An inventory valuation method required for companies that follow U.S. GAAP Show
What is Lower of Cost or Market (LCM)Lower of cost or market (LCM) is an inventory valuation method required for companies that follow U.S. GAAP. In the lower of cost or market inventory valuation method, as the name implies, inventory is valued at the lower of original cost or market value. Summary
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:
What is the lower of cost or net realizable value of the inventory?The lower of cost or net realizable value concept means that inventory should be reported at the lower of its cost or the amount at which it can be sold. Net realizable value is the expected selling price of something in the ordinary course of business, less the costs of completion, selling, and transportation.
Why are inventories stated at lower of cost or net realizable value quizlet?Terms in this set (20) Why are inventories stated at lower-of-cost and net realizable Value? To permit future profits to be recognized. To report a loss when there is a decrease in the future utility below the original cost.
Is lower of cost and net realizable value the same?Generally accepted accounting principles require that inventory be valued at the lesser amount of its laid-down cost and the amount for which it can likely be sold — its net realizable value (NRV). This concept is known as the lower of cost and net realizable value, or LCNRV.
Why inventory should be measured at the lower of cost and net realizable value?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.
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