What is the Lower of Cost or Market Method
The lower of cost or market method states that when valuing a company's inventory, it is recorded on the balance sheet at either the historical cost or the market value. Historical cost is the cost at which the inventory was purchased. However, the value of a good can change. If the price at which the inventory can be sold falls below the net realizable value of the item resulting in a loss to the company, the lower of cost or market method can be employed to record the loss.
BREAKING DOWN Lower of Cost or Market Method
The lower of cost or market method allows the company to record the loss by writing down the value of the affected inventory items. The value of the item can be reduced to the market value, which is defined as the middle value when comparing the cost to replace the inventory, the difference between the net realizable value and the typical profit on the item, and the net realizable value of the item. The amount by which the inventory item was written down is recorded under cost of goods sold on the balance sheet.
The lower of cost or market method is part of the GAAP rules used in the U.S. Recently, the FASB issued an update to their code and standards that affects companies that use the average cost and FIFO methods of inventory accounting. Companies that use these two methods of inventory accounting must now use the lower of cost or net realizable value method, which is more consistent with IFRS rules.