What Is the Lower of Cost or Market Rule?
Uncover the core accounting guideline that shapes how businesses represent their holdings for accurate reporting.
The Lower of Cost or Market (LCM) principle is a fundamental accounting rule for valuing inventory. It ensures a company’s inventory is not reported at a value higher than its true worth. This principle departs from the historical cost principle, which records assets at their original purchase price. The LCM rule aligns with the conservatism principle, advising accountants to choose methods that result in lower asset values and net income when uncertainty exists. This approach prevents overstating assets and profits, providing a more realistic financial picture for stakeholders.
Understanding the Components: Cost and Market Value
“Cost” refers to the historical cost of inventory. This includes all expenditures incurred to acquire the inventory and bring it to its current condition and location, such as the purchase price and freight-in costs.
“Market value” is a more complex concept, especially for inventory measured using the Last-In, First-Out (LIFO) or retail inventory methods. For these methods, “market” is defined as the current replacement cost—the amount it would cost to purchase or produce the same inventory item today.
There are two limits on this replacement cost: a ceiling and a floor. The ceiling is the net realizable value (NRV), which is the estimated selling price minus any reasonably predictable costs of completion and disposal. For example, if an item is expected to sell for $100 and has $10 in selling costs, its NRV is $90. The replacement cost cannot exceed this ceiling.
The floor is the net realizable value less a normal profit margin. This ensures inventory is not valued below an amount that would prevent the company from earning its usual profit on the sale. If the NRV is $90 and the normal profit margin is $20, the floor would be $70. The replacement cost cannot be less than this floor.
For inventory measured using methods other than LIFO or the retail inventory method, such as First-In, First-Out (FIFO) or average cost, the Financial Accounting Standards Board (FASB) simplified the measurement principle. These inventories are now measured at the lower of cost and net realizable value (NRV) directly, eliminating the need to consider replacement cost, the ceiling, or the floor.
Applying the Lower of Cost or Market Rule
Applying the Lower of Cost or Market (LCM) rule involves comparing the historical cost of inventory with its determined market value, or net realizable value for certain inventory methods. The inventory is then recorded at the lower of these two amounts. This comparison can be performed using different methods.
One common approach is the individual item basis, where the LCM rule is applied to each specific inventory item separately. For example, if Product A costs $50 and has a market value of $40, it is valued at $40. If Product B costs $70 and has a market value of $80, it remains at $70. This method typically results in the lowest inventory valuation and the highest write-down.
Another method is the category basis, where the LCM rule is applied to groups or categories of similar inventory items. For instance, all types of electronic components could be grouped together. The total cost of the category is compared to the total market value, and the lower sum is chosen. This approach can lead to a slightly higher inventory value compared to the individual item basis, as declines in some items might be offset by stable or increasing values in others within the same category.
The third method is the total inventory basis, which applies the LCM rule to the entire inventory as a whole. Here, the total historical cost of all inventory is compared to the total market value of all inventory. The lower of these two aggregate amounts is then used to value the entire inventory. This method generally results in the highest inventory valuation among the three, as it allows for the broadest offsetting of value declines against value increases across the entire inventory.
Once the lower value is determined, an adjustment is made to record the inventory at that lower amount. This adjustment is often referred to as an inventory write-down. The decision of which application method to use should consider the nature of the inventory and the company’s overall financial reporting objectives.
Impact on Financial Statements
Applying the Lower of Cost or Market (LCM) rule impacts a company’s financial statements. When the market value, or net realizable value, of inventory falls below its historical cost, a write-down is required. This write-down reduces the reported value of inventory on the balance sheet.
On the income statement, this write-down increases the Cost of Goods Sold (COGS) in the period the decline occurs. For example, if inventory costing $10,000 is written down to $8,000, the $2,000 difference increases COGS. This increased COGS leads to a decrease in the company’s gross profit and net income for that period.
Under U.S. GAAP, once inventory is written down to its lower value, that reduced value becomes the new cost basis. If the market value of the inventory recovers in a subsequent period, the inventory cannot be written back up above this new cost basis.