Lower of cost or market (LCM or LOCOM) is a conservative approach to valuing and reporting inventory. Normally, ending inventory is stated at historical cost. However, there are times when the original cost of the ending inventory is greater than the net realizable value, and 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 lower of cost or market concept first became part of normal accounting practices in England during the nineteenth century. Lower of cost or market was considered fair because assets were valued on a going-concern basis, rather than the price at which the assets were purchased. During the nineteenth century, lower of cost or market was not common practice for valuation of factory inventory in the United States. The concept was not easy for the Academic Accountants to accept due to its lack of logic. Despite the criticism, lower of cost or market quickly caught on in practice and by the early twentieth century was described as the most commonly accepted method for inventory valuation according to the Report of the Special Committee on Co-operation with Stock Exchanges.[1] Although it lacked accounting logic, lower of cost or market survived because of its conservative approach to valuation and because it addressed opposing principles of cost and value. Its conservatism allowed users to value the inventory at the price for which the inventory could be sold.
Three possible values can represent the market value: the replacement cost of the inventory, the net realizable value (also known as the "ceiling"), and the "floor" (the difference between the net realizable value and the normal profit).[2][3] In the lower of cost or market approach, companies must determine these three values and find the median of the values. The companies then compare the median value, which is called the designated market value, to the inventory cost that is recorded. The lower of these two values is subsequently reported on the balance sheet.[2] Because the lower of cost or market approach requires companies to use three possible market values, the companies' financial statements can be difficult to compare.
The term "lower of cost or market" is now obsolete and is officially replaced by "lower of cost and net realizable value". According to the FASB Accounting Standards Update, An entity should measure inventory within the scope of this Update at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.
This FASB update makes usage consistent with the IFRS wording and removes the use of "or" in a context where "and" was always the correct one.[4] However, the update does not apply to all companies. Companies that use the FIFO (first-in, first-out) and average-cost methods of inventory valuation are required to implement the changes, whereas companies that use the LIFO (last-in, first-out) and retail inventory methods are not affected by the update.[3]
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:
|
Lower of cost or market is only applicable to companies using FIFO
zusammenhängende Posts
Urheberrechte © © 2024 frojeostern Inc.
