Which method may be used to record a loss due to a price decline in the value of inventory

Rationale Behind Lower of Cost or Market (LCM)

When inventory is purchased by a company, it sits on the balance sheet at cost. However, over time, the value of the inventory may depreciate or appreciate. To increase the reliability of financial statements, the changing value of inventory, to an extent, must be accounted for.

For example, if a company purchased inventory at the cost of $100,000 but the market value of the inventory is $20,000, users of financial statements would want the lower value to be reflected in the books. If the inventory value were not reassessed to the appropriate value, it would overstate the company’s assets and mislead users. However, as will be discussed below, the lower of cost or market inventory valuation method is not as simple as just comparing cost and market.

Valuing Inventory at Lower of Cost or Market (LCM)

In the lower of cost or market inventory valuation method, the company’s inventory purchased at cost is compared against the market value of that inventory. The market value of inventory is essentially the replacement cost of that inventory or the amount of money it would take to replace the inventory in the open market. However, there are some caveats for understanding replacement value:

1. The replacement cost cannot exceed the net realizable value (NRV).
2. The replacement cost cannot be lower than net realizable value less a normal profit margin.

Net realizable value is the sale price of the inventory minus any costs incurred to prepare the inventory for sale. A normal profit margin is the average spread between the cost and sale price of the inventory. Such caveats for replacement cost establish a floor and ceiling for replacement cost. It is illustrated as follows:

Here are the steps to valuing inventory at the lower of cost or market:

1. First, determine the historical purchase cost of inventory.

2. Second, determine the replacement cost of inventory. It is the same as the market value of inventory.

3. Compare replacement cost to net realizable value and net realizable value minus a normal profit margin. If:

• Replacement cost > net realizable value, use net realizable value for replacement cost.
• Replacement cost < net realizable value minus a normal profit margin, use net realizable value minus a profit margin for replacement cost.
• Net realizable value minus a normal profit margin < replacement cost < net realizable value, use replacement cost.

4. Compare the cost of inventory to replacement cost. Lastly, if:

• Historical cost of inventory < replacement cost, a write-down is not necessary.
• Cost of inventory > replacement cost, write-down inventory to replacement cost.

To fully understand the concepts, a comprehensive example is prepared below.

Examples of Lower of Cost or Market (LCM)

Example 1

ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:

• The purchase cost: $250
• The replacement cost: $150
• The net realizable value: $160 ($200 – $40)
• The net realizable value minus a normal profit margin: $140 ($160 – $20).

In this example, replacement cost falls between net realizable value and net realizable value minus a normal profit margin. Therefore, the replacement cost used is $150. Comparing the amount to the purchase cost of $250, a $100 write-down is necessary.

Example 2

ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:

• The purchase cost: $250
• The replacement cost: $120
• The net realizable value: $160 ($200 – $40)
• The net realizable value minus a normal profit margin: $140 ($160 – $20)

In this example, replacement cost falls below the net realizable value minus a normal profit margin. Therefore, the replacement cost used is $140. Comparing the amount to the purchase cost of $250, a $110 write-down is necessary.

Example 3

ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:

• The purchase cost: $250
• The replacement cost: $240
• The net realizable value: $160 ($200 – $40)
• The net realizable value minus a normal profit margin: $140 ($160 – $20)

In this example, replacement cost is above net realizable value. Therefore, the replacement cost used is $160. Comparing the amount to the purchase cost of $250, a $90 write-down is necessary.

Recording Lower of Cost or Market

If the market cost is lower than the cost, a write-down is necessary. The journal entry would be as follows:

The loss from the decline in inventory value would be reflected in the income statement and reduce net income. Inventory would be reflected in the balance sheet and reduce the value of inventory.

The journal entry for the three examples above would be:

Example 1

Example 2

Example 3

More Resources

Thank you for reading CFI’s guide to Lower of Cost or Market. To keep advancing your career, the additional CFI resources below will be useful:

• IFRS vs. US GAAP
• Inventory Audit
• Market Valuation Approach
• T Accounts Guide

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The lower of cost or market method refers to an inventory costing approach that values a company's stock on the balance sheet either at its current market cost or historical cost. The term historical cost refers to the cost of purchasing inventory, although there is a possibility of the value of a good change. If the value of the stock decreases below the historical price of the product causing loss to the company, then the market or lower of cost method can be applied to record the damage. The lower of cost or market method assumes that if the items purchasing price falls, its selling price will also go down.

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How is the Lower of Cost or Market Method Used?

According to LCM or market rule, every business must record the inventory at its current market price or the original cost. The law operates under the Generally Accepted Accounting Principles (GAAP) accounting framework. The situation usually comes up when there is a decline in market prices or when inventory becomes obsolete. The LCM rule is, in most cases, applicable when a business holds the stock for a more extended period. Note that the above conditions usually occur as time passes by. There is a simple rule that you must apply when using LCM. When the cost and the market value are equal, there is no loss or gain recognized. However, when the price happens to be higher than the market value, there is a loss acknowledged. What LCM method does is that it allows a business to record a loss by writing down the affected inventory items value. You can reduce the items value to the market value, also known as the middle value when comparing:

• The cost to replace the inventory
• The variance between the profit on the item and the net realizable value
• The net realizable value of the item

Steps for Valuing Inventory at the LCM

There are several steps involved when valuing inventory at lower of cost or market. They are as follows: Step one: Determine the inventory's purchase cost Step two: Determine the inventory's replacement cost Step three: Compare the net realizable value to the cost of replacement first, followed by the net realizable value minus average profit margin. If the replacement cost is higher than the net realizable value, then a net realizable value for replacement cost is used. However, if the replacement cost is less than the net realizable value, minus a normal profit margin, you can use the net realizable value for replacement cost. Where the net realizable value minus a normal profit margin is less than the replacement cost and less than the net realizable value, you can apply a replacement cost. Step four: Compare the inventory's cost to replacement cost. Where the inventory's price is less than the cost of replacement, there is no need for a write-down. However, if the inventory's price happens to be higher than the replacement cost, then a write-down inventory to cost of replacement becomes necessary.

Example of Lower of Cost or Market Method

Other Factors Applicable to Lower of Cost or Market Value

Category analysis: Although LCM or market rule applies to a specific inventory item, you can also use it on other inventory categories. 

Raw Materials: When you are expecting to sell the finished goods either at the cost or above the raw materials expense, then you are not supposed to write down the raw materials cost. 

Hedges: When there is hedging of inventory by a fair value hedge, then adding the hedges effects to the inventory's cost is necessary because it removes the need for market adjustment or lower price. 

Recovery: You can avoid a write-down to LCM if there is evidence that before selling the inventory, the market prices will increase. 

Sales incentives: If there is a loss on an items sales resulting from unexpired sales incentives, it is an indication that there could be a market problem with the object or a lower cost.

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