🔹 Lower of Cost or Market
📌 The Lower of Cost or Market (LCM) method is an accounting principle used to value inventory at the lower of its original purchase cost or its current market value. This method is used to recognize losses from holding inventory that has declined in value, ensuring that the financial statements present a more conservative and realistic picture.
Under LCM, you compare the cost of your inventory to its market value. The lower of the two becomes the valuation for your inventory.
- Cost: This is the original purchase price of the inventory.
- Market Value: This can be the current selling price, replacement cost, or net realizable value, depending on which is most applicable.
After comparing these two amounts for each inventory item, you'll use the lower of cost or market for your financial statements.
Let's say you have 100 units of a particular type of electronic component in your inventory. The cost of each component was $5 when you purchased it.
- Cost of Inventory = 100 units * $5/unit = $500 total cost
Now, due to technological advancements, newer models are available and the market value for the type of component you hold drops to $4 per unit.
- Market Value = 100 units * $4/unit = $400 total cost
Using LCM, you would compare the cost of $500 to the market value of $400. You'll choose the lower amount, $400, to value your inventory on your balance sheet.
By doing this, you're recognizing a "write-down" of $100, using the following journal entry:
Transaction: Recording a “write-down” for Lower of Cost or Market calculations
What It Means:
- Credit to Merchandise Inventory ($100):
- Simple: Your inventory lost value, so you reduce its worth on the balance sheet by $100.
- Why: You're adjusting the books to show that your assets are now worth less than before, in line with accounting's conservatism principle.
- Simple: Consider this the "dump" for the $100 loss in value—this is the other side of the entry needed to make the books balance
- Why: You're acknowledging that it'll effectively cost you an extra $100 to generate revenue from the inventory you have left. This is captured as an additional expense on the income statement.