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Lower of Cost or Market Method



Definition

The Lower of Cost or Market Method is a financial accounting technique used to value inventory. Essentially, it states that businesses should record inventory at the lower cost between the original cost (purchase or production cost) and its current market value. This approach adheres to the conservative principle in accounting, preventing overstatement of assets.

Phonetic

The phonetics for “Lower of Cost or Market Method” are as follows:Lower – “loh-er”of – “uhv”Cost – “kawst”or – “or”Market – “mahr-kit”Method – “meth-uhd”

Key Takeaways

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  1. The Lower of Cost or Market Method (LCM) is a conservative approach to valuing and reporting inventory. It compares the market cost against the original cost of inventory and the inventory is then reported on the balance sheet at the lower of the two.
  2. Under the LCM method, if the market cost falls below the original cost, it allows businesses to account for the probable loss immediately rather than waiting until they sell the items. It offers a way to estimate and record anticipated losses in the value of inventory, potentially reducing income tax liability.
  3. It’s important to note that the use of LCM method adheres to the accounting principle of conservatism, which prefers understatement to overstatement of financial figures. However, this method doesn’t adhere to the historical cost principle, which emphasizes recording assets at their original cost.

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Importance

The Lower of Cost or Market (LCM) Method is an important principle in the field of business and finance, chiefly used in inventory valuation. It adheres to the conservative practice of reporting the lesser of the inventory’s original cost or its current market value. This approach is crucial to ensure firms don’t inflate their earnings and asset values when the market price decreases. By doing so, LCM enhances the accuracy and reliability of financial reporting, thus providing a clearer and more honest picture of a company’s financial health to investors, stakeholders, and regulators. Moreover, it abides by the Generally Accepted Accounting Principles (GAAP) notion of conservatism, potentially preventing future potential losses from being understated. Therefore, the Lower of Cost or Market Method plays a critical role in maintaining transparency and integrity in financial accounting.

Explanation

The Lower of Cost or Market Method serves an important purpose in financial accounting by enabling businesses to assess and align their inventory’s recorded cost with the current market cost. Essentially, this method reduces the potential overstatement of the inventory or the company’s earnings, ensuring a prudent representation by reflecting any loss in value of an inventory item before a tangible loss arises, such as a decline in the market value below the initially recorded cost. Thus, it helps maintain transparency in the business’s financial reporting process, which is critical for understanding the true state of the organization’s financial health.In practical terms, the Lower of Cost or Market Method is extensively used in multiple industries where prices are subject to significant fluctuations. As market prices can rise or fall, this method allows businesses to report inventory at the lesser amount – either the original purchase cost or the current market price. This is crucial for abiding by the conservatism principle in accounting, which advises reporting the less favorable financial figures to avoid overstating income and asset values. Ultimately, it provides a more cautious and realistic view of the company’s assets, providing a safeguard against potential revenue or inventory value declines.

Examples

The Lower of Cost or Market (LCM) method is an inventory valuation approach where items in inventory are recorded at the lower of their original cost (what was paid to get the inventory) or their current market price. Here are three real-world examples:1. Electronics Retail Business: Say a technology company buys 1,000 units of a cell phone model for $150 each. However, a new model is released several months later, causing the market value of the older model to drop to $100 each. In such a scenario, the company would need to write down the value of their inventory to reflect the current market price. Thus, in line with the LCM method, the company would take a loss of $50 per phone.2. Food Related Business: Consider a prosperous grocery store that purchases a large quantity of tropical fruits at $10 per pound. Unfortunately, due to unexpected weather conditions, there is a sudden over-supply in the market and the price falls to $6 per pound. According to the LCM method, the grocery store would have to reduce its inventory’s value to reflect the lower market price.3. Clothing Retail Outlet: A clothing outlet buys an assortment of sweaters at a cost of $30 each, expecting to sell them in the winter. However, the winter turns out to be unusually warm leading to a surplus of sweaters in the market, thus the value drops to $20 each. With LCM method, the store would have to adjust the value of its unsold sweater stock to the lower market price.

Frequently Asked Questions(FAQ)

What is the Lower of Cost or Market Method (LCM)?

The Lower of Cost or Market (LCM) Method is a rule for valuing inventory that reports the replacement cost of inventory if this cost is less than the original or historical cost, reflecting potential losses due to market changes.

Why is the LCM method used in accounting?

The LCM method is used to provide a more realistic reflection of the company’s financial health. It adheres to the conservatism principle of accounting, where potential losses are recorded as they are recognized, but potential gains are not recorded until they are realized.

How is the LCM method applied?

Under the LCM method, you compare the market value of each item in inventory to its cost. If the market value is lower, then you use this value instead of the cost in the financial statements. If the cost is lower, then you use the cost.

What do we mean by Market in the Lower of Cost or Market Method?

In the LCM model, Market refers to the current replacement cost — what it would cost to replace an item in the inventory today, not the price the item may be sold for in the market.

How does the LCM method impact taxes?

Using the LCM method can lower a company’s reported income, which reduces its income tax obligation. Since the value of the inventory is reported as lower, the cost of goods sold (COGS) is higher, reducing the gross profit and taxable income.

What is the main advantage of the Lower of Cost or Market Method?

The main advantage of the LCM method is that it prevents overstatement of inventory value and income, thus providing a more faithful representation of a business’s financial condition.

Is the Lower of Cost or Market Method applicable to all types of businesses?

The LCM method is widely applicable. However, it is particularly prevalent in sectors where inventory items are subjected to large price fluctuations such as the retail and commodities sectors.

How does the LCM method affect the balance sheet?

The LCM method may lower the total assets listed on a business’s balance sheet if the market value of inventory is less than its cost. It also reduces the net income reported on the income statement.

Related Finance Terms

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