Lower of Cost or Market (LCM)

Definition§

The Lower of Cost or Market (LCM) rule is an accounting principle used to value and report inventory. Under this method, inventory is recorded on the balance sheet at either its original cost or market value, whichever is lower. The purpose of this rule is to recognize inventory losses earlier and prevent overstatement of assets.

• Historical Cost: The original purchase price of the inventory.
• Market Value: This is the current replacement cost of the inventory. It is limited by two factors:
  • Upper Limit (Net Realizable Value - NRV): The estimated selling price of inventory in the normal course of business, less reasonably predictable costs of completion, disposal, and transportation.
  • Lower Limit (NRV minus normal profit margin): NRV further reduced by a normal profit margin.

Examples§

1. Example 1: A company purchased inventory for $100,000, but the replacement cost has fallen to $90,000 due to market conditions. The NRV of the inventory is $95,000, and the NRV minus a normal profit margin is $85,000. In this case, the inventory is written down to the replacement cost of $90,000 because it falls between the upper and lower limits.
2. Example 2: If the replacement cost of the same inventory fell to $80,000, which is below the NRV minus normal profit margin of $85,000, the inventory would be written down to the lower limit of $85,000.

Frequently Asked Questions§

Q1: What is the purpose of the Lower of Cost or Market method?

• The LCM method aims to ensure that inventory is not overstated on the balance sheet. It provides a conservative approach by recognizing losses in inventory value early.

Q2: How often does an accountant need to apply the LCM analysis?

• Typically, the LCM analysis is performed at the end of each accounting period when financial statements are prepared.

Q3: Can the LCM method cause fluctuations in net income?

• Yes, by writing down inventory to market value, companies might report lower net income in periods when inventory value declines significantly.

Q4: How does LCM compliance enhance financial reporting?

• Compliance with LCM prevents the overstatement of assets and ensures that financial statements provide a realistic view of a company’s financial condition.

Related Terms§

• Net Realizable Value (NRV): The estimated selling price in the ordinary course of business minus any costs to complete and sell the product.
• Historical Cost: The original purchase price or production cost of an asset or inventory.
• Replacement Cost: The cost to replace an inventory item in its identical form.

Online References§

• FASB Accounting Standards Codification
• Investopedia on Lower of Cost or Market
• American Institute of CPAs (AICPA)

Suggested Books for Further Studies§

• “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.
• “Financial Accounting” by Robert Libby, Patricia Libby, and Frank Hodge.
• “Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso.

Fundamentals of Lower of Cost or Market: Accounting Basics Quiz§

Thank you for exploring the essential accounting concept of “Lower of Cost or Market” with this in-depth guide and challenging quiz questions to enhance your financial reporting knowledge!