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الجمعة، 16 يناير 2015

Lower of Cost or Market (LCM)

Introduction to Lower of Cost or Market (LCM)

Assume it is the end of December 2012 and your retail store has 20 digital cameras in inventory. You purchased the cameras directly from the manufacturer at a cost of $150 each and you planned to sell the cameras at a retail price of $200, a price that is in line with competing retailers.
Unexpectedly, on December 31, the camera manufacturer announces a permanent price reduction—you and the other retailers can now purchase the cameras for $135 instead of $150. You know that your competitors will buy up these cameras and pass the savings on to their customers by immediately advertising a retail price reduction—selling the cameras for $185 instead of $200. If you drop your retail price to $185, however, your gross profit will be just $35 each on the 20 cameras you already have in stock, instead of the $50 per camera that you had planned on. This means your profits will be $300 less than you projected ($15 less profit times 20 cameras). Much to your dismay, you will have to drop your price to meet that of your competitors. There is nothing you can do to avoid this "holding loss" of $300.
When and how should this loss be reported on your store's income statement? Should the loss be reported as a smaller gross profit when the cameras are sold in January 2013? Or, should the entire $300 of loss be reported in December 2012, when the manufacturer announced the lower price? Should your December 31 balance sheet report inventory at $3,000 (20 cameras at the actual cost of $150) or at $2,700 (20 cameras at the lowerreplacement cost of $135)?
The conservatism principle and a specific accounting pronouncement, Accounting Research Bulletin No. 43 (ARB No. 43) leads to an accounting valuation method known as the lower of cost or market, or LCM. In this method the term "market" includes both the market in which the company purchases its merchandise as well as the market in which it sells its merchandise. We will discuss the details of the rule later, but for now, think of the lower of cost or market rule as the lower of cost or replacement cost—with certain limitations placed on the replacement cost amount.

Conservatism Principle

Accountants usually associate the lower of cost or market (LCM) rule with the conservatism principle. This principle gives accountants guidance when they are faced with a choice between two divergent amounts. The conservatism principle directs them to choose the amount that results in a smaller asset amount and/or less profit.
How would the conservatism principle affect your camera "holding loss" described in the Introduction? On your December 31 balance sheet, the accountant must decide between reporting the cameras in inventory at their actual cost of $150 each, or at their replacement cost of $135 each. The conservatism principle and the Accounting Research Bulletin No. 43 direct the accountant to report them at $135 each and to recognize the $300 loss on your 2012 income statement. (In other words, the loss should be reported as a loss in 2012, and not as a reduction in profits in 2013 when the cameras are sold.) However, there are some limitations on the replacement cost. The limitations involve the net realizable value (NRV), which will be defined in the next section.
While the conservatism principle and the lower of cost or market rule in ARB No. 43 may require that inventory be reported at less than cost, the cost principle and the revenue recognition principle prevent the reporting of inventory at more than cost. (However, there are exceptions for a few select industries such as mining, commodities, securities, etc.)

Net Realizable Value (NRV)

Net realizable value (NRV) is defined as the expected selling price in the ordinary course of business minus the cost necessary for completion and disposal.
To illustrate NRV, let's assume that a company has an item in inventory that could be sold for $5. It will cost $0.80 to get the item ready for sale (by way of such costs as packaging the item), and to actually sell it (by way of such costs as sales commissions). This makes the net realizable value $4.20 (selling price of $5.00 less $0.80 of cost to complete and dispose).
Net realizable value is a key component in determining "market" in the lower of cost or market rule.

Market

In the term lower of cost or market the word "market" refers to an item's current replacement cost (whether through purchase or production). The market amount is constrained or limited by two amounts: (1) an upper limit, or "ceiling," and (2) a lower limit, or "floor." An item's market amount (or replacement cost) cannot be higher than the ceiling nor lower than the floor.
Both the upper limit (the ceiling) and the lower limit (the floor) are related to the net realizable value (defined above) in the following ways:
  1. Upper Limit or Ceiling for Market The upper limit, or ceiling, for the market amount is the net realizable value (NRV). In other words, the market amount cannot be higher than NRV. If the current replacement cost of an item in inventory is greater than NRV, the NRV is used as the market amount.
  2. Lower Limit or Floor for Market The lower limit, or floor, for the market amount is the net realizable value (NRV) minus the normal profit. In other words, the market amount cannot be lower than NRV minus the normal profit. If the current replacement cost of an item in inventory is less than the NRV minus the normal profit, the NRV minus the normal profit is used as the market amount.
Here's a recap on how to determine the market amount used in the lower of cost or market rule:
  • If the current replacement cost is between the floor and the ceiling, the current replacement cost is the market amount.
  • If the current replacement cost is greater than the ceiling, the ceiling amount is the market amount.
  • If the current replacement cost is lower than the floor, the floor amount is the market amount.

