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

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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 Ma𒉰🦄rket (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官方开奖结果体彩网:balance sheet at either the 澳洲幸运5官方开奖结果体彩网:historical cost or the market value. Historical cost refers to the co꧋st at which 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官方开奖结果体彩网:net realizable value (NRV) of the item, thus trigg🧜ering a loss for the company, then the 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官方开奖结果体彩网: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 (LCM) Metho♔d 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官方开奖结果体彩网:cost of goods sold on the balance sheet.

The LCM method is part of 澳洲幸运5官方开奖结果体彩网:generally accepted acc🎉ounting principles🐼 (GAAP) used in the United States and in international commerce. Almost all assets enter the 澳洲幸运5官方开奖结果体彩网:accounting system with a value equal to acquisition cost. 🐭GAAP prescribes many diffཧerent methods for adjusting asset values in subsequent reporting periods.

In 2017, the 澳洲幸运5官方开奖结果体彩网:Financial Accounting Standards B🌠oard (FASB) issued an update to its code and standards that affect companies that use the 澳洲幸运5官方开奖结果体彩网:average cost and 澳洲幸运5官方开奖结果体彩网: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 Reporting Standa♛rds (IFRS).

Application of the Lo💜wer of Cost or Market (LCM) Rule

🌳 The lower of cost or market (LCM) rule traditionally applies to companies with products that become obsolete. The rule also applies to products that lose value due to a dwindled current market price, which is defined as the current cost of replacing 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.

Other Factors in Applying🐭 the Lower of Cost or M♏arket (LCM) Rule

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官方开奖结果体彩网: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官方开奖结果体彩网:raw material costs, if the finished products are projected to sell at or above their costs.
Recovery: A 澳洲幸运5官方开奖结果体彩网: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 chang🎀ed, 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 under GAAP. This methജod became required 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 current 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 low𒁃er of cost or market (LCM) method being required by GAAP reporting, other inventory costing methods allowed by GAAP are:

澳洲幸运5官方开奖结果体彩网:First in, first out (FIFO)
Last in, first out (LIFO)
澳洲幸运5官方开奖结果体彩网: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.