Generally, companies should use historical cost to value inventories and cost of goods sold. However, some circumstances justify departures from historical cost. One of these circumstances is when the utility or value of inventory items is less than their cost. A decline in the selling price of the goods or their replacement cost may indicate such a loss of utility. This section explains how accountants handle some of these departures from the cost basis of inventory measurement.
The lower-of-cost-or-market (LCM) method is an inventory costing method that values inventory at the lower of its historical cost or its current market (replacement) cost. The term cost refers to historical cost of inventory as determined under the specific identification, FIFO, LIFO, or weighted-average inventory method. Market generally refers to a merchandise item’s replacement cost in the quantity usually purchased. The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall. The LCM method has long been accepted in accounting.
Under LCM, inventory items are written down to market value when the market value is less than the cost of the items. For example, assume that the market value of the inventory is $39,600 and its cost is $40,000. Then, the company would record a $ 400 loss because the inventory has lost some of its revenue-generating ability. The company must recognize the loss in the period the loss occurred. The journal entry would be:
|Cost of goods sold||$400|
On the other hand, if ending inventory has a market value of $ 45,000 and a cost of $ 40,000, the company would not recognize this increase in value and no adjusting entry would be required.
LCM applied A company may apply LCM to each inventory item (such as Monopoly), each inventory class (such as games or toys), or total inventory (as seen in the above examples). To see how the company would apply the method to individual items, look at Exhibit 19.
|1||100 units||$10||$9.00||$1,000||$900||$900 (market lower )|
|2||200 units||8||8.75||$1,600||$1,75 0||1,600 (cost lower)|
|3||500 units||5||5||$2,500||$2,500||2,500 (same)|
If LCM is applied on an item-by-item basis, ending inventory would be $ 5,000. The company would report $5,000 value for inventory in the current assets section of the balance sheet by making an adjustment to inventory for $100 ($5,100 inventory cost – $5,000 LCM basis):
|Cost of goods sold||$100|
Under the class method, a company applies LCM to the total cost and total market for each class of items. One class might be games; another might be toys. Then, the company compares each class total at the lower of its cost or market amount.
|Toy 1||100 units||$10||$9.00||$1,000||$900|
|Toy 2||200 units||8||8.75||$1,600||$1,750|
|Toy||Totals||$2,600||$2,650||$2,600 (since total toy cost lower)|
|Games 1||500 units||$5||$5||$2,500||$2,500|
|Games 2||300 units||7.00||6.00||$2,100||$1,800|
|Games||Totals||$4,600||$4,300||$4,300 (since total games market lower)|
$6,900 (2600 + 4300)
Inventory on the balance sheet would be reported at $6,900 with the following adjusting entry for $300 ($7,200 inventory cost – $6,900 LCM by item class):
|Cost of goods sold||$300|
The lower-of-cost-or-market method is really as simple as it sounds. We are taking the LOWER of the cost or the market value of the inventory.