Lower of Cost or Market
“Lower of Cost or Market” (LCM) is a conservative approach to valuing and reporting inventory. Under this principle, companies compare the purchase or production cost of each inventory item with its current market price and report the lower of the two. This is done to prevent overstatement of inventory and income when market prices have declined.
The LCM method complies with the conservatism principle in accounting, which advises that potential expenses and liabilities should be recognized as soon as possible, but revenue should not be recognized until it’s fully earned.
The “market” value in LCM is generally interpreted as the replacement cost (i.e., what it would cost to replace the item on the inventory). However, this value cannot be greater than the net realizable value (estimated selling price less costs to sell) or less than the net realizable value less a normal profit margin.
If the market price is less than the cost price, it indicates that the inventory has lost value and may not be able to recover its original cost. Therefore, the inventory is written down to its market value, and an impairment loss is recognized to reflect the reduced value of the inventory.
However, the specific guidelines for using LCM can vary by accounting standards (like U.S. GAAP vs. IFRS) and may have some exceptions or variations. It’s always a good idea to consult with a financial professional or an updated resource to get the most accurate and current information.
Example of Lower of Cost or Market
Let’s consider a hypothetical example involving a company that sells handmade wooden furniture.
Say, at the beginning of the year, the company purchases a certain type of wood for $200 per unit. By the end of the year, due to a surplus of this type of wood on the market, the price has dropped to $150 per unit.
In this case, the company would apply the Lower of Cost or Market (LCM) rule. Even though the company originally paid $200 per unit of wood, the current market price is only $150. According to the LCM rule, the company should value its inventory of this type of wood at the lower price, which is the current market price of $150 per unit.
The write-down from $200 to $150 would also result in a loss of $50 per unit, which would be recognized in the company’s income statement for that year. This way, the financial statements reflect the loss in the inventory’s value due to the market price decline, following the principle of conservatism in accounting.
This is a simplified example, and actual inventory accounting can be more complex, especially for large companies with diverse product lines. Always consult with a financial professional for accurate accounting.