The lower of cost or market basis is an example of the accounting concept of conservatism

What is the Lower of Cost or Market Rule?

Lower cost or market (LCM) is the conservative way through which the inventories are reported in the books of accounts, which states that the inventory at the end of the reporting period is to be recorded at the original cost or the current market price of the inventory, whichever is lower.

It simply means that the carrying amount of inventories on the balance sheet should be written down if the reported inventory value exceeds the market value.

Such adjustment to inventory value affects the financial statements –

• Inventory Write downInventory Write-Down refers to decreasing the value of an inventory due to economic or valuation reasons. When the inventory loses some of its value due to damaged or stolen goods, the management devalues it & reduces the reported value from the Balance Sheet. read more to the current market value reduces the inventory and total assetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more.
• Inventory Write-down comes as an expense in the income statementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more.
• When the inventory value rises, the gains are ignored, and inventory is valued at cost.

Let us take a simple example –

• Assume that a company has inventory on its balance sheet at $55,000, and the management learns that the inventory’s replacement cost is $48,000.
• As per the LCM method, management writes inventories down to a balance of $48,000.

• We note that the inventory write-down of $7000 reduces the Asset Size.
• The write-downWhen the carrying value (purchase price – accumulated depreciation) of an asset exceeds its fair value, it is referred to as a write down.read more reduces the net profit by $7000 (assuming no taxes).
• This reduced net profit reduces the Shareholders EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more (as it flows through retained earnings).

Inventory Valuation Using Lower Cost or Market Rule

Let us understand in the below table how we should take the stock price of any product: For materials A, B & E, the cost price is lower than the Market price, so we have taken the cost price as the stock price. For material C & ED, the cost price is higher than the Market price, so we have taken the Market price as the stock price.

It is very important to analyze the reasoning behind this accounting policy. The accounting policiesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.read more globally state that revenue or gains should be shown in the books when there is a high certainty of realizing it. However, all the foreseeable expenses or losses should be accounted for immediately. The lower cost or market price policy follows this closely.

The stock can be in the form of raw material inventoryRaw materials inventory is the cost of products in the inventory of the company which has not been used for finished products and work in progress inventory. Raw material inventory is part of inventory cost which is reported under current assets on the balance sheet.read more,  work in progress inventory, and finished well. It is widely known as Closing Stock/Inventory. The closing stock is shown as an asset in the Trial balanceTrial Balance is the report of accounting in which ending balances of a different general ledger are presented into the debit/credit column as per their balances where debit amounts are listed on the debit column, and credit amounts are listed on the credit column. The total of both should be equal.read more, and while preparing financial statements, the closing stock is shown on the credit side of the Profit & Loss and asset side of the Balance sheet.

Examples of Lower Cost or Market Price Rule

Let us understand the following examples:

Consider Cost Price $1000 and Market Price $1200.

Example #1

In this case, when stock is valued at a cost price of $1000, Gross Profit is $1500:

Example #2

In this case, when the stock is valued at a Market price of $1200, Gross Profit is $1700:

For example, 1, when we have valued stock at a lower cost or a Market Price of $1000, the Gross Profit is $1500, whereas in example 2, when we have valued stock at a higher cost or a Market Price of $1200 the Gross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more is $1700. In the second example, just because the stock is valued at a high price, the profit increases by $200.The organization will pay taxes and comply with other statutory obligations on this amount.

Even if we say that at some point, the organization will realize this $200, it is only going to be in the next accounting periodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more, and that is where it should be shown as sales. Showing stock at a Market price of $1200 also goes against the periodicity concept where we are showing revenue in one period and realizing it in another.

Note: $200 is not yet realized by the organization.

Advantages

Some of the advantages of lower cost are as follows:

• Lower of cost follow the periodicity and conservatism concept of accountingThe conservatism principle of accounting guides the accounting, according to which there is any uncertainty. All the expenses and liabilities should be recognized. In contrast, all the revenues and gains should not be recorded, and such revenues and profits should be recognized only when there is reasonable certainty of its actual receipt.read more.
• It allows for more expensive items to be absorbed.
• Lower cost saves an organization from paying extra taxes.
• Inventory valuation can be used as collateral for short term loansShort-term loans are defined as borrowings undertaken for a short period to meet immediate monetary requirements.read more.
• Inventory valuation is also useful at the time of business sell-off.

Limitations

Some of the limitations of lower cost are as follows:

• Lower cost ignores the time factor, leading to over or understating profit.
• The selection of the correct method of valuation is always a complicated process.
• Any change is the valuation method must be informed to auditorsAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws.read more and regulatory bodies.
• Stock counting and physical verification of stock are time-consuming processes.

Points to Note

• You need to analyze if a change is short or long-term.
• The valuation method leads to a change in inventory value – it should be consistent with prior years.
• Any loss in value should be accounted for immediately.
• Any gain should not be accounted for unless realized or has a certainty of realization.

Conclusion

Lower of cost or market (LCM) is a method of inventory valuation Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company's inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company's bottom-line numbers and cash flow situation.read more. It helps in reporting the true and fair view of the financial statements of any organization to all the stakeholders. This accounting standard policy should be followed diligently to avoid any discrepancy in the audit process and reporting of financial statementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more.

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