The Revised Lower of Cost or Market Rule (#200)
/In this podcast episode, we discuss the recent change to the lower of cost or market rule. Key points made are noted below.
The Original Lower of Cost or Market Rule
The original rule came from the Accounting Research Bulletins, so it’s quite old – from the 1950s. The original rule stated that you had to record inventory at the lower of its cost or its market value, so essentially it was a write-down rule – something that businesses usually did as part of their year-end close. This write-down could happen for a lot of reasons, such as a decline in market prices, or inventory damage or obsolescence.
The trouble with the original rule was that there were a couple of ways to come up the market value part of the comparison. It could be replacement cost, or net realizable value, or net realizable value minus a normal profit margin. This meant that you needed to create a detailed spreadsheet to figure out if there might be a write-off. And, since companies usually only did it once a year, there was a lot of wasted effort every year to figure out how the calculation worked again. In short, it wasn’t overly practical.
The Revised Lower of Cost or Market Rule
The new approach streamlines the calculation, but not if an organization uses the last in, first out method or the retail inventory method. Those people are still stuck with the old, complicated approach.
The new rule is that the lower of cost or market means the lower of cost or net realizable value. Net realizable value is the estimated selling price, minus any expected costs for completing the inventory, disposing of it, and transporting it. There’s a certain amount of guessing and estimating to come up with net realizable value, but it can be done. And if market is lower than cost, then write off the difference.
From the perspective of a student, it makes the situation more difficult to comprehend, since you still have to learn about the more complex rules for the LIFO and retail costing methods. And if a company has subsidiaries where some use LIFO and some use FIFO, then different rules will apply to each one. Another point is that the results of companies will be slightly less comparable, depending on which lower of cost or market method they use.
The reason why they decided to use these differing approaches is that several companies using the LIFO and retail methods complained that converting to the new system would be excessively costly. So, because of these arguments, which strike me as being a one-time cost, we’re permanently stuck with a situation that’s even more complex than the old system, which was too complex to begin with.
Banning the Use of LIFO
A possible solution would be to ban the use of the LIFO method, since it’s already not allowed under international standards, and then force this new lower of cost or market approach onto anyone who’s using the retail method. And then we’d finally have a more streamlined system.