Updated July 14, 2023
Definition of Lower of Cost or Market
Lower Cost or Market is also known as LCM, followed by USGAAP to value a company’s inventory. 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 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 a true picture of the financial statements. For this reason, the lower value between cost and market is reflected.
Example of Lower 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 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 inventory value will have to be reduced by $100 and recorded at $300 instead of $400.
Factors to Applying Lower Cost or Market
- If the evidence 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 using derivatives to hedge the price fluctuation of inventory in the market, the LCM (Lower of Cost or Market) rule is not necessary because the rise in the value of the derivative offsets the fall in value.
- The LCM method is mostly applied to individual items, but in some cases, the entire inventory category can follow the LCM method.
Recording of Lower of Cost or Market
It may sound simple that the lower market cost must be recorded. The market value and 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 the company will get after selling. So there is always a selling cost involved in any sale.
Example:
- Purchase price of Inventory = $500
- Replacement Cost (Market Price) = $400
- Net Realizable Value = $350
Solution:
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 reflected 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, crediting it will reduce the value of the Inventory account.
Challenges of Lower 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, it will reflect the loss in the accounts, which is false.
Application of Lower of Cost or Market
The Lower Cost or Market rule can be applied in industries that face the difficulty of losing 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 help stakeholders estimate the true picture of the inventory that the company is carrying.
If a market crisis is not predicted to reverse in the short term, the rule will also help estimate the correct value of the inventory.
Uses of Lower Cost or Market
Companies use the Lower Cost or Market rule following USGAAP. This rule applies in many industries and helps portray the company’s true picture in front of stakeholders.
Advantages
Some of the advantages are given below:
- The financial statements accurately show the correct inventory value, enabling stakeholders to analyze the statements properly.
- As the inventories reflect the correct value, research analysts can predict the sale more accurately.
- The loss from revaluation reduces the taxable income, which decreases the company’s tax burden.
Disadvantages
Some of the disadvantages are given below:
- Companies may try to reduce their profit to escape from the tax burden.
- If the change in market price is temporary and the inventory is written down accordingly, it may lead to an incorrect recording of losses.
Conclusion
The lower Cost or Market method is useful for properly recording inventory. USGAAP follows the method and helps to portray a true picture to the stakeholders. Proper analysis regarding the correct market price should be done before writing down the inventory value.
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