Lower of Cost or Market
Lower of cost or market is the accounting method that requires the company to record the cost of inventory in the balance sheet at either at original cost or market value. The company requires to use whichever option is lower. We usually record the inventory base on the purchasing cost (original cost) and they present in the balance sheet. However, if we hold them for a long time, the inventory market value may be decreased over time and they could be lower than our balance. At this point, we have to evaluate and decrease our inventory to the market level. The company needs to record loss for the variance between original cost and market price.
Example
The company has purchased an inventory cost of $ 100,000 and they are recorded in the company balance sheet. Due to some reasons, these inventories remain within the warehouse for several years. Two years later, they realize that the market price of the same items has significantly decreased in price. In order to ensure that the financial statements are true and fair, we have to write down the inventory to market price otherwise they will be overstated and mislead the users.
Lower of Cost or Market Detail
The company will compare the inventory’s original cost against the market value. The market value of inventory is not only the purchase price but the replacement cost which includes other components such as shipping and insurance. The replacement cost should follow the below criteria:
- It should not be higher than Net Realized Value
- It should not be lower than Net Realized Value less Profit Margin
Net realized value is the inventory selling price less the cost incurred to sell the inventory. Profit Margin is the difference between the inventory’s selling price and cost of goods sold.
Lower of Cost or Market Value Steps
- Determine the original cost of inventory, it is simply the balance on the balance sheet
- Determine market value which is the replacement cost
- Compare Replacement cost with NRV
- Replacement Cost > NRV => use replacement cost
- Replacement Cost < NRV – Profit Margin => use NRV – Profit Margin as Replacement Cost
- NRV – Profit Margin < Replacement Cost < NRV => use Replacement Cost
(We have to consider NRV less Profit Margin because
- Compare replacement from step 3 with the cost of inventory.
Replacement Cost < Cost of inventory: Write down the inventory balance to replacement cost.
Replacement Cost > Cost of inventory: No write down require.
Lower for Cost or Market Example
Base on the Company A financial statement, there is the following information related to the inventory:
| Description | Amount |
|---|---|
| Purchase Cost (Original Cost) | 100,000 |
| Replacement Cost | 85,000 |
| Selling Price | 150,000 |
| Selling Cost | 20,000 |
Please use the lower cost or market to evaluate if any adjustment required.
Step 1. The original cost equal to $ 100,000
Step 2. The market value is $ 85,000
Step 3. Compare replacement cost with NRV
NRV – Profit Margin ( 80,000 = 130,000- 50,000) < Replacement cost (85,000) < NRV (130,000 = 150,000 – 20,000)
In this case, we have to use the replacement to compare with the original cost
Step 4. The replacement cost less than the inventory’s original cost, so we have to write down the inventory balance otherwise it will be overstated. We need to write down $ 15,000 (100,000 – 85,000)
Journal Entries
| Account | Debit | Credit |
|---|---|---|
| Loss on Inventory write down | 15,000 | |
| Inventory | 15,000 |
The inventory write-down will impact the income statement as the other expense. At the same time, the inventory balance will reduce by $ 15,000.
Factors to consider when applying lower of cost or market
- Category Analyst: we can use the lower of cost or market accounting method for a specific inventory type or the entire category.
- Hedge: If the company uses a fair value hedge to recognize inventory cost, then the hedge will replace the need for lower of cost or market.
- Last in, First Out layer recovery: The company will not require to adjust the inventory during the interim report if they have enough evidence which suggests that the market value will be increase at the year-end.
- Raw Material: raw material will not require to adjust if the company is able to manufacture the finished product which expects to sell higher than the cost.
- Recovery: The company can avoid inventory written down if they have enough evidence that the market price will increase before they are sold.
- Sale incentive: unexpired sale incentive is a strong indicator of the lower of cost or market.