Lower of Cost or Market (LCM) Method: Why It’s Used and Application

Updated April 10, 2023

Definition

The lower of cost or market method is an accounting approach that values a company's inventory at the lesser of its historical cost or current market value.

What Is the Lower of♋ Cost or Market (LCM) ⛦Method?

The lower of cost or market (LCM) method states that when valuing a company’s inventory, it is recorded on the 澳洲幸运5开奖号码历史查询:balance sheet at either the 澳洲幸运5开奖号码历史查询:historical cost or the market value. Historical cost refers to the cost at ꦡwhich the inventory was purchased.

The value of a good can shift over time. This holds significance, because if the price at which the inventory can be sold falls below the 澳洲幸运5开奖号码历史查询:net realizable value (NRV) of the item, thus triggering a loss for the company, then th🌞e🌸 lower of cost or market method can be employed to record the loss.

Key Takeaways

The lower of cost or market (LCM) method relies on the fact that when 澳洲幸运5开奖号码历史查询:investors value a company’s inventory, those assets shall be recorded on the balance sheet at either the market value or the historical cost.
Historical cost refers to the cost of inventory at the time it was originally purchased.
The LCM method takes into account that the value of a good can fluctuate. Under this scenario, if the price at which the inventory may be sold dips below the net realizable value (NRV) of the item, which consequently results in a loss, then the LCM method can be employed to record the loss.
The LCM method is a tenet of generally accepted accounting principles (GAAP).

Why Is the Lower of Cost or Market (LC𓄧M) Method Used💦?

The lower of cost or market (LCM) method lets companies record losses by writing down the value of the affected inventory items. This value may be reduced to market value, which is defined as the middle value when comparing the cost to replace the inventory, the difference between the net realizable value and the typical profit on the item, and the net realizable value of the item. The amount by which the inventory item was written down is recorded under 澳洲幸运5开奖号码历史查询:cost of goods sold on the balance sheet.

The LCM method is part of 澳洲幸运5开奖号码历史查询:generally accepted accou🥃nting principlesಌ (GAAP) used in the United States and in international commerce. Almost all assets enter the 澳洲幸运5开奖号码历史查询:accounting system with a value equal to acquisition cost. GAAP prescribes many different methods🌱 for adjusting asset values in subsequent reporting periods.

In 2017, the 澳洲🍌幸运5开奖号码历史查询ꦯ:Financial Accounting Standards Board (FASB) issued an update to its code and standards that affect companies that use the 澳洲幸运5开奖号码历史查询:average cost and 澳洲幸运5开奖号码历史查询:last in, first out (LIFO) methods of inventory accounting. Companies that use these two methods of inventory accounting must now use the lower of cost or net realizable value method, which is more consistent with International Financial Reportinℱg Standards (IFRS).

Appliඣcation of the Lower of Cos♔t or Market (LCM) Rule

The lower of cost or market (LCM) rule traditionally applies to companies with products that become obsolete. The rule also ap💃plies to products that lose value due to a dwindled current market price, which is defined as the current cost of rep𝕴lacing outdated inventory, provided that the market price isn’t larger or smaller than the net realizable value, which is essentially the projected selling price minus disposal fees.

𒈔Other Factors in Applying the Lower of Cost or Market (LCM) Rul♑e

Category analysis: Although the lower of cost or market (LCM) rule is typically linked to a single product, it may also relate to a broad swath of related products.
Hedges: In cases where inventory is hedged by a 澳洲幸运5开奖号码历史查询:fair value hedge, the hedge’s effects should be added to the inventory’s cost, which may obliterate the need for LCM adjustments.
Last in, first out (LIFO) layer recovery: One may sidestep a write-down to the LCM during interim periods when evidence suggests that inventory will be restored by year’s end.
Raw materials: One shouldn’t write down 澳洲幸运5开奖号码历史查询:raw material costs, if the finished products are projected to sell at or above their costs.
Recovery: A 澳洲幸运5开奖号码历史查询:write-down to the LCM may be avoided if ample evidence exists that market prices will climb, prior to the sale of inventory.
Sales incentives: Potential LCM problems may exist with specific items where yet-to-be expired sales incentives are still in play.

The LCM rule was recently changed, making things easier for businesses that do not use the retail method or the last in, first out ♛(LIFO) method. Under the new guidelines, the measurement can be solely restricted to the lower of cost or net realizable value.

Is the lower of cost or market (LCM) method required by generally accepted accounting principles (GAAP)?

Yes, the LCM method is required un๊der GAAP. This method became requ🦹ired as of 2017.

What is the meaning of the lower of cost or market (LCM) method?

The lower of cost or market (LCM) method is used to value inventory by comparing the original cost and the c🌟urrent market price, and recording the cost of inventory by whichever is lower. This method is typically applicable to companies that hold inventories for extended periods, when inventory has declined in cost, or if inventory has gone obsolete.

What inventory costing methods are allowed by GAAP?

Along with the lower of cost or market (LCM) method being required by 🏅GAAP reporting, other inventory costing methods allowed by GAAP are:

澳洲幸运5开奖号码历史查询:First in, first out (FIFO)
Last in, first out (LIFO)
澳洲幸运5开奖号码历史查询:Weighted average valuation

The Bottom Line

The lower of cost or market (LCM) method is a conservative accounting principle used to value a company's inventory. While the LCM method may result in lower profits and lower taxes, it provides a more accurate picture of a company's financial health. Companies should carefully consider the LCM method when valuing their inventory to ensure that their financial statements are transparent and accurate.