Lower of cost or market is a rule intended to account for the possibility of losses in inventory value from drops in price or outmoded merchandise. It is a conservatism measure provided when inventory has fallen below current market and historical cost. Any of these losses are charged as cost of goods sold or loss on the reduction of inventory to LCM.
Products may fall in value for a number of reasons. For example, if a retailer purchased a product in bulk for $50 each, intends to sell it for $70 each, and the price was cut by the manufacturer to $30 each, other retailers will lower their prices to accommodate. Each sale for the original retailer would automatically come with a loss. This loss must be accounted for on the income statement for that period.
In most cases, product losses are detailed in the cost of goods sold account. However, in the case of considerable losses in market value, the losses are recorded in a loss due to market decline account. Note that lower of cost or market can be utilized with any inventory method (periodic/retail) and costing method (Specific Identification Costing, Weighted Average, FIFO), with the exception of LIFO. The LIFO method is not allowed for lower of cost or market, as defined by the IRS.
The lower of cost or market rule can apply to an item-by-item basis, a group of products, or to products in total. The item-by-item basis is most common, as defined by the IRS, and is the most conservative method favored by accountants. By utilizing the item-by-item basis, each item’s value is unique and losses are not offset by gains.
The ‘market’ in lower of cost or market details the replacement cost of an item. This amount has an upper limit and a lower limit and cannot go higher than the upper limit or lower than the lower limit. This upper limit directly correlates with the net realizable value of an item and cannot be exceeded by the market value. However, if the cost to replace an item exceeds the upper limit, or ceiling amount, the net realizable value replaces the market amount. The lower limit for market directly correlates with the net realizable value, minus regular profits. If the cost to replace an item falls below this amount, the lower limit, or floor amount, replaces the market value.
In order to determine the market value, the replacement costs, upper/ceiling value, and lower/floor value should be found. Then, the values are arranged from lowest to highest. When the amounts are accumulated, the middle value serves as the market value. This market value is then compared with the cost amount and, using conservatism, the lower value determines the ending inventory amount. Once market value is determined, this forms the cost basis for determining lower of cost or market in the future.