The lower of cost or market rule is associated with the accounting guideline or constraint known as conservatism. (Conservatism means that if doubt exists between two alternatives, the accountant should choose the alternative that will result in a lesser asset amount and less profit.)
When the lower of cost or market is applied to inventory, the accountant will value the inventory items at the lower of (1) the cost, or (2) the replacement cost within a ceiling and a floor.
The ceiling is the highest amount for the market amount. The ceiling is the net realizable value (NRV) and it is calculated as follows: the selling price in the ordinary course of business minus any costs of completion and disposal.
The floor is the lowest amount for the market amount and it is the net realizable value minus the normal profit.
Here is one example. Assume an inventory item had a cost of $10. Its replacement cost is now $8. Its net realizable value is $9, and the normal profit is $2. The cost of $10 is compared to the market amount. Market is the replacement cost of $8 constrained by a ceiling of $9 (NRV) and a floor of $7 (NRV of $9 minus $2 profit). Since the $8 replacement cost is within the ceiling and the floor, the accountant compares the cost of $10 to the market of $8. The lower of cost or market is $8.
Here's another example. An item in inventory had a cost of $10. Its replacement cost is $5. The net realizable value is $7 and the normal profit is $1. The market amount is the replacement cost of $5, but it is constrained by a ceiling of $7 and a floor of $6 ($7 minus the normal profit of $1). Because the replacement cost is below the floor amount, the floor amount is used. This means the accountant chooses between the lower of the cost of $10 or the market of $6. Hence, the item should be valued at $6 under the lower of cost or market rule.
Sample Lower of Cost or Market Questions
1) Another term for "limitation". (For example, the ceiling or floor for replacement cost.)
2) "Market" in LCM is the constrained replacement cost whether by purchase or production. In other words LCM will apply to a merchant and to a __________________.
3) The upper limit for the market amount in LCM is also referred to as the _____________.
4) When cost is less than the floor, the LCM rule requires that ________ be used.
5) __________ profit is subtracted from NRV in order to determine the floor in LCM.
6) The type of gain that occurs when the value of items in a company's inventory increases.
7) The "R" in NRV.
8) Only in exceptional cases will ARB No. 43 allow inventory to be reported at more than cost. One of these exceptional cases would involve precious ______________ (plural).
9) If you desire to have the most conservative results from LCM, you should apply the LCM rule to every inventory _________.
10) The result on the income statement when an adjustment is made to reduce inventory from cost to market.