Lower of cost or market

What Is Lower of Cost or Market?

Lower of cost or market (LCM) is an accounting principle and method used to value inventory on a company's balance sheet. It falls under the broader category of accounting principles and inventory valuation. This conservative approach mandates that inventory must be recorded at the lower of its original historical cost or its current market value. The primary aim of the lower of cost or market rule is to prevent the overstatement of assets and earnings by recognizing potential losses from declines in inventory value promptly. This ensures that a company's financial statements present a more realistic and cautious view of its financial health.

History and Origin

The concept of lower of cost or market has deep roots in the tradition of conservative accounting, emerging in England during the 19th century and gaining traction in the United States by the early 20th century.³⁰ Initially, academic accountants found the concept difficult to accept due to perceived inconsistencies, yet it quickly became a widely adopted method for inventory valuation in practice.²⁸, ²⁹ Its widespread acceptance stemmed from its conservative nature, ensuring that inventory was valued at a price it could realistically be sold for, and its ability to reconcile the opposing principles of cost and value.²⁶, ²⁷

A significant development in the application of this principle occurred with the issuance of Accounting Standards Update (ASU) 2015-11 by the Financial Accounting Standards Board (FASB). This update, effective for fiscal years beginning after December 15, 2016, officially replaced the traditional lower of cost or market concept for most inventory under U.S. Generally Accepted Accounting Principles (GAAP) with a new standard: "lower of cost and net realizable value" (LC&NRV).²⁵ This change aimed to simplify the complexities of determining "market" and reduce the associated measurement costs.²⁴

Key Takeaways

• Lower of cost or market (LCM) is a conservative accounting principle that requires inventory to be valued at the lower of its historical cost or its current market value.
• This rule prevents the overstatement of assets on the balance sheet and ensures that potential losses from declining inventory value are recognized promptly.
• Under U.S. GAAP, the traditional "lower of cost or market" rule was largely superseded by "lower of cost and net realizable value" (LC&NRV) in 2016 for inventory not valued using LIFO or the retail inventory method.
• The application of LCM (or LC&NRV) can significantly impact a company's profitability and reported tax liability.
• It serves as a vital tool in financial reporting to present a cautious and realistic financial position to stakeholders.

Formula and Calculation

The traditional Lower of Cost or Market (LCM) rule involved a multi-step calculation to determine the "market" value, which had specific upper and lower limits:

1. Replacement Cost: The cost to replace the inventory item.
2. Net Realizable Value (NRV): The estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.
3. Net Realizable Value less a Normal Profit Margin (NRV - Normal Profit): This establishes a "floor" for the market value.

Under the original LCM rule, the "market" value used for comparison was the middle value of these three figures (replacement cost, NRV, and NRV less a normal profit margin). The inventory would then be valued at the lower of its historical cost or this calculated "market" value.²³

However, as of 2016, for most inventory in U.S. GAAP, the calculation has been simplified to the Lower of Cost and Net Realizable Value (LC&NRV). This means the inventory is simply valued at the lower of its historical cost or its net realizable value.²¹, ²²

The calculation of the write-down amount is:

This write-down is recorded as an expense, typically increasing cost of goods sold on the income statement.¹⁹, ²⁰

Interpreting the Lower of Cost or Market

The interpretation of the Lower of Cost or Market principle, and its current iteration as Lower of Cost and Net Realizable Value, centers on its impact on a company's financial portrayal. When inventory's market value declines below its original cost, applying this rule leads to an immediate recognition of a loss. This conservative approach means that the reported value of inventory on the balance sheet will be lower, directly impacting a company's liquidity ratios, such as the working capital and current ratio.¹⁸

For stakeholders, a write-down under LCM or LC&NRV signals potential issues with inventory management, product obsolescence, or adverse market conditions. It provides a more cautious financial outlook, preventing the overstatement of earnings and assets during periods of declining market prices. This proactive recognition of losses enhances the reliability of financial statements, giving investors and creditors a clearer picture of the company's true financial position. Conversely, if market prices recover after a write-down, the inventory value cannot be written back up beyond its original historical cost under U.S. GAAP, adhering to the principle of conservatism.

Hypothetical Example

Consider a retail company, "GadgetCo," which purchases 1,000 units of a particular electronic accessory at a historical cost of $50 per unit, totaling $50,000. Before the end of the accounting period, a newer model is released by a competitor, causing the market price of GadgetCo's accessory to drop.

GadgetCo estimates the selling price of its accessory to be $40 per unit, with estimated costs to complete and sell (shipping, sales commission) totaling $5 per unit.

1. Calculate Net Realizable Value (NRV) per unit:
   NRV = Estimated Selling Price - Estimated Costs to Complete and Sell
   NRV = $40 - $5 = $35 per unit

2. Compare Cost vs. Net Realizable Value:
   Historical Cost per unit = $50
   Net Realizable Value per unit = $35

   Since the NRV ($35) is lower than the historical cost ($50), GadgetCo must value its inventory at the NRV.

3. Calculate the Inventory Write-Down:
   Write-down per unit = Historical Cost - NRV = $50 - $35 = $15
   Total Inventory Write-Down = $15/unit * 1,000 units = $15,000

GadgetCo would then record a $15,000 loss, which would typically be included in cost of goods sold on its income statement, and the inventory's value on the balance sheet would be reduced to $35,000. This example demonstrates how the lower of cost or market principle, specifically the LC&NRV rule, helps reflect the diminished utility of the inventory.

