Lower of Cost or Market (LCM) Theory
What is meant by Lower of cost or market?
Lower of cost or market is a method of inventory pricing by which the inventory is priced at cost or market, whichever is lower. It is an application of conservatism in accounting.
Under generally accepted accounting principles (GAAP), the presumption is that inventories will be recorded at cost, If however, the utility of the goods in the inventory is not as great as their cost is, the goods must be written down to the lower of cost or market. Although this is a violation of the historical cost principle, accountants feel that losses should be recorded as soon as they become evident. thus, in this case, the concept of conservatism takes precedence over historical cost convention. Approximately 90% of the 600 companies surveyed by the AICPA in 2019 reported their inventory at the lower of cost or market.
The theory of lower of cost or market (LCM)
In applying the lower of cost or market rule, cost is determined by one of the cost flow methods; market, in this case, generally means replacement cost, or the cost to purchase a similar inventory item. The use of lower of cost or market is based on the theory that if an item’s replacement cost decreases in the current period, its sales price will ultimately decrease. Because accountants feel that all losses should be recognized when they occur, this loss is recognized in the period that it occurs – that is, when the price declines – not in a later period – when the item is eventually sold.
To illustrate the theory behind the LCM rule, assume the following facts:
- During year 1 the Shanken Company purchases one item of inventory for $80. The normal selling price is $100, which represents a gross margin percentage of 20%.
- The item is held during the entire year. However, during the current year its replacement cost falls 10%. from $80 to $72. No other transaction takes place during the year.
- During year 2 the item is sold for $90.
The analysis in the above example shows the effect on reported earnings over a two-year period, both with and without the application of lower of cost or market rule. This example assumes that when replacement cost dropped 10%, or $8 from $80 to $72, there was a corresponding decrease of 10%, or $10 from $100 to $90, in the item’s selling price.
Case 1 shows the effect of applying the LCM rule. In year 1, there is a reported loss of $8 due to the decline in the replacement cost. In year 2, when the actual sale takes place, there is an $18 gross margin on sales. This $18 gross margin represents a 20% gross margin percentage, the normal gross margin percentage that the Shanken Company earns. The result of applying the lower of cost or market is to force the company to take a loss in year 1, the year of the price decline, but it allows the company to earn its normal gross margin percentage in future years. Over the 2-year period, the combined income is $10.
Case 2 shows the effect of not applying the lower of cost or market rule. There is no income or loss in year 1; the entire effect is felt in year 2 when the sale takes place. In year 2, the gross margin falls to $10, and the gross margin percentage falls to 11%. Over a 2-year period, combined income is 410, the same as it is in Case 1. thus, the application of lower of cost or market changes the allocation of income within the 2-year period but does not change the combined income.
This illustration is based on the assumption that a decrease in the replacement cost of the item will result in a corresponding decrease in the sales price. However, in reality, that one-for-one relationship does not always hold. For example, assume that although the replacement cost of the inventory item held by the Shanken Company drops 10%, there is little or no change in the sales price. To apply the lower of cost or market in this situation would understate income in year 1 and overstate income in year 2 and would be the improper application of conservatism. Thus, lower of cost or market must be applied with caution.
The application of lower of cost or market
The application of lower of cost or market is a two-step process. In the first step, market, defined as the item’s replacement cost, is determined. This can usually be done by examining vendors’ invoices at the end of the year. In the second step, market or replacement cost is compared with cost, and if necessary, the inventory is reduced to the lower of cost or market (LCM). Under generally accepted accounting principles, the comparison can be made on (1) an item-by-item basis, (2) a group-of-items basis, or (3) the inventory as a whole.
The LCM comparison on all three bases is shown in the below example.
When the item-by-item basis is used, individual comparison for all items must be made. This results in an inventory value of $24,000. Under the group basis, the inventory is divided into a luxury group and a standard group, and the comparison is then made for each group total. For example, in the luxury group the cost of $22,500 is compared with the market of $22,000, and so the value of the group is determined to be $22,000. The same comparison is then made for the standard group, and its value is $2,750. This results in a total inventory value of $24,750. On a total-inventory basis, the cost and the market of the entire inventory are compared, resulting in an inventory value of $24,800.
Comparing all three methods, we see that the item-by-item method is the most conservative; that is, it results in the lowest inventory value. This is because increases in the value of one item cannot offset decreases in other items, as is the case under the group and total inventory methods.
Lower of cost and market and income taxes
The Internal Revenue Code contains specific regulations pertaining to the use of lower of cost or market for federal tax purposes. Two of these provisions differentiate the use of lower of cost or market for tax purposes from financial reporting purposes.
First, for tax purposes, only FIFO (no LIFO) can be used in conjunction with lower of cost or market. For generally accepted accounting (GAAP) purposes, however, LIFO combined with lower of cost or market is a valid method. Second, for tax purposes, lower of cost or market can be applied only on an item-by-item basis. The group or total inventory method cannot be used.