How to Calculate the Lower of Cost or Market (LCM)

We will use the information in the following table to calculate the net realizable value and the lower of cost or market for five products:
Recall the lower of cost or market (LCM) rule: LCM is the lower of cost or replacement cost, with the replacement cost being no higher than NRV and no lower than NRV minus the normal profit.
Since the replacement cost was given, we will begin by calculating the net realizable value (NRV) of each of the products. Recall that net realizable value is the expected selling price in the ordinary course of business minus the cost to complete and dispose. NRV will be the upper limit (the ceiling) for the replacement cost.
Next we will calculate the NRV minus the normal profit. This amount will be the lower limit (the floor) for the replacement cost.
The following chart displays the four relevant amounts used in the lower of cost or market rule: (1) cost, (2) the upper limit, or ceiling, for the replacement cost, (3) replacement cost, and (4) the lower limit, or floor, for the replacement cost. The lower of cost or market amount appears in bold font:
Let's review the lower of cost or market for each of the five products shown in the above table:

Lower of Cost or Market - Quick and Easy

An easy way to apply the lower of cost or market (or to check your calculations) is to arrange the four relevant amounts (cost, replacement cost, NRV, and NRV minus normal profit) in descending order of amount. The third amount is the lower of cost or market, unless cost is lower. (When cost is the fourth amount, the lower of cost or market is the fourth amount.) To illustrate:
To recap this quick and easy approach to finding the lower of cost or market...
1) Arrange the four relevant amounts in descending order.
2) The lower of cost or market is the third amount, unless cost is lower.


Applying Lower of Cost or Market To Inventory

Generally accepted accounting principles allow for the lower of cost or market rule to be applied in one of three ways: (1) on an inventory totals basis, (2) on an inventory categories basis, or (3) on an item-by-item basis.
  1. Applying LCM to inventory totals is the least conservative application since it results in the smallest writedown or reduction of inventory from cost and the smallest loss on the income statement.
  2. Applying LCM to inventory categories results in values that fall somewhere in between the other two methods of applying LCM.
  3. Applying LCM on an item-by-item basis is the most conservative application since it results in the largest writedown or reduction of inventory from cost and the largest loss on the income statement.
Let's use the information below to illustrate the three ways of applying LCM:
The Total Cost column shows a grand total of $9,455. This is the cost of the items held in inventory. In most industries, the inventory reported on the balance sheet cannot exceed this amount. However, because of the lower of cost or market rule, the inventory reported on the balance sheet might be smaller than this amount. Thesmaller amount could be based on the lower of cost or market applied to the inventory totals, inventory categories, or each individual item in inventory.
If the LCM rule is applied to the inventory totals, the Grand Total Cost ($9,455) is compared to Grand Total Market ($9,284). The lower of cost or market is the lower of these two amounts. Therefore $9,284 is the amount to be reported on the company's balance sheet. The difference of $171 ($9,455 minus $9,284) is reported as a loss on the company's income statements in the accounting periods when the loss took place.
If the LCM rule is applied to the inventory categories, the lower of each category's total cost and total market amount is selected. For example, the Category A Total Market amount of $981 is selected over Category A Total Cost amount of $1,080 and is entered in the column "LCM by Category." The Grand Total LCM by Category of $9,274 is less than the Grand Total Cost of $9,455. Therefore, $9,274 is the amount reported on the company's balance sheet. The amount of the writedown or reduction from $9,455 to $9,274 is $181. This $181 will be reported on the income statements in the periods when the market amount dropped below cost.
If the LCM is applied on an item-by-item basis, the lower of each item's total cost and total market amount is selected. For example, the Item 212 Total Cost amount of $160 is selected over Item 212 Total Market amount of $168 and is entered in the column "LCM Item-by-Item." The Grand Total LCM Item-by-Item of $9,135 is the amount reported on the company's balance sheet. The difference between this amount and the Grand Total Cost of $9,455 is $320. This $320 reduction from cost is reported as a loss on the company's income statements in the accounting periods when the loss took place. As mentioned earlier, this is the most conservative way in which to apply the lower of cost or market rule.