Practical Applications

The Lower of Cost or Market principle, or its modern equivalent, Lower of Cost and Net Realizable Value (LC&NRV), is primarily applied in the context of inventory valuation for financial reporting. Companies that hold physical goods for sale in the ordinary course of business, such as retailers, manufacturers, and distributors, must adhere to this rule under U.S. Generally Accepted Accounting Principles (GAAP).¹⁷

Its application is crucial for determining the accurate value of inventory on the balance sheet and its corresponding impact on the cost of goods sold and ultimately, the income statement. For instance, if a company's product line becomes obsolete due to rapid technological advancements or shifts in consumer demand, the market value of the remaining inventory will likely decline significantly. Applying the LC&NRV rule ensures that this decline in value is reflected in the financial statements, preventing an overstatement of assets. The U.S. Securities and Exchange Commission (SEC) staff routinely issues comments to companies regarding their inventory valuation policies, emphasizing consistency with accounting standards like ASC 330-10-35-1B, which prescribes LC&NRV.¹⁶

Furthermore, the method chosen for inventory costing can have implications beyond financial reporting, including on a company's tax liability.¹⁵ A lower inventory valuation can result in lower taxable income, leading to potential tax savings in the current period.

Limitations and Criticisms

Despite its widespread adoption and conservative nature, the traditional Lower of Cost or Market (LCM) rule, and even its successor, faced several limitations and criticisms before and after its revision. One primary critique of the original LCM rule was its complexity in determining the "market" value, which involved a convoluted assessment of replacement cost, net realizable value (NRV), and NRV less a normal profit margin.¹³, ¹⁴ This complexity often led to inconsistencies and challenges in comparing financial statements across different companies or even within the same company over time.¹²

Another significant limitation is the asymmetry of its application: while it requires recognition of losses when market value falls below cost, it prohibits recognizing gains when market value rises above cost. This can lead to a consistently understated asset value on the balance sheet if market prices fluctuate upward. Critics also argued that the rule could be subject to manipulation, as management might have some discretion in estimating NRV or normal profit margins, potentially influencing the amount of the write-down and thereby impacting reported profitability.¹¹

The conservative nature of LCM also means that a company's inventory might be valued well below its fair value if prices rebound, which is a criticism some academic studies have explored.¹⁰ While the shift to Lower of Cost and Net Realizable Value (LC&NRV) in U.S. GAAP simplified the "market" determination by eliminating the need for replacement cost and the "floor," it retains the core conservative principle, meaning inventory is still not written up beyond its original historical cost. This contrasts with International Financial Reporting Standards (IFRS), which allow for the reversal of inventory write-downs under certain conditions if the net realizable value subsequently increases.⁹

Lower of Cost or Market vs. Net Realizable Value

The terms Lower of Cost or Market (LCM) and Net Realizable Value (NRV) are closely related in inventory valuation but represent distinct concepts, with NRV now playing a central role in the application of the updated valuation rules under U.S. Generally Accepted Accounting Principles (GAAP).

Historically, LCM was the overarching principle stating that inventory should be valued at the lower of its historical cost or its market value. The definition of "market" under the traditional LCM rule was complex, involving replacement cost, a "ceiling" (which was net realizable value), and a "floor" (net realizable value less a normal profit margin). The market value used for comparison was the middle value of these three.⁷, ⁸

Net Realizable Value, on the other hand, is a specific component within this valuation framework. It is defined as the estimated selling price of an asset in the ordinary course of business, minus the estimated costs of completion and disposal.⁵, ⁶ NRV reflects the net cash that a company expects to realize from the sale of its inventory.

The confusion between the two terms largely stems from the 2016 FASB Accounting Standards Update (ASU 2015-11), which superseded the complex "market" definition in LCM for most inventory in U.S. GAAP. This update replaced the traditional Lower of Cost or Market rule with the Lower of Cost and Net Realizable Value (LC&NRV) rule.⁴ Under LC&NRV, the inventory is simply valued at the lower of its historical cost or its net realizable value, thereby simplifying the calculation and making NRV the direct "market" proxy for the comparison. While the phrase "Lower of Cost or Market" is still often used colloquially, the specific methodology for non-LIFO/retail inventory in U.S. GAAP now directly references NRV as the sole market determinant.

FAQs

What is the main purpose of the Lower of Cost or Market rule?
The main purpose is to adhere to the principle of conservatism in accounting principles. It ensures that inventory is not overstated on a company's balance sheet and that potential losses from a decline in inventory value are recognized as soon as they occur.

How does Lower of Cost or Market affect a company's financial statements?
When the market value of inventory falls below its historical cost, a write-down is required. This write-down increases the cost of goods sold on the income statement, which in turn reduces net income and consequently impacts a company's profitability. On the balance sheet, the inventory asset is reported at a lower value.

Has the Lower of Cost or Market rule changed recently?
Yes, under U.S. Generally Accepted Accounting Principles (GAAP), for most inventory (except for those using LIFO or the retail inventory method), the traditional "Lower of Cost or Market" rule was replaced by the "Lower of Cost and Net Realizable Value" (LC&NRV) rule in 2016. This change simplified the determination of the "market" value by using only Net Realizable Value for comparison.³

What types of inventory does this rule apply to?
This rule, in its current LC&NRV form, applies to inventory measured using methods other than Last-In, First-Out (LIFO) or the retail inventory method. This includes inventory valued using First-In, First-Out (FIFO) and weighted-average methods.²

Can inventory value be written up if the market price recovers?
Under U.S. Generally Accepted Accounting Principles, if inventory is written down due to the Lower of Cost and Net Realizable Value rule, it generally cannot be written back up beyond its original historical cost even if market prices recover. This is a key aspect of the conservatism principle.¹