Why are inventories stated at lower of cost or market

Lower of cost or market LCM is an approach to valuing and reporting inventory. Ending inventory is normally stated at historical cost what was paid to obtain it , but there are times when the original cost of the ending inventory is greater than the cost of replacement. Thus, the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The criterion for reporting this is the current market value.

Any loss resulting from the decline in the value of inventory is charged to cost of goods sold COGS if non-material, or loss on the reduction of inventory to LCM if material.

The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall. Under LCM, inventory items are written down to market value when the market value is less than the cost of the items.

The company would then record a USD loss because the inventory has lost some of its revenue-generating ability.

Employees should check the stock of certain items to maintain an accurate record for dollars of inventory in stock. Friedrich Von Hayek : Austrian economist Friedrich von Hayek, along with University of Chicago economist Milton Friedman are two classic liberal economists attributed with the return of laissez-faire economics and deregulation.

The company must recognize the loss in the period the loss occurred. List of Partners vendors. The lower of cost or market LCM method states that when valuing a company's inventory, 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.

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. 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. Recently, 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.

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.

Net realizable value is defined as the estimated selling price, minus estimated costs of completion and disposal. Additional factors to consider when applying the lower of cost or market rule are:.

Analysis by category. You normally apply the lower of cost or market rule to a specific inventory item, but you can apply it to entire inventory categories. In the latter case, an LCM adjustment can be avoided if there is a balance within an inventory category of items having market below cost and in excess of cost.

If inventory is being hedged by a fair value hedge , then add the effects of the hedge to the cost of the inventory, which frequently eliminates the need for a lower of cost or market adjustment. Last in, first out layer recovery. You can avoid a write-down to the lower of cost or market in an interim period if there is substantial evidence that inventory amounts will be restored by year end , thereby avoiding recognition of an earlier inventory layer.

Raw materials. Do not write down the cost of raw materials if the finished goods in which they are used are expected to sell either at or above their costs. Privacy Policy. Skip to main content. Unit 7: Inventory Valuation Methods. Search for:. Lower of Cost or Market Rule Generally, companies should use historical cost to value inventories and cost of goods sold.

Licenses and Attributions.