditionally applies to companies whose products become obsolete. The rule also applies to products that lose value, due to a dwindled current market price, which is defined as the current cost of replacing outdated inventory, provided that the market price isn't larger or smaller than the net realizable value, which is essentially the projected selling price minus disposal fees.

Other Factors in Applying the Lower of Cost or Market Rule

• Category analysis: Although the lower of cost or market rule is typically linked to a single product, it may also relate to a broad swath of related products.

• Hedges: In cases where inventory is hedged by a fair value hedge, the hedge's effects should be added to the inventory's cost, which may obliterate the need for LCM adjustments.

• Last in, first out layer recovery: One may sidestep a write-down to the LCM during interim periods where evidence suggests that inventory will be restored by the year's end.

• Raw materials: One shouldn't write down raw material costs, if the finished products are projected to sell at or above their costs.

• Recovery: A write-down to the LCM may be avoided if ample evidence exists that market prices will climb, prior to the sale of inventory.

• Sales incentives: Potential LCM problems may exist with specific items, where yet-to-be expired sales incentives are still in play.

The LCM rule was recently changed, making things easier for businesses that do not use the retail method, or the last-in, first-out method. Under the new guidelines, the measurement can be solely restricted to the lower of cost and net realizable value.

Is Lower of Cost or Market Method Required by GAAP?

Yes, lower of cost or market method is required under generally accepted accounting principles (GAAP). This method became required as of 2017.

What Is the Meaning of Lower of Cost or Market Method?

The lower of cost or market method is used to value inventory by comparing the original cost and the current market price, and recording the cost of inventory by whichever is lower. This method is typically applicable to companies that hold inventories for extended periods, when inventory has declined in cost, or if it has gone obsolete.

What Inventory Costing Methods are Allowed by GAAP?

Along with lower of cost or market method being required by GAAP reporting, first in first out (FIFO), last in last out (LIFO), and the weighted average valuation method are inventory costing methods allowed by GAAP

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