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.
Understanding 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. and in international commerce. Almost all assets enter the accounting system with a value equal to acquisition cost. GAAP prescribes many different methods for adjusting asset values in subsequent reporting periods.
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.
Applying the Lower of Cost or Market Rule
The situation to apply the lower of cost or market rule typically arises when inventory has deteriorated, or has become obsolete, or market prices have declined. The rule is likely to be more relevant when a business has held inventory for a long time, since the passage of time can bring about the deteriorating conditions. The rule is set forth under the Generally Accepted Accounting Principles accounting framework.
The “current market price” is the current replacement cost of the inventory, as long as the market price does not exceed net realizable value. In addition, the market price is not 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.
Other Factors in Applying the Lower of Cost or Market Rule
- Category analysis: The lower of cost or market rule is normally applied to a specific inventory item, but it can apply to entire inventory categories. For instance, 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, add the effects of the hedge to the cost of the inventory, which frequently removes the need for a lower 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 with solid 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 over 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 the inventory is sold.
- Sales incentives: If there are unexpired sales incentives that cause a loss on the sale of a specific item, this indicates there may be a lower of cost or market problem with that item.
Recently, the rule was updated, which simplified matters somewhat, but only if a business is not using the last in, first out method or the retail method. The variation states that the measurement can be restricted to just the lower of cost and net realizable value.