Lower of Cost or Market: Videos & Practice Problems

The lower of cost or market (LCM) rule in accounting is a principle that requires inventory to be recorded at the lower of its historical cost or its current market value. The market value is defined as the net realizable value, which is the estimated selling price minus any disposal costs. This rule aligns with the conservatism principle, ensuring that potential losses are recognized promptly, while gains are only recorded when realized. For example, if inventory purchased for $84,000 has a net realizable value of $79,000, it should be marked down to $79,000, resulting in a $5,000 loss.

The net realizable value (NRV) of inventory is calculated by estimating the selling price of the inventory and then subtracting any costs associated with selling or disposing of the inventory. The formula is:

$\mathrm{NRV}=\mathrm{Estimated} \mathrm{Selling} \mathrm{Price}-\mathrm{Disposal} \mathrm{Costs}$

For example, if the estimated selling price is $86,000 and the disposal costs are $7,000, the NRV would be $79,000.

The lower of cost or market rule is important in financial accounting because it ensures that inventory is not overstated on the balance sheet. This rule adheres to the conservatism principle, which prioritizes recognizing potential losses over unrealized gains. By valuing inventory at the lower of its cost or market value, companies provide a more accurate and conservative representation of their financial position, which is crucial for stakeholders making informed decisions.

To record a loss from a write-down of inventory, you need to make a journal entry that debits a loss account and credits the inventory account. For example, if inventory originally valued at $84,000 is written down to $79,000, the entry would be:

$\mathrm{Debit}:\mathrm{Loss} \mathrm{from} \mathrm{Write-Down} \mathrm{of} \mathrm{Inventory} \$5,000$

$\mathrm{Credit}:\mathrm{Inventory} \$5,000$

This entry reduces the inventory value on the balance sheet and recognizes the loss on the income statement.

The rule of conservatism in accounting is a principle that advises accountants to exercise caution and prudence when recording financial transactions. It suggests that potential losses should be recognized as soon as they are foreseeable, while gains should only be recorded when they are realized. This approach ensures that financial statements do not overstate assets or income, providing a more accurate and reliable representation of a company's financial position. The lower of cost or market rule for inventory valuation is an application of this principle.