Lower of Cost or Market (LCM): Definition, Overview & Example
Inventories are typically recorded at cost in accordance with generally accepted accounting principles (GAAP). If, however, the utility of the products in the inventory is less than their cost, the inventory must always be written down to the lower of cost or market.
That’s where the lower of cost or market comes into play.
But what exactly is the lower of cost or market? Read on as we take you through a full definition, and overview, and give you an example of how it works.
Table of Contents
KEY TAKEAWAYS
- The lower of cost or market (LCM) rule is an accounting principle that requires businesses to report inventory on their balance sheets.
- They must be at the lower of either its historical cost or current market value.
- This rule intends to prevent businesses from overstating the value of their inventory. This could lead to them paying too much tax.
- There are two ways to determine market value: the replacement cost method and the net realizable value method.
What Is the Lower of Cost or Market (LCM)?
Lower of cost or market (LCM) is an accounting principle that requires businesses to report the value of their inventory at the lower of its cost or current market value. This principle is used in order to prevent businesses from overstating the value of their inventory on their financial statements.
Under the LCM principle, businesses must determine the cost of their inventory items and compare it to the current market value of those same items. If the market value is lower than the cost, then the business must report the inventory at the lower market value.
The rationale behind this rule is that a company should only report inventory on its balance sheet at the lower of its cost or market value. This ensures that a company’s balance sheet accurately reflects the true value of its inventory and has not overstated its assets.
The LCM principle is important because it provides transparency into a business’s inventory value and helps investors and creditors understand the true value of a company’s assets.
Advantages of Lower of Cost or Market Rule
There are a few advantages to using the LCM rule when it comes to reporting inventory values:
- It helps businesses avoid overstating the value of their inventory.
- The LCM rule may lead to more accurate financial statements. This can make it easier to compare a company’s financial statements to its competitors.
- It helps investors and creditors understand the true value of a company’s assets.
- It is a generally accepted accounting principle (GAAP).
- It is required by the Financial Accounting Standards Board (FASB).
Disadvantages of Lower of Cost or Market Rule
There are also a few disadvantages to using the LCM rule:
- The LCM rule may result in frequent write-downs of inventory. This can be costly.
- LCM may also result in a lower reported profit. This can impact a company’s stock price.
- The LCM rule can be difficult to apply. Companies must keep track of the cost of each item in inventory. They also need to monitor market conditions.
Example of Lower of Cost or Market Rule (LCM)
For example, let’s say that a company has 100 widgets in inventory that cost $10 each to produce. The current market value of the widgets is $12 each. Under the LCM rule, the company would report the value of its inventory at $1,000 (100 widgets x $10 per widget). If the company did not use the LCM rule, it would report the value of its inventory at $1,200 (100 widgets x $12 per widget).
While the LCM rule may result in a lower reported value for inventory, it is important to remember that this value is more accurate and provides greater transparency into a company’s financial condition.
In another example, let’s say that a company has 100 widgets in inventory that cost $10 each to produce. The current market value of the widgets is $8 each. Under the LCM rule, the company would report the value of its inventory at $800 (100 widgets x $8 per widget). If the company did not use the LCM rule, it would report the value of its inventory at $1,000 (100 widgets x $10 per widget).
In this second example, you can see how using the LCM rule can lead to a lower reported profit. However, it is important to remember that the LCM rule provides greater transparency into a company’s financial condition and helps investors and creditors understand the true value of a company’s assets.
Summary
The “lower of cost or market” (LCM) rule is an accounting principle that requires businesses to write down the value of inventory on their balance sheets if the inventory’s current market value is lower than its historical cost.
The LCM rule is important for businesses because it provides a more accurate picture of a company’s inventory valuation, ensuring that inventory isn’t overvalued on the balance sheet.
Lower of Cost or Market FAQs
The lower of cost or market rule is a generally accepted accounting principle (GAAP) that requires businesses to report the value of their inventory at the lower of its cost or current market value.
The LCM rule is important because it provides transparency into a business’s inventory levels and helps investors and creditors understand the true value of a company’s assets.
While the LCM rule may result in a lower reported value for inventory, it is important to remember that this value is more accurate and provides greater transparency into a company’s financial condition.
The LCM rule applies to inventory items. It does not apply to other assets, such as land or buildings.
The main difference between lower of cost or market and replacement cost is that replacement cost considers obsolescence while lower of cost or market does not. Replacement cost is also a more difficult calculation than lower of cost or market.
The lower of cost or market rule is used in accounting because it provides transparency into a business’s inventory value and helps investors and creditors understand the true value of a company’s assets.
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