Lower Cost Or Market Method

A merchandise firm more often than not uses historical cost to value merchandise inventory and cost of goods sold. Just sometimes information technology justifies a departure from the historical cost for many reasons.

This is where the utility or value of inventory item is less than its toll. This may happen due to a subtract in the selling price or replacement cost of merchandise inventory.

Companies should not carry appurtenances inventory at more than their internet realizable value.

Net realizable value is the estimated selling price of an item of goods less the estimated cost that the company incurs in preparing the particular of goods for sale or selling.

Damaged, obsolete or shop born goods internet realizable value oft become lower than their historical costs. And these must exist written downwardly to their net realizable value.

Besides, technological changes, changes in manner and increased competition do cause a significant reduction in the selling price of some products such as computers, calculators, gear up-made dress, toys etc.

To evidence a necessary write down in the cost of inventory, assuming that an electronics company has a television on hand which has been used for sit-in purpose.

The company acquired the television receiver at a cost of $x,000.

Lower of Cost or Market (LCM) Inventory Valuing Method

The television has an original selling price of $ xiii,000. Due to alter of model, and also for the long use of the television, its present estimated selling price is merely $9,500.

In such case, the tv inventory is to be valued at $9,500. So, the loss due to fallen price is $500.

For inventory purpose necessary periodical is;

	Debit	Credit
	$	$
Loss due to fall in market cost of inventory	500
Merchandise inventory		500
(To write down inventory to realizable market value.)

Such entry for loss is necessary only when net realizable is less than toll.

If net realizable value declines simply still exceeds cost, the company will proceed to acquit the inventory at cost.

The lower of cost or market (LCM) is a widely accepted inventory valuation method.

Under this method, the inventory is valued at the lower of its historical cost or its current market place/replacement price.

The term toll refers to the historical price of inventory equally determined past the specific identification, FIFO, LIFO or weighted average inventory method.

The market generally refers to a merchandise item's replacement price in the quantity usually purchased.

The basic supposition of the LCM method is that if the purchase price of an particular falls, its selling price also falls or will fall. The LCM has long been accustomed in accounting globally.

Under LCM, inventory items are written down to marketplace value when the market value, is less than the toll of the items. For instance, presume that the market value of the inventory is $50,000 and its cost is $55,000.

And then, the visitor would record a $5,000 loss because the inventory has lost some of its revenue – generating ability.

The company must recognize the loss in the period the loss occurred.

On the other hand, if ending inventory has a market place value of $55,000 and a cost of $50,000, the company would non recognize this increment in value. To exercise then would recognize acquirement earlier the time of sale.

The LCM can be applied to each item of inventory, to various sub groupings of inventory or to the inventory equally a whole, as shown below: Inventory item no.

No.	Description	Quantity	Cost (FIFO)	Market / Replacement cost	LCM item by particular
1	Hose	twenty	twenty	xviii	18
two	Subclass	40	40	41	twoscore
three	Clamp	10	x	15	x
4	Motor	2	120	100	100
5	Generator	i	400	410	400
			590	584	568

The LCM item-past-item column amounts are determined past comparing the price and market for each item and choosing the lower of the two in each case.

These LCM detail-by-item amounts are totaled and this corporeality, $568 is used to calculate the loss, as follows;

	$
Cost (FIFO)	590
LCM (item by item)	(568)
Loss	22

The loss in value can also be estimated by comparing the full cost of the entire inventory with the total market of the unabridged inventory:

	$
Cost (FIFO)	590
Market (total inventory)	(584)
Loss	vi

A firm volition choose whichever method – detail-by-item or total inventory – is easier for it to utilise.

Either method of estimating the loss is acceptable, provided that it is used consistently from flow to menstruum. The loss volition so be reported on the income statement either as a separate item or under the cost of appurtenances sold.

The principle of conservatism is suitably applicable to the LCM dominion.

Conservatism in accounting means that one should choose accounting methods that are to the lowest degree likely to overstate assets and income. Valuing inventory at price when its replacement cost is lower overstates the asset merchandise inventory.

Thus, we apply the conservatism principle and utilize LCM to reduce inventory to a more than realistic value and, at the same fourth dimension, recognize the loss in value that has incurred.