Accounting For Lower of Cost or Market

For companies reporting inventory under the lower of cost or market rule, it is common to use the contra asset inventory account Allowance to Reduce Inventory to LCM. This balance sheet account is used to report the amount that the inventory's market amount is below the inventory's cost amount. In other words, the combination of the Inventory account balance and the Allowance account balance will equal the lower of cost or market. The result is the account Allowance to Reduce Inventory to LCM will have a credit balance for the amount that the market value of the inventory is less than the cost shown in the Inventory account. If the market value of the inventory is greater than cost, a zero balance appears in the account Allowance to Reduce Inventory to LCM. (There cannot be a debit balance in Allowance account because of the cost principle and the revenue recognition principle.)
Because of the rules of double-entry accounting, whenever the balance in the Allowance account is adjusted, a second account is needed. The second account will be an income statement account, such as Loss from Reducing Inventory to LCM.
We'll use the following information to illustrate accounting for lower of cost or market (LCM):
At December 31, 2012 the company's balance sheet will report Inventory of $80,000 since this amount is the lower of cost ($80,000) or market ($82,900). The general ledger accounts show these balances:
No adjustment was needed at December 31 because 1) market was greater than the cost, and 2) the balance in the Allowance account was previously at $-0-.
At January 31, 2013 the company's balance sheet needs to report Inventory of $75,000 since this amount is the lower of cost or market on that date. The company's income statement for the month of January 2013 should report a Loss of $1,000, since the decline below market occurred in January and the market is expected to remain lower than cost. If the company uses the Allowance account for valuation, the pertinent general ledger accounts will have the following adjustment:
In general journal format, the adjusting entry at January 31, 2013 is:
This entry is similar to other adjusting entries (see Explanation of Adjusting Entries) in that it involves a balance sheet account (Allowance to Reduce Inventory to LCM) and an income statement account (Loss from Reducing Inventory to LCM).
We used the T-accounts to make certain we got the correct amounts into the balance sheet account. We asked ourself: What should the balance be in the account Allowance to Reduce Inv to LCM at January 31, 2013? The answer is that the balance at January 31 should be a credit balance of $1,000 because the market value at that date is $1,000 below the cost being reported in the Inventory account. The second question we asked was: What is the present balance in the Allowance account? The answer was that prior to an adjustment on January 31, the balance was $-0-. So how do we get the Allowance account from a balance of $-0- to the $1,000 credit balance that is needed as of January 31? The solution is to enter a credit of $1,000 in the Allowance account. (That of course means a debit of $1,000 will be entered into the Loss account.) After we record that January 31 adjusting entry the balance sheet will report the ending account balances as follows:
On February 28, 2013 the balance sheet needs to report the lower of cost or market of $71,800. (Earlier, we assumed that on Feb. 28 the cost was $72,000 and the market was $71,800.) Throughout February there were transactions in the Inventory account that resulted in the ending cost balance on February 28 of $72,000. In order for the balance sheet to report the correct lower of cost or market of $71,800 as shown next, the balance in the Allowance account at February 28 will need to be a credit balance of $200:
The journal entry needed at February 28 can be determined by using T-accounts:
In general journal format, the adjusting entry at February 28, 2013 is:
This journal entry shows a recovery of $800 of the $1,000 loss recorded in January.
On March 31, 2013 the balance sheet needs to report the lower of cost or market of $70,000. (Recall that our assumptions were cost of $70,000 and market of $70,400.) Throughout March there were transactions in the Inventory account and our assumptions meant that the ending balance in Inventory at March 31 was $70,000. In order for the balance sheet to report the correct LCM of $70,000, the balance in the Allowance account at March 31 will need to be a balance of $0.
Again, the journal entry needed at March 31 can be determined by using T-accounts:
In general journal format, the adjusting entry at March 31, 2013 is:
Our March 31 journal entry shows the remaining $200 recovery from the $1,000 loss previously recorded in January 2013. (Note: We did not report the recovery as a "gain" of $200 during March nor did we report a "gain" of $800 in February. We avoided the word "gain" since the company did not increase its inventory carrying amount above its cost; it merely restored the inventory amount back to its cost.)

Additional Information and Resources

Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances

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