Lower of Cost or Market - AccountingTools
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Home >> Inventory Accounting Topics
Lower of Cost or Market (LCM)
Lower of Cost or Market Overview
The lower of cost or market rule states that a business must
record the cost of inventory at
whichever cost is lower the original cost or its current market
price. This situation typically
arises when inventory has deteriorated, or has become obsolete,
or market prices have
declined. The rule is more likely to be applicable when a
business has held inventory for a
long time, since the passage of time can bring about the
preceding conditions. The rule is
set forth under the Generally Accepted Accounting Principles
accounting framework.
The current market price is defined as the current replacement
cost of the inventory, as
long as the market price does not exceed net realizable value;
also, the market price shall
not be less than the net realizable value, less the normal
profit margin. 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.
Hedges. 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.
Recovery. You can avoid a write-down to the lower of cost or
market if there is
substantial evidence that market prices will increase before you
sell the inventory.
Sales incentives. If there are unexpired sales incentives that
will result in a loss on the
sale of a specific item, this is a strong indicator that there
may be a lower of cost or
market problem with that item.
Lower of Cost or Market Example
Mulligan Imports resells five major brands of golf clubs, which
are noted in the following
table. At the end of its reporting year, Mulligan calculates the
lower of its cost or net
realizable value in the following table:
Product Line
Quantity
on Hand
Unit Cost
Inventory
at Cost
Market
per Unit
Lower of Cost
or Market
Free Swing 1,000 $190 $190,000 $230 $190,000
Golf Elite 750 140 105,000 170 105,000
Hi-Flight 200 135 27,000 120 24,000
O p e r a t i o n a l A c c o u n t i n g T o p i c s
Lower of Cost or Market - AccountingTools
http://www.accountingtools.com/lower-of-cost-or-market[3/29/2015
11:35:22 AM]
Iridescent 1,200 280 336,000 160 192,000
Titanium 800 200 160,000 215 160,000
Based on the table, the market value is lower than cost on the
Hi-Flight and Iridescent
product lines. Consequently, Mulligan recognizes a loss on the
Hi-Flight product line of
$3,000 ($27,000 - $24,000), as well as a loss of $144,000
($336,000 - $192,000) on the
Iridescent product line.
If the amount of a write-down caused by the lower of cost or
market analysis is minor, then
charge the expense to the cost of goods sold. If the loss is
material, then you may want to
track it in a separate account (especially if such losses are
recurring), such as Loss on LCM
adjustment. To use the information in the preceding example, the
journal entry would be:
Debit Credit
Loss on LCM Adjustment 147,000
Finished Goods Inventory 147,000
Related Topics
Accounting inventory methods
FIFO vs. LIFO accounting
How do I report an inventory write down?
Journal entries for inventory transactions
Obsolete inventory accounting
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