Lower of Cost or Market Assignment Help
Lower of cost or market (LCM) is an approach of valuing and reporting inventory in financial statements. As we know, accounting follows some principles & conventions for recording any transaction & presenting the financial statements. Assets are generally stated in the financial statements according to the cost principle. However, in case of inventory, cost principle does not apply. Conservatism principle requires inventory to be reported at the lower of cost or market. LCM’s application is also mandated under the provisions of GAAP.
Market value means the replacement cost of the inventory. Replacement cost may be in the form of purchase cost or manufacturing cost. In other words, market value is amount that we would have to pay to acquire inventory of the same quantity and quality through purchase or through manufacture. However, the lower of cost and market method has two boundaries on the valuation of inventories. Upper and lower limits have been placed on the market value of inventory.
a) Upper limit (also called ceiling) is the net realizable value (NRV) of inventory. It requires that inventory must be reported no higher than the net realizable value less expenses.
b) Lower limit (also called floor) requires that inventory value be reported at no lower than the net realizable value plus normally attainable profit.
To determine the market amount used in the lower of cost or market rule:
i) If the current replacement cost is between the floor and the ceiling, the current replacement cost is the market amount.
ii) If the current replacement cost is greater than the ceiling, the ceiling amount is the market amount.
iii) If the current replacement cost is lower than the floor, the floor amount is the market amount.
The LCM rule can be applied to inventory on individual items basis, inventory className basis or to entire inventory. However the choice must be consistent.
Let’s take an example:-
Company A owns an item of inventory having original cost of $900. Its replacement cost is $880. The company expects to sell it at $980. However an expense of $40 must be incurred to make the sale. Calculate the value of inventory according to lower of cost of market rule.
Upper limit = 980-40 = $940
Market = $880
Lower Limit= 940-(980-880) = $840
Since the current replacement cost or market i.e. $880 lies between upper & lower limit, $880 will be the allowable market value of inventory. This market value is to be compared to the original cost $900. Since the market value of inventory is lesser than its original cost, hence it should be stated as $880 in financial statements.