Lower of Cost or Market Method - Explained
What is the Lower of Cost or Market Method?
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Table of ContentsWhat is the Lower of Cost or Market Method?How is the Lower of Cost or Market Method Used?Steps for Valuing Inventory at the LCMExample of Lower of Cost or Market MethodOther Factors Applicable to Lower of Cost or Market ValueAcademic Research on Lower of Cost or Market Method
What is the Lower of Cost or Market Method?
The lower of cost or market method refers to an inventory costing approach that values a company's stock on the balance sheet either at its current market cost or historical cost. The term historical cost refers to the cost of purchasing inventory, although there is a possibility of the value of a good change. If the value of the stock decreases below the historical price of the product causing loss to the company, then the market or lower of cost method can be applied to record the damage. The lower of cost or market method assumes that if the items purchasing price falls, its selling price will also go down.
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How is the Lower of Cost or Market Method Used?
According to LCM or market rule, every business must record the inventory at its current market price or the original cost. The law operates under the Generally Accepted Accounting Principles (GAAP) accounting framework. The situation usually comes up when there is a decline in market prices or when inventory becomes obsolete. The LCM rule is, in most cases, applicable when a business holds the stock for a more extended period. Note that the above conditions usually occur as time passes by. There is a simple rule that you must apply when using LCM. When the cost and the market value are equal, there is no loss or gain recognized. However, when the price happens to be higher than the market value, there is a loss acknowledged. What LCM method does is that it allows a business to record a loss by writing down the affected inventory items value. You can reduce the items value to the market value, also known as the middle value when comparing:
- The cost to replace the inventory
- The variance between the profit on the item and the net realizable value
- The net realizable value of the item
Steps for Valuing Inventory at the LCM
There are several steps involved when valuing inventory at lower of cost or market. They are as follows: Step one: Determine the inventory's purchase cost Step two: Determine the inventory's replacement cost Step three: Compare the net realizable value to the cost of replacement first, followed by the net realizable value minus average profit margin. If the replacement cost is higher than the net realizable value, then a net realizable value for replacement cost is used. However, if the replacement cost is less than the net realizable value, minus a normal profit margin, you can use the net realizable value for replacement cost. Where the net realizable value minus a normal profit margin is less than the replacement cost and less than the net realizable value, you can apply a replacement cost. Step four: Compare the inventory's cost to replacement cost. Where the inventory's price is less than the cost of replacement, there is no need for a write-down. However, if the inventory's price happens to be higher than the replacement cost, then a write-down inventory to cost of replacement becomes necessary.
Example of Lower of Cost or Market Method
Other Factors Applicable to Lower of Cost or Market Value
Category analysis: Although LCM or market rule applies to a specific inventory item, you can also use it on other inventory categories.
Raw Materials: When you are expecting to sell the finished goods either at the cost or above the raw materials expense, then you are not supposed to write down the raw materials cost.
Hedges: When there is hedging of inventory by a fair value hedge, then adding the hedges effects to the inventory's cost is necessary because it removes the need for market adjustment or lower price.
Recovery: You can avoid a write-down to LCM if there is evidence that before selling the inventory, the market prices will increase.
Sales incentives: If there is a loss on an items sales resulting from unexpired sales incentives, it is an indication that there could be a market problem with the object or a lower cost.
Academic Research on Lower of Cost or Market Method
- The impact of standard setting on relevance and reliability of accounting information: lower of cost or market accounting reforms in China, Yang, Z., Rohrbach, K., & Chen, S. (2005). Journal of International Financial Management & Accounting, 16(3), 194-228. In the era 1998-2000, China applied many new asset rules that makes the lower of cost or LCM for assets which are noncash. The paper studies the link of the value of net assets to the market value of capital and the link of accounting revenues with the inventory return on the basis of HCA (Historical Cost Accounting) and LCM. A model that controls the impacts of year and industry effects are named as Fixed Effects Model. It is used in the sample of a balanced panel. Its regressions indicate high explanatory power. The comparative evaluations of non-nested overlapping model famous as J and Cox measure the reliability. LCM reforms are related but the reliability doesnt increase.
- Where does the Information in Mark-to-Market Come from, Bleck, A., & Gao, P. (2010). Chicago Booth Research Paper# 10, 6. This paper investigates the data in MtM (Mark-to-Market) and from where it comes.
- Measuring reporting conservatism, Givoly, D., Hayn, C. K., & Natarajan, A. (2007). The Accounting Review, 82(1), 65-106. This paper presents a review of accounting in the perspective of estimating the conservatism in reporting.
- Control of international joint ventures, Groot, T. L., & Merchant, K. A. (2000). Accounting, Organizations and Society, 25(6), 579-607. This research states that several IJVs (International Joint Ventures) got no success. Some authors are of the view that control issues are its main reason. However, little International Joint Ventures research stresses on control problems. The results of big explanatory research involve in 3 successful IJ Ventures. But, it noticed fairly large differences in using the disputes settling policies, control tightness and focus as well. In short, the study provides a base for the contingency theory of Control Systems of International Joint Ventures.
- On cost tradeoffs between conservative and market value accounting, Bachar, J., Melumad, N. D., & Weyns, G. (1997). Review of Accounting Studies, 2(1), 7-34.The authors of this paper compare alternative accounting authorities. They point out a cost trade-off related to this comparison, which includes losses of equilibrium deadweight because of making transactions and audits across the LCM (Lower of Cost/Market), historical cost, and regimes of the market value. The authors give conditions for all these regimes to overcome others. Accounting of the market value spreads in the inflationary system as well as optimal in deflation. Finally, the historical cost persists only if the changes in the price of the asset is high enough.
- The capital market implications of the frequency of interim financial reporting: an international analysis, Mensah, Y. M., & Werner, R. H. (2008). Review of Quantitative Finance and Accounting, 31(1), 71-104. This is an empirical analysis of how many times the meantime financial reporting influences the vitality of the inventory price in 4 countries (Canada and the US with quarterly reporting), Australia and the UK with interim reporting on a semiannual basis during the fiscal year with numerous regimes of the interim reporting. The interim reporting of the semiannual basis will have lesser volatility of the price after other effects accounting. Further tests indicate higher volatility of the industries as compared to the domestic industries on their home SEs (Stock Exchanges).
- Examining the differences between United States Generally Accepted Accounting Principles (US GAAP) and International Accounting Standards (IAS): implications for , Ampofo, A. A., & Sellani, R. J. (2005, June). In Accounting forum(Vol. 29, No. 2, pp. 219-231). Elsevier. Modern trends show a continuous move to the accounting standards harmony. But it is not without any problem and concern. The pressure of the financial and political market push this move reversely. The frameworks of GAAP (Global Generally Accepted Principles), the United States GAAP and IAS (International Accounting Standards) have been discussed with many transactional examples. The implementation of accounting standards for the harmony comprise the arguments of GAAP as for and against.
- Lower of cost or market inventory valuation: IFRS versus US GAAP, Gray, D., & Ehoff Jr, C. (2014). Journal of Business & Economics Research. This paper takes under discussion the stock valuation of LCM (Lower of Cost/Market) in detail.
- Recoverable cost: the basis of a general theory of financial accounting measurement, Salvary, S. C. (1992). This research revolves around the measurement of financial accounting, which is stated in the rules of diverse valuation. Is it hodgepodge (miscellanies argument theory) or developed logically? The author highlights the recoverable cost being a measurement of financial accounting. He explains with strong evidence the recoverable cost is the focus of economic gravity. It can be derived from advanced axioms. He describes the difference in measurement theory and decision theory. So, we can conclude that the measurement of financial accounting is developed logically.
- SFAS No. 12 and the conceptual framework, Foran, N. J., & Foran, M. F. (1987). Accounting Horizons, 1(4), 43.This paper is about the Summary of Statement Number 12 and its underlying conceptual framework.
- Conservatism research: Historical development and future prospects, Basu, S. (2009). The conservatism of Chinese accounting has been under research made empirically in the last ten years. Bell, Wu (2000) and Robin initiated this research to use the latest research techniques for Chinese information. The author conducts a survey on its background. He gives suggestions for future research on Chinese conservatism. Lastly, he explains how his research is relevant to conservative accounting.