Understanding the Lower of Cost or Market (LCM) Method
Let me explain what the lower of cost or market (LCM) method is. This accounting approach values your company's inventory at the lesser of its historical cost or current market value. Historical cost means the price you paid when you originally purchased the inventory.
You need to know that the value of goods can change over time. If the selling price drops below the net realizable value (NRV) of the item, causing a loss, you can use the LCM method to record that loss on your balance sheet.
Key Points on LCM
When valuing inventory, you record it at either the market value or historical cost, whichever is lower. Remember, historical cost is the original purchase price.
The method accounts for fluctuations in value; if the potential selling price falls below NRV, resulting in a loss, apply LCM to capture it. This is a core principle of generally accepted accounting principles (GAAP).
Why Use the Lower of Cost or Market Method?
You use the LCM method to record losses by writing down affected inventory items to market value. Market value here is the middle of three figures: replacement cost, NRV minus normal profit, and NRV itself. The write-down amount goes under cost of goods sold on your balance sheet.
LCM is part of GAAP in the US and international standards. Assets start at acquisition cost, but GAAP allows adjustments like this in later periods.
In 2017, the FASB updated rules for companies using average cost or LIFO methods, requiring them to switch to lower of cost or net realizable value for better alignment with IFRS.
Applying the LCM Rule
The LCM rule typically applies to products that become obsolete or lose value due to a lower current market price. Market price is the replacement cost, as long as it's within the range of NRV minus disposal costs.
Consider other factors: You can apply LCM to categories of related products, not just single items. If inventory is hedged with a fair value hedge, add the hedge effects to cost, which might eliminate the need for adjustments.
For LIFO, you might avoid write-downs in interim periods if inventory recovers by year-end. Don't write down raw materials if finished goods will sell at or above cost. If evidence shows prices will rise before sale, skip the write-down. Watch for sales incentives that could affect LCM.
Recent changes simplify things for non-retail and non-LIFO users; now you can just use lower of cost or net realizable value.
Frequently Asked Questions
Is LCM required by GAAP? Yes, it became required in 2017.
What does LCM mean? It values inventory by taking the lower of original cost or current market price, especially for long-held, declined, or obsolete inventory.
What other inventory methods does GAAP allow? Besides LCM, you can use FIFO, LIFO, or weighted average.
The Bottom Line
The LCM method is a conservative way to value inventory. It might lead to lower reported profits and taxes, but it gives a truer picture of your company's finances. Make sure to apply it carefully for transparent and accurate statements.
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