By default, the value of stock and inventory finds mention in accounting records at historical cost, or the cost paid to obtain inventory. At times, the inventory may become obsolete and newer technologies may reduce the cost of the product in the market, or the inventory may deteriorate, all leading to loss in value of carryover inventory. In such cases, the present value of inventory becomes lower than the historical or purchase costs. For instance, a retail merchant selling laptop computers may have purchased ten computers for sale at $1,000 each, but owing to the presence of latest models, the unsold stock becomes obsolete and the retailer now obtains the same stock for $800 each instead of the $1,000 he paid initially.
Very often, such loss in value also means reduced selling prices in the future for the unsold items. For instance, if the merchant had proposed to sell the laptops for $1,500, owing to reduced prices, competitors may sell the same for $1,300. The merchant would then have no option to sell for $1,300, causing a loss of $200 in estimated profits, corresponding to the loss of value in inventory.
In such cases, GAAP requires charging the loss in value of inventory to the revenues of the same period. The Accounting Research Bulletin No. 43 (ARB No. 43) recommends adopting Lower of Cost or Market, or the LCM method to help determine the amount of loss to charge against revenues. LCM is a conservative approach of taking the lowest figure when faced with two or more uncertain alternatives. “Cost" refers to the cost required to manufacture or acquire the inventory, and "market" refers to the prevailing prices in the market from where the merchant purchased the inventory, or the market where the merchant sells the merchandise or inventory stock.