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 –

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

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 policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.read more 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 inventoryRaw Material InventoryRaw materials inventory is the cost of products in the inventory of the company which has not been used for finished products and work in progress inventory. Raw material inventory is part of inventory cost which is reported under current assets on the balance sheet.read more, 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.

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 ProfitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more 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 periodNext Accounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more, 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:

Limitations

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

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 valuationInventory Valuation Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company's inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company's bottom-line numbers and cash flow situation.read more. 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more.

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