WallStreetMojo

WallStreetMojo

WallStreetMojo

MENUMENU
  • Free Tutorials
  • Certification Courses
  • 250+ Courses All In One Bundle
  • Login
Home » Accounting Tutorials » Assets Tutorials » Lower of Cost or Market

Lower of Cost or Market

What is the Lower of Cost or Market Rule?

Lower of cost or market (LCM) is the conservative way through which the inventories are reported in the books of accounts which states that the inventory at the end of the reporting period is to be recorded at the original cost or the current market price of the inventory, whichever is lower.

It 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 the 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.

Lower of the Cost or Market

  • 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 the below table how we should 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.

Example1

It is very important to analyze the reasoning behind this accounting policy. The accounting policies globally state 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 the Profit & Loss and asset side of the Balance sheet.

Popular Course in this category
Sale
All in One Financial Analyst Bundle (250+ Courses, 40+ Projects)
4.9 (1,067 ratings)
250+ Courses | 40+ Projects | 1000+ Hours | Full Lifetime Access | Certificate of Completion
View Course

Examples of Lower of Cost or Market Price Rule

Let us understand the following examples:

Consider Cost Price $1000 and Market Price $1200.

Example #1

In this case, when stock is valued at cost price $1000, Gross Profit is $1500:

Lower of Cost Example1.1

Example #2

In this case, when stock is valued at Market price $1200, Gross Profit is $1700:

Example1.2

For example, 1 when we have valued stock at a lower cost or a Market Price of $1000, the Gross Profit is $1500, whereas in example 2, when we have valued stock at a higher cost or a Market Price of $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.

Note: $200 is not yet realized by the organization.

Advantages

Some of the advantages of lower cost are as follows:

  • Lower of cost follow the periodicity and conservatism concept of accounting.
  • It allows for 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

Some of the limitations of lower-cost are as follows:

  • Lower 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.

Conclusion

Lower of cost or market (LCM) is a method of inventory valuation. It 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.

Recommended Articles

This article 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 –

  • Inventory Excel Template
  • Periodic Inventory System
  • Cost Structure
  • Cost of Debt Formula
0 Shares
Share
Tweet
Share
Primary Sidebar
Footer
COMPANY
About
Reviews
Contact
Privacy
Terms of Service
RESOURCES
Blog
Free Courses
Free Tutorials
Investment Banking Tutorials
Financial Modeling Tutorials
Excel Tutorials
Accounting Tutorials
Financial Statement Analysis
COURSES
All Courses
Financial Analyst All in One Course
Investment Banking Course
Financial Modeling Course
Private Equity Course
Venture Capital Course
Excel All in One Course

Copyright © 2021. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. CFA® And Chartered Financial Analyst® Are Registered Trademarks Owned By CFA Institute.
Return to top

WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

* Please provide your correct email id. Login details for this Free course will be emailed to you

Book Your One Instructor : One Learner Free Class
Let’s Get Started
Please select the batch
Saturday - Sunday 9 am IST to 5 pm IST
Saturday - Sunday 9 am IST to 5 pm IST

This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy. By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy

Login

Forgot Password?

WallStreetMojo

Free Accounting Course

You will Learn Basics of Accounting in Just 1 Hour, Guaranteed!

* Please provide your correct email id. Login details for this Free course will be emailed to you

New Year Offer - All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) View More