What is the Lower of Cost or Market Rule?
Lower of Cost or Market is an accounting tool for valuation of inventory which simply means that the carrying amount of inventories on the balance sheet should be written down if the reported inventory value cost exceeds the market value.
Such adjustment to inventory value affects the financial statements –
- Inventory Write down to the current market value reduces the inventory as well as total assets.
- Inventory Write-down comes as an expense in the income statement.
- When the inventory value rises, the gains are ignored and inventory is valued at cost
Let us take a simple example –
- Assume that a company has inventory on its balance sheet at a cost of $55,000 and the management learns that the inventory’s replacement cost is $48,000.
- As per the LCM method management writes inventories down to a balance of $48,000.
- We note that the inventory write-down of $7000 reduces the Asset Size.
- The write-down reduces the net profit by $7000 (assuming no taxes).
- This reduced net profit reduces the Shareholders Equity (as it flows through retained earnings).
Inventory Valuation using Lower of Cost or Market Rule
Let us understand in below table how should we take the stock price of any product: For material A, B & E the cost price is lower than the Market price, so we have taken the cost price as the stock price. For material C & ED the cost price is higher than the Market price, so we have taken Market price as the stock price.
It is very important to analyze the reasoning behind this accounting policy. The accounting policies globally states that revenue or gains should be shown in the books when there is a high certainty of realizing it, however, all the foreseeable expenses or losses should be accounted for immediately. The lower of cost or market price policy follows this closely.
The stock can be in the form of raw material inventory, work in Progress inventory and finished well. It is widely known as Closing Stock/Inventory. The closing stock is shown as an asset in the Trial balance and while preparing financial statements, the closing stock is shown in the credit side of Profit & Loss and asset side of the Balance sheet.
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Examples of Lower of Cost or Market Price Rule
Let us understand the following examples:
Consider Cost Price $1000 and Market Price $1200.
In this case, when stock is valued at cost price $1000, Gross Profit is $1500:
In this case, when stock is valued at Market price $1200, Gross Profit is $1700:
In example 1 when we have valued stock at a lower of cost or a Market Price $1000, the Gross Profit is $1500, whereas in example 2 when we have valued stock at a higher of cost or a Market Price $1200 the Gross Profit is $1700. In the second example just because the stock is valued at a high price, the profit goes up by $200.The organization will end up paying taxes and complying with other statutory obligations on this amount.
Even if we say that at some point the organization will realize this $200, it is only going to be in the next accounting period and that is where it should be shown as sales. Showing stock at Market price $1200 also goes against the periodicity concept where we are showing revenue in one period and realizing in another.
Advantages of Lower of Cost or Market Price Rule
- Lower of cost follow the periodicity and conservatism concept of accounting.
- Lower of cost or market price allows more expensive items to be absorbed.
- Lower of cost saves an organization from paying extra taxes.
- Inventory valuation can be used as collateral for short term loans.
- Inventory valuation is also useful at the time of business sell-off.
Limitations of Lower of Cost or Market
- Lower of cost ignores the time factor which leads to over or understatement of profit.
- The selection of the correct method of valuation is always a complicated process.
- Any change is the valuation method must be informed to auditors and regulatory bodies.
- Stock counting and physical verification of stock is a time-consuming process.
Points to Note
- You need to analyze if a change is a short or long term.
- The method of valuation leads to a change in inventory value – it should be consistent with prior years.
- Any loss in value should be accounted for immediately.
- Any gain should not be accounted for unless realized or has a certainty of realization.
This is a method of inventory valuation which helps in reporting the true and fair view of financial statements of any organization to all the stakeholders. This accounting standard policy should be followed diligently to avoid any discrepancy in the audit process and reporting of financial statements.
This has been a guide to the Lower of Cost or Market. Here we discuss LCM Accounting Rule along with practical examples, advantages, and disadvantages. You can learn more about accounting from following articles –