Additional Topics in Inventory Valuation

In addition to the four inventory costing methods above, there are a couple more methods you should be aware of. This section discusses the lower of cost or market and methods in retail inventory.

Lower of Cost or Market

In lower of cost or market (LCM), inventory items are written down to market value when the market value is less than the cost of the items.


LEARNING OBJECTIVES

Explain how a would use the Lower of Cost or Market to value inventory


KEY TAKEAWAYS

Key Points
  • The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall.
  • Ending inventory is normally stated at historical cost (what was paid to obtain it), but there are times when the original cost of the ending inventory is greater than the cost of replacement. Thus, the inventory has lost value.
  • Any loss resulting from the decline in the value of inventory is charged to cost of goods sold (COGS) if non-material, or loss on the reduction of inventory to LCM if material.
Key Terms
  • stated value: par value
  • purchase price: The price at which something is actually purchased, especially from the point of view of the purchaser.
  • historical cost: The original monetary value of an economic item and based on the stable measuring unit assumption. Improvements may be added to an asset's cost.
  • market value: The price which a seller or insurer might reasonably expect to fetch for goods, services or securities on the open market.


Lower Of Cost or Market

Lower of cost or market (LCM) is an approach to valuing and reporting inventory. Ending inventory is normally stated at historical cost (what was paid to obtain it), but there are times when the original cost of the ending inventory is greater than the cost of replacement. Thus, the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The criterion for reporting this is the current market value. Any loss resulting from the decline in the value of inventory is charged to cost of goods sold (COGS) if non-material, or loss on the reduction of inventory to LCM if material.

The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall.


LCM In Practice

Under LCM, inventory items are written down to market value when the market value is less than the cost of the items. For example, assume that the market value of the inventory is USD 39,600 and its cost is USD 40,000. The company would then record a USD 400 loss because the inventory has lost some of its revenue-generating ability. Employees should check the stock of certain items to maintain an accurate record for dollars of inventory in stock.

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The company must recognize the loss in the period the loss occurred. On the other hand, if ending inventory has a market value of USD 45,000 and a cost of USD 40,000, the company would not recognize this increase in value. To do so would recognize revenue before the time of sale. A company may apply LCM to each inventory item (such as Monopoly), each inventory class (such as games), or total inventory.

Under the class method, a company applies LCM to the total cost and total market for each class of items compared. One class might be games, while another might be toys. The company then values each class at lower its cost or market amount.


Business Insight

Procter & Gamble markets a broad range of laundry, cleaning, paper, beauty care, health care, food, and beverage products around the world. Procter & Gamble's footnote in its Notes to Consolidated Financial Statements in its annual report illustrates that companies often disclose LCM in their notes to financial statements.

Inventories are valued at cost, which is not in excess of current market price. Cost is primarily determined by either the average cost or the first-in, first-out method. The replacement cost of last-in, first-out inventories exceeds carrying value by approximately USD 169 million.

Businesses need to manage their inventories.: Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.



Source: Boundless, https://courses.lumenlearning.com/boundless-accounting/chapter/additional-topics-in-inventory-valuation/
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