Lower of Cost or Market Overview
The lower of cost or market rule states that a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price. This situation typically arises when inventory has deteriorated, or has become obsolete, or market prices have declined. The rule is more likely to be applicable when a business has held inventory for a long time, since the passage of time can bring about the preceding conditions. The rule is set forth under the Generally Accepted Accounting Principles accounting framework.
The “current market price” is defined as the current replacement cost of the inventory, as long as the market price does not exceed net realizable value; also, the market price shall not be 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.
Additional factors to consider when applying the lower of cost or market rule are:
- Analysis by category. You normally apply the lower of cost or market rule to a specific inventory item, but you can apply it to entire inventory categories. In the latter case, 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, then add the effects of the hedge to the cost of the inventory, which frequently eliminates the need for a lower of 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 if there is substantial 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 above 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 you sell the inventory.
- Sales incentives. If there are unexpired sales incentives that will result in a loss on the sale of a specific item, this is a strong indicator that there may be a lower of cost or market problem with that item.
Lower of Cost or Market Example
Mulligan Imports resells five major brands of golf clubs, which are noted in the following table. At the end of its reporting year, Mulligan calculates the lower of its cost or net realizable value in the following table:
|Lower of Cost
Based on the table, the market value is lower than cost on the Hi-Flight and Iridescent product lines. Consequently, Mulligan recognizes a loss on the Hi-Flight product line of $3,000 ($27,000 - $24,000), as well as a loss of $144,000 ($336,000 - $192,000) on the Iridescent product line.
If the amount of a write-down caused by the lower of cost or market analysis is minor, then charge the expense to the cost of goods sold. If the loss is material, then you may want to track it in a separate account (especially if such losses are recurring), such as “Loss on LCM adjustment.” To use the information in the preceding example, the journal entry would be:
|Loss on LCM Adjustment||147,000|
|Finished Goods Inventory||147,000|