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Lower of Cost or Market (LCM)

🎯 Learning Objectives

  • Understand the conservatism principle underlying LCM inventory valuation
  • Calculate inventory value using the Lower of Cost or Market rule
  • Distinguish between U.S. GAAP and IFRS treatment of inventory write-downs
  • Record journal entries for inventory write-downs and reversals
  • Analyze the impact of LCM on financial statements and ratios

📚 Background & Principles

Lower of Cost or Market (LCM) requires inventory to be reported at the lower of its historical cost or its current replacement cost (market value). This conservative approach prevents overstatement of inventory assets when market conditions have deteriorated.

Core Principle: Under the conservatism principle, when inventory value has declined, companies must recognize the loss immediately rather than waiting for eventual sale. This ensures financial statements don't overstate asset values.

"Market" in LCM typically means replacement cost—the amount that would be paid to replace the inventory today. However, market cannot exceed net realizable value (selling price minus selling costs) or be below net realizable value minus a normal profit margin.

💡 Key Insight: LCM is like a "safety net" for inventory valuation. If the market crashes below what you paid, you must recognize the loss NOW, not when you eventually sell at a loss. This prevents misleading investors about asset values.

🔑 Key Concepts

Historical Cost

Original purchase price or production cost of inventory. The baseline for LCM comparison.

Market (Replacement Cost)

Current cost to replace inventory. "Market" in LCM means replacement cost, not selling price.

Conservatism Principle

Accounting principle that when in doubt, prefer to understate rather than overstate assets and income.

Inventory Write-Down

Reducing inventory from cost to lower market value, recording a loss immediately.

Net Realizable Value (NRV)

Estimated selling price minus completion and disposal costs. Ceiling for "market" value.

LCM Floor and Ceiling

Market must be ≥ NRV - Profit Margin and ≤ NRV. These constrain the replacement cost range.

🔍 Deep Dive

Explore LCM at different levels of depth:

🟢 Foundational Level

Understanding the "Tech Gadget" rule.

The Declining Value Problem

Analogy: The Outdated Smartphone

You bought 100 smartphones at $500 each ($50,000 total). Then a new model was released.

The Problem:

Now customers only want to pay $400 for your old model. Your "market" value dropped.

The LCM Decision:

Cost = $500, Market = $400 → Report at $400 (the LOWER amount)

The Impact:

Take a $100 × 100 = $10,000 loss NOW, even before selling any phones.

Historical Cost

$1,000
vs

Market Value

$900
→

LCM Value

$900

🟡 Standard Level

Calculation and journal entries.

LCM Calculation

Scenario: Item has cost $1,000, replacement cost $900, NRV $1,200, NRV minus 20% margin $800.

Step 1: Determine "Market" Range

Ceiling = NRV = $1,200

Floor = NRV - Profit Margin = $800

Replacement Cost = $900 (within range)

Step 2: Apply LCM Rule

Cost = $1,000, Market = $900

Lower = $900

Step 3: Record Write-Down
Journal Entry:
Debit: Loss on Inventory Write-Down $100
Credit: Inventory $100

Per-Item vs. Total Inventory

LCM can be applied:

1. Item-by-item: Each inventory item valued separately (most common, most conservative)

2. Category: By product line or department

3. Total inventory: Entire inventory as one pool (least conservative)

🔴 Advanced Level

GAAP vs. IFRS differences and reversals.

🇺🇸 U.S. GAAP (Conservatism)

  • Write-downs are PERMANENT
  • Once reduced, inventory value CANNOT be increased
  • Even if market recovers, stays at lower value
  • Journal Entry: Loss to Inventory

🌍 IFRS (Recovery Allowed)

  • Write-downs can be REVERSED
  • If market recovers, can write back up
  • Reversal limited to original write-down amount
  • Journal Entry: Inventory to Recovery of Loss

IFRS Reversal Example

Year 1: Cost $1,000, Market $700 → Write down $300

Entry: Dr Loss $300, Cr Inventory $300

Year 2: Market recovers to $850

Entry: Dr Inventory $150, Cr Recovery of Loss $150
(Cannot exceed original $300 write-down)

🎨 Interactive: LCM Calculator

Compare historical cost with current market value to determine inventory valuation.

Historical Cost

$1,000
vs

Market Value

$900
→

LCM Value

$900

WRITE-DOWN REQUIRED: $100

GAAP vs IFRS Treatment

Scenario U.S. GAAP IFRS
Market drops below cost Write down to market. Permanent. Write down to market. Reversal allowed.
Market later recovers No change. Stays at lower value. Can write back up (to original cost).
Recovery exceeds write-down N/A - cannot recover Reversal limited to original write-down

🚫 Common Misconceptions & Professional Tips

❌ Misconception 1: "Market means selling price."

✅ Reality: In LCM, "market" means replacement cost—the cost to buy or produce the same item today. It's not what customers pay, but what you would pay to replace it.
❌ Misconception 2: "LCM write-downs are optional."

✅ Reality: LCM is a REQUIRED accounting rule. Companies must evaluate inventory at least annually and write down any items where market value has declined below cost.
❌ Misconception 3: "IFRS allows writing inventory UP to any value."

✅ Reality: IFRS reversals are limited to the original write-down amount. You can never report inventory above its original historical cost.
💡 Professional Tip #1: Document LCM calculations thoroughly. Auditors will examine whether you've properly identified items where market has declined and applied the rule correctly.
💡 Professional Tip #2: For industries with rapid obsolescence (tech, fashion), LCM analysis should be done more frequently than annually. Quarterly reviews may be necessary.
💡 Professional Tip #3: Consider the NRV floor constraint. If replacement cost is below NRV minus normal profit, you must use the floor, not the lower replacement cost.

🧠 Memory Aids & Quick Reference

⚡ Quick Recall: LCM Rule

LCM = Lower of (Cost OR Market)

Where Market = Replacement Cost, constrained by:

Floor: NRV - Normal Profit Margin

Ceiling: Net Realizable Value (NRV)

📊 Write-Down Entry

Dr: Loss on Inventory, Cr: Inventory

🇺🇸 GAAP Rule

Write-downs are permanent. No reversals allowed.

🌍 IFRS Rule

Reversals allowed up to original write-down amount.

📦 Market Constraints

Floor ≤ Market ≤ Ceiling

📖 Glossary

Lower of Cost or Market (LCM)

Inventory valuation rule requiring inventory to be reported at lower of historical cost or current replacement cost.

Historical Cost

Original purchase or production cost of inventory. The amount originally paid or incurred.

Replacement Cost

Current cost to acquire or produce identical inventory. The meaning of "market" in LCM.

Net Realizable Value (NRV)

Estimated selling price minus estimated completion and disposal costs. Acts as ceiling for market value.

Inventory Write-Down

Reduction of inventory from cost to lower market value, recognized as a loss in the current period.

Conservatism Principle

Accounting principle preferring understatement over overstatement when uncertainty exists.

IFRS Inventory Reversal

Under IFRS, write-downs can be reversed if market value recovers, limited to original write-down amount.

NRV Floor

Lower constraint on "market" value: NRV minus normal profit margin. Prevents excessive write-ups.

🎯 Final Knowledge Check

Test your understanding of LCM:

Question 1: Inventory has cost of $1,000 and replacement cost of $850. What is the LCM value?



Question 2: Under U.S. GAAP, if inventory is written down due to LCM:



Question 3: In LCM, "market" means:



Question 4: Which constraint limits "market" from being too low?



Question 5: Under IFRS, inventory written down by $200 can be reversed by up to: