Lower of Cost or Market: Definition, Rule, Formula, Method, Example, Calculation

Inventory is a crucial aspect of the operations and activities conducted by many companies. Usually, it includes the acquisition cost and any additional expenses in bringing the goods to their current condition. Accounting standards require companies to record inventory at that cost. Sometimes, though, it may not reflect the value of those goods on the financial statements.

Companies must conduct regular checks to ensure the inventory’s value reflects the actual value of those goods. If it does not, the lower of cost or market principle may apply.

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What is Lower of Cost or Market (LCM)?

Lower of Cost or Market (LCM) is an accounting principle used to value inventory at the lower of its cost or market value. This method is necessary for situations where the stock’s market value has decreased significantly. Similarly, companies must use it when there is a risk that the inventory may become obsolete. The LCM principle ensures that stock gets valued at a conservative estimate and is not overstated on financial statements.

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Lower of cost or market is a crucial accounting concept that helps companies accurately reflect the value of their inventory on financial statements. On top of that, it protects investors by providing them with accurate information about a company’s assets. Similarly, lower of cost or market ensures that companies are not overvaluing their inventory, which could lead to misleading financial statements.

How does the Lower of Cost or Market (LCM) method work?

Under the lower of cost or market method, a company must compare the cost of inventory to its current market value. If the stock’s market value is less than its cost, the company must adjust the inventory’s value to reflect the lower market value. Usually, it means that the goods get recorded on the financial statements at the lower of their cost or market value, ensuring they accurately reflect the value of the company’s assets.

The lower of cost or market principle also conforms to the conservatism principle in accounting. The latter requires companies to record an increase in losses or liabilities at the earliest possible. When the market value of goods becomes lower than its cost, it implies the company has suffered a loss on them. In that case, the company must record them when there is any indication of such decreases in the market value.

Example

A company, Red Co., holds 100 units of an item that cost $50 at the time. Currently, the company has these goods recorded on its financial statements at $5,000 ($50 x $100 units). However, recent changes in market conditions show that these goods may not be worth that much. The current market value of these items is $40 per unit.

The lower of cost or market principle requires Red Co. to record these items at $4,000 ($40 x 100 units). The $1,000 difference in value is the loss suffered by the company for those goods. However, it does not imply that the goods will remain at this value in the future. Red Co. must assess further changes in market conditions and determine the lower of cost and market after regular intervals for all items.

Conclusion

Lower of cost or market is an accounting principle requiring companies to record inventory accurately. As the name suggests, it entails companies determining which of two is lower, the inventory’s cost or market value. This principle is a part of the accounting standards associated with the stock. The lower of cost or market principle also conforms to the conservatism principle.