In this session, I explain lower of cost or market. The lower of cost or market rule states that a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price.The lower of cost or market (LCM) method states that when valuing a company's inventory, it is recorded on the balance sheet at either the historical cost or the market value. Farhat Accounting Lectures can help you understand lower of cost or market.
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Inventories are recorded at their cost. However, if inventory declines in value below its original cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline a company should write down the inventory to net realizable value to report this loss. The term net realizable value (NRV) refers to the net amount that a company expects to realize from the sale of inventory. Specifically, NRV is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.
Companies may apply the LCNRV rule either directly to each item, to each category, or to the total of the inventory. If a company follows a major category or total inventory approach in applying the LCNRV rule, increases in selling prices tend to offset decreases in selling prices.
Companies usually price inventory on an item by item basis. In fact, tax rules require that companies use an individual item approach barring practical difficulties. In addition, the individual item approach gives the most conservative valuation for balance sheet purposes.
Whichever method a company selects, it should apply the method consistently from one period to another.