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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.
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LCM requires choosing the lower of market or “replacement cost" and cost or “net realizable value" to value inventory. The calculation of inventory value from the “cost" is based on changes to the cost price of the inventory, or the “replacement cost" to produce or repurchase the inventory, and not the selling price of the inventory, or what selling the inventory would realize. This replacement cost finds use to value inventory if it does not exceed “net realizable value," which is selling at prices less any sales related expense, or falls below “net realizable value" minus profits. If the replacement cost exceeds net realizable value, the net realizable value becomes the basis to value inventory, and if the replacement costs fall below net realizable value minus profits, then this figure, the net realizable value minus profits, becomes the basis to value inventory.
One easy way of applying LCM is to arrange the purchase cost, replacement cost, net realizable value (market value minus selling costs), and net realizable value minus normal profits in a descending order of amount. Unless the original purchase cost or historical cost is lower, the third amount is the LCM.
For instance, assume the historical cost of an inventory unit is $1,000, the replacement cost as $800, the market value at $1,200, normal profits at $500, and cost of selling at $50. Arranging the same in descending order lists the same as:
- Net realizable value (market value $1,200 - selling costs $50 = $1,150)
- Historic cost ($1,000)
- Net realizable value minus normal profits ($1,150 - $500 = $650
- Replacement cost ($800)
Here, the net realizable cost less normal profits is the LCM.
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Applying the LCM method to reduce the carrying value of inventory requires making journal entries to reflect the loss in the balance sheet.
- Debit: Loss from write-down of inventory (for material inventory)
- Debit: Cost of Goods Sold (for non-material inventory, or relatively small amounts)
- Credit: Inventory
To avoid distortions in cost of goods sold, companies reporting inventory under the lower of cost or market rule may also use a contra asset inventory allowance account. This account retains a credit balance for the amount equivalent to the amount by which the market value of the inventory is less the cost shown in the inventory account. The combination of the original inventory account balance and the contra asset inventory allowance account balance will equal the LCM.
If the market value of the inventory is greater than cost, a zero balance appears in the account Allowance to Reduce Inventory to LCM. There cannot be a debit balance in the Allowance account because of the cost principle and the revenue recognition principle.
The rules of double-entry accounting require a second account to balance an Allowance account. This second account will be an income statement account, such as Loss from Reducing Inventory to LCM.
LCM adjustments may apply to individual inventory items or item-by-item basis, inventory categories, or the entire inventory total. Applying LCM to inventory total is the least conservative approach, and applying LCM item-by-item is the most conservative method. Regardless of the approach, once done, such revised value becomes the "cost" value for future adjustments, ignoring historical cost or any future recovery.
LCM is a method of valuing inventory, and has the potential to create distortions in balance sheets. For instance, a company looking to show greater profits may overstate the current market value of obsolete inventory to retain the historical value and prevent slippage of the year’s profitability figure. The application of the LCM method to reduced inventory valuation nevertheless helps a company reduce its tax burden.
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- University of Oregon. "Lower of Cost or Market." http://darkwing.uoregon.edu/~stevem/actg610/102600.pdf. retrieved JUne 07, 2011.
- Accounting Coach. “Lower of Cost or Market (LCM)." http://www.accountingcoach.com/online-accounting-course/27Xpg01. Retrieved June 07, 2011.
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