Lower of cost or market is a term used to refer to the method by which inventory is valued and shown in the balance sheet of a business. Under the historical cost accounting concept, all balance sheet assets should be shown at cost, however, the lower of cost or market basis is an exception to this rule.
Lower of Cost or Market Journal Entry
Suppose a business purchases goods from a supplier at a cost of 5,000, the cost is posted to the inventory account as follows:
| Account | Debit | Credit |
|---|---|---|
| Inventory | 5,000 | |
| Accounts payable | 5,000 | |
| Total | 5,000 | 5,000 |
The inventory would now be shown in the balance sheet under the heading of current assets at its cost of 5,000.
As time passes, the inventory doesn’t sell and the current market value for this inventory falls to 3,000. The business is still showing the inventory in the balance sheet at its original cost of 5,000, and if it sold the inventory, would make a loss of 2,000. As it stands, the business has a potential loss which it has not recognized.
Unfortunately, this puts the business in contravention of one of the fundamental modifying principles of accounting, the prudence or conservatism principle, which requires that all potential losses are recognized in the financial statements.
To comply with this principle, the business must now reduce the value of the inventory to the lower of cost or market, and recognize the loss, using the following journal.
| Account | Debit | Credit |
|---|---|---|
| Allowance to reduce inventory to LCM | 2,000 | |
| Loss on inventory write down | 2,000 | |
| Total | 2,000 | 2,000 |
The allowance to reduce inventory to LCM account is a contra asset account in the balance sheet, which is offset against the inventory account reducing its value to the lower of cost or market.
The business has now complied with the conservatism principle by recognizing the loss of 2,000 using the loss on inventory write down account in the income statement.
Market Value
In the above example we simply stated that the market value of the inventory was 3,000, but what do we mean by the term market value?
Under US GAAP, market value is defined as the current replacement cost subject to upper and lower limits defined relative to net realizable value (NRV) as follows:
Upper limit
Net realizable value (NRV)
Lower limit
Net realizable value less the normal profit margin (NRV-GP)
Where net realizable value is defined as the selling price less costs of completion and disposal. The use of upper and lower limits is demonstrated in the diagram below.
The current replacement cost can either be less than the lower limit, between the two limits, or more than the upper limit, in each instance the market value can be determined by applying the following rules:
- Current replacement cost < Lower limit, Market value = Lower limit
- Current replacement cost > Upper limit, Market value = Upper limit
- Current replacement cost between limits, Market value = Current replacement cost
Lower of Cost or Market Example 1
As an example, consider a business which has a product in inventory at a cost of 90, with costs to complete of 30. The product is currently selling for 220 and has a normal profit margin of 60% and a replacement cost of 75. The lower of cost or market calculation can be carried out in five steps as follows:
1. Calculate the Net Realizable Value
NRV = Selling price - Costs to complete NRV = 220 - 30 = 190
2. Calculate the Normal Profit
Normal profit = Selling price x Gross margin % Normal profit = 220 x 60% = 132
3. Calculate the Upper and Lower Limits
Upper limit = NRV = 190 Lower limit = NRV - GP = 190 - 132 = 58
4. Calculate the Market
The market value to use is the current replacement cost subject to the upper and lower limits. As the current replacement cost is 75, and as this is between the upper and lower limits, the market value to use is 75.
5. Calculate the Lower of Cost or Market
As the market value to use is 75 and the cost is 90, the lower of cost and market is 75. The value of the inventory would now be stated in the balance sheet at 75.
The lower of cost or market inventory adjustment required in the accounting records to reflect the write down is as follows:
| Account | Debit | Credit |
|---|---|---|
| Allowance to reduce inventory to LCM | 15 | |
| Loss on inventory write down | 15 | |
| Total | 15 | 15 |
Lower of Cost or Market Example 2
As a further example, consider a business which has a product in inventory at a cost of 140, with costs to complete of 40. The product is currently selling for 250 and has a normal profit margin of 40% and a replacement cost of 90.
1. Calculate the Net Realizable Value
NRV = Selling price - Costs to complete NRV = 250 - 40 = 210
2. Calculate the Normal Profit
Normal profit = Selling price x Gross margin % Normal profit = 250 x 40% = 100
3. Calculate the Upper and Lower Limits
Upper limit = NRV = 210 Lower limit = NRV - GP = 210 - 100 = 110
4. Calculate the Market
The market value to use is the current replacement cost subject to the upper and lower limits. As the current replacement cost is 90, and as this is lower than the lower limit of 110, the market value to use is 110.
5. Calculate the Lower of Cost or Market
As the market value to use is 110 and the cost is 140, the lower of cost and market is 110. The value of the inventory would now be stated in the balance sheet at 110.
The lower of cost or market inventory adjustment required in the accounting records to reflect the write down is as follows:
| Account | Debit | Credit |
|---|---|---|
| Allowance to reduce inventory to LCM | 30 | |
| Loss on inventory write down | 30 | |
| Total | 30 | 30 |
The above rules and calculations relating to lower of cost or market basis can be applied by a business in one of three ways:
- Item by item basis
- Category basis
- Total inventory basis
The business is free to choose which method of lower of cost or market it wants to apply, however, it must apply the chosen method on a consistent basis.
Note: IFRS and UK GAAP and Lower of Cost or Market
Although the lower of cost or market method is used under US GAAP to determine the carrying value of inventory, under IFRS and UK GAAP a lower of cost or net realizable value approach is used.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.