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18/10/2016 03:11:51 PM

Applying Lower of Cost or Market To Inventory

Generally accepted accounting principles allow for the lower of cost or market rule to be applied in one of three ways: (1) on an inventory totals basis, (2) on an inventory categories basis, or (3) on an item-by-item basis.

  1. Applying LCM to inventory totals is the least conservative application since it results in the smallest writedown or reduction of inventory from cost and the smallest loss on the income statement.
  2. Applying LCM to inventory categories results in values that fall somewhere in between the other two methods of applying LCM.
  3. Applying LCM on an item-by-item basis is the most conservative application since it results in the largest writedown or reduction of inventory from cost and the largest loss on the income statement.

Let's use the information below to illustrate the three ways of applying LCM:

27X-table-15

The Total Cost column shows a grand total of $9,455. This is the cost of the items held in inventory. In most industries, the inventory reported on the balance sheet cannot exceed this amount. However, because of the lower of cost or market rule, the inventory reported on the balance sheet might be smaller than this amount. Thesmaller amount could be based on the lower of cost or market applied to the inventory totals, inventory categories, or each individual item in inventory.

If the LCM rule is applied to the inventory totals, the Grand Total Cost ($9,455) is compared to Grand Total Market ($9,284). The lower of cost or market is the lower of these two amounts. Therefore $9,284 is the amount to be reported on the company's balance sheet. The difference of $171 ($9,455 minus $9,284) is reported as a loss on the company's income statements in the accounting periods when the loss took place.

If the LCM rule is applied to the inventory categories, the lower of each category's total cost and total market amount is selected. For example, the Category A Total Market amount of $981 is selected over Category A Total Cost amount of $1,080 and is entered in the column "LCM by Category." The Grand Total LCM by Category of $9,274 is less than the Grand Total Cost of $9,455. Therefore, $9,274 is the amount reported on the company's balance sheet. The amount of the writedown or reduction from $9,455 to $9,274 is $181. This $181 will be reported on the income statements in the periods when the market amount dropped below cost.

If the LCM is applied on an item-by-item basis, the lower of each item's total cost and total market amount is selected. For example, the Item 212 Total Cost amount of $160 is selected over Item 212 Total Market amount of $168 and is entered in the column "LCM Item-by-Item." The Grand Total LCM Item-by-Item of $9,135 is the amount reported on the company's balance sheet. The difference between this amount and the Grand Total Cost of $9,455 is $320. This $320 reduction from cost is reported as a loss on the company's income statements in the accounting periods when the loss took place. As mentioned earlier, this is the most conservative way in which to apply the lower of cost or market rule.