• The lower of cost or market (LCM) method values inventory at the lesser of its historical cost or its market value (or, under newer guidance, net realizable value).
– LCM is a conservatism-based rule: it forces recognition of losses when inventory has declined in value, protecting users of financial statements from overstated assets and