Meaning of Lower of Cost or Market?

lesser of cost or market pricing prices inventory at the lesser of cost or market. It’s conservative accounting.

Explanation

Standard accounting standards (GAAP) assume inventories be recognized at cost.

If inventory goods are less useful than their cost, they must be written down to cost or market.

Accountants believe losses should be documented immediately, even though this violates the historical cost principle. Conservatism trumps historical cost convention here.

At least 90% of the 600 AICPA-surveyed corporations in 2019 reported inventory at cost or market.

Lower Cost or Market Theory

The lower of cost or market rule uses one of the cost flow methods to determine cost, which is usually replacement cost or the cost of a similar inventory item.

The lower of cost or market hypothesis states that if an item’s replacement cost lowers, its sales price will too.

Accountants believe that all losses should be recorded when they occur, therefore this loss is recognized when the price drops, not when the item is sold.

Example

Assume these facts to demonstrate the LCM rule:

Shanken Company buys one inventory item for $80 in year 1. The average selling price is $100, with a 20% gross margin.

The object is kept year-round. However, its replacement cost drops 10% this year. from $80 to $72. There are no transactions in the year.

The item costs $90 in year 2.

The above example exhibits the effect on two-year reported earnings with and without lowest of cost or market rule.

Assuming replacement cost dropped 10%, or $8 from $80 to $72, the item’s selling price reduced 10%, or $10 from $100 to $90.

In Case 1, the LCM rule is applied. Replacement cost drop causes a $8 loss in year 1. Year 2 sales had a $18 gross margin.

Shanken Company’s typical gross margin is 20%, thus this $18 gross margin is 20%.

Applying the lesser of cost or market forces the company to lose money in year 1, the year of the price drop, but it allows it to earn its typical gross margin % in subsequent years. Total income is $10 over two years.

Case 2 highlights the impact of not using the lower of cost or market criteria. With no income or loss in year 1, the sale has the most impact in year 2. Gross margin drops to $10 and 11% in year 2.

The two-year income is 410, the same as Case 1. Thus, decrease of cost or market affects income distribution within two years but not combined income.

This graphic assumes that a lower replacement cost will lower the sales price. However, that one-for-one relationship is not always true.

Suppose the Shanken Company’s inventory item’s replacement cost lowers 10% but the sales price doesn’t change.

Applying the lowest of cost or market would understate income in year 1 and overestimate income in year 2 and violate conservative. Lower of cost or market must be used cautiously.

Application of Lower Cost or Market

Two steps are needed to apply lower cost or market.

Market, or the item’s replacement cost, is calculated first. This is normally done by reviewing vendor bills at year-end.

Second, market or replacement cost is compared to cost, and inventory is lowered to the lower of cost or market if necessary.

Generally accepted accounting rules allow item-by-item, group-of-item, or inventory-wide comparisons.

Example of LCM comparison on all three bases.

The item-by-item basis requires individual comparison for all things. This yields $24,000 inventory. Under the group basis, inventory is separated into luxury and standard groups and compared for each group total.

For instance, the luxury group’s value is $22,000 because its cost is $22,500 and its market value is $22,000. The standard group is valued at $2,750 after comparison.

This yields $24,750 in inventory. Comparing the cost and market of the entire inventory yields $24,800.

Out of the three ways, the item-by-item method has the lowest inventory value and is most cautious. This is because increases in one item cannot offset decreases in others, as in group and total inventory.

Cost-Market-Income Tax Lower

The Internal Revenue Code regulates federal tax use of lesser of cost or market.

Two rules distinguish tax usage of lower of cost or market from financial reporting.

First, tax purposes only allow FIFO, not LIFO, with lower of cost or market. However, LIFO plus lower of cost or market is acceptable under GAAP.

Second, tax reasons only apply lowest of cost or market item-by-item. Group or total inventory isn’t allowed.