8-1 Introduction
A key aspect of generating an inventory valuation is the concept of the lower of cost or market. Under this concept, a company is required to recognize an addi- tional expense in its cost of goods sold in the current period for any of its inven- tory whose replacement cost (subject to certain restrictions) has declined below its carrying cost. If the market value of the inventory subsequently rises back to or above its original carrying cost, its recorded value cannot be increased back to the original carrying amount.
The basis for this concept is contained within Statements 5 through 7 in Chapter 4 of Accounting Research Bulletin Number43. Statement 5 notes that when the util- ity (as indicated by damage, obsolescence, and so forth) of a good falls below its recorded cost, one must recognize a loss for the full amount of the difference in the current period. Statement 6 defines “market” as the current replacement cost of an inventory item, except that the resulting market cost cannot be less than the item’s net realizable value less a normal profit margin, nor can it exceed the net realizable value less any completion and disposal costs.
Statement 7 notes that the lower of cost or market rule can be applied either to individual items, groups of inventory, or the inventory as a whole; the application method chosen should be the one resulting in the most close approximation to pe- riodic income. Statement 7 has been the cause of considerable interpretation, be- cause its application to a large inventory group presents the possibility (allowed within Discussion Note 12 to the Statement) that a company can offset losses on reduced-utility items against gains experienced by increased-utility items within the same inventory group, resulting in no write-down of the total inventory valuation, as long as the offsetting items are in “balanced” quantities. However, in practice, the use of inventory groups for lower of cost or market calculations is unusual and so is not addressed further within this chapter. Discussion Note 14 accompanying State- ment 7 also suggests that large write-downs caused by application of the lower of cost or market rule can be itemized separately from the cost of goods sold within the income statement.
The remainder of this chapter explores the practical application of the lower of cost or market rule.
8-2 Applying the Lower of Cost or Market Rule1
The lower of cost or market (LCM) calculation means that the cost of inventory cannot be recorded higher than its replacement cost on the open market; the re- placement cost is bounded at the high end by its eventual selling price, less costs of disposal, nor can it be recorded lower than that price, less a normal profit per- centage. The concept is best demonstrated with the four scenarios listed in the fol- lowing example:
Completion/ Upper Lower Existing Market
Selling Selling Price Normal Price Inventory Replacement Value Item Price Cost Boundary Profit Boundary Cost Cost (1) (2) LCM
A $15.00 $4.00 $11.0 $2.20 $8.80 $8.00 $12.50 $11.00 $8.00
B 40.15 6.00 34.15 5.75 28.40 35.00 34.50 34.15 34.15
C 20.00 6.50 13.50 3.00 10.50 17.00 12.00 12.00 12.00
D 10.50 2.35 8.15 2.25 5.90 8.00 5.25 5.90 5.90
(1) The cost at which an inventory item could be purchased on the open market.
(2) Replacement cost, bracketed by the upper and lower price boundaries.
In the example, the numbers in the first six columns are used to derive the upper and lower boundaries of the market values that will be used for the LCM calculation. By subtracting the completion and selling costs from each product’s selling price, we establish the upper price boundary (in bold) of the market cost calculation. By then subtracting the normal profit from the upper cost boundary of each product, we establish the lower price boundary. Using this information, the LCM calculation for each of the listed products is as follows:
Product A, replacement cost higher than existing inventory cost.The market price cannot be higher than the upper boundary of $11, which is still higher than the existing inventory cost of $8. Thus, the LCM is the same as the existing in- ventory cost.
Product B, replacement cost lower than existing inventory cost, but higher than upper price boundary. The replacement cost of $34.50 exceeds the upper price boundary of $34.15, so the market value is designated at $34.15. This is lower than the existing inventory cost, so the LCM becomes $34.15.
1The contents of this section have been adapted with permission from p. 44 of Bragg, GAAP Implementation Guide, John Wiley & Sons, 2004.
Product C, replacement cost lower than existing inventory cost and within price boundaries. The replacement cost of $12 is within the upper and lower price boundaries, and so is used as the market value. This is lower than the existing inventory cost of $17, so the LCM becomes $12.
Product D, replacement cost lower than existing inventory cost, but lower than lower price boundary. The replacement cost of $5.25 is below the lower price boundary of $5.90, so the market value is designated as $5.90. This is lower than the existing inventory cost of $8, so the LCM becomes $5.90.
Whenever there is a calculated inventory write-down, use the following jour- nal entry to record the valuation reduction. Although this loss can be recorded within the general cost of goods sold account, the magnitude of LCM losses tend to be lost that way, so use the “Loss on Inventory Valuation” account to more con- spicuously record the information.
Debit Credit
Loss on inventory valuation xxx
Raw materials inventory xxx
Work-in-process inventory xxx
Finished goods inventory xxx
Although the sample journal entry shows a credit to specific inventory accounts, it is also acceptable to credit an inventory valuation account instead.
8-3 Enforcement of the LCM Rule
Given the considerable amount of manual calculation required to determine if there is a loss under the LCM rule, few inventory accountants are interested in fol- lowing its dictates regularly. One of the better approaches to enforcement is to have the Board of Directors formally approve a company policy requiring at least an an- nual LCM review, and to then include this policy in the job description of the in- ventory accountant. An example of possible policy wording follows:
Lower of cost or market calculations shall be conducted at least an- nually for the entire inventory.
This policy may be modified to require more frequent reviews, based on the vari- ability of market rates for various inventory items.
Even with a policy in place, the LCM calculation is only likely to be conducted at such infrequent intervals that the inventory accountant forgets how the calcula- tion was made in the past. Thus, there is a considerable risk that the calculations will be conducted differently each time, yielding inconsistent results. To avoid this problem, consider including in the accounting procedures manual a clear definition of the calculation to be followed. A sample procedure is shown in Exhibit 8-1.
Exhibit 8-1 Lower of Cost or Market Procedure
Use this procedure to periodically adjust the inventory valuation for those items whose market value has dropped below their recorded cost.
1. Export the extended inventory valuation report to an electronic spreadsheet. Sort it by declining extended dollar cost, and delete the 80% of inventory items that do not comprise the top 20% of inventory valuation. Sort the remaining 20% of inventory items by either part number or item description. Print the report.
2. Send a copy of the report to the materials manager, with instructions to compare unit costs for each item on the list to market prices, and be sure to mutually agree upon a due date for completion of the review.
3. When the materials management staff has completed its review, meet with the materials manager to go over its results and discuss any major adjustments. Have the materials management staff write down the valuation of selected items in the inventory database whose cost exceeds their market value.
4. Have the accounting staff expense the value of the write down in the accounting records.
5. Write a memo detailing the results of the lower of cost or market calculation. Attach one copy to the journal entry used to write down the valuation, and issue another copy to the materials manager.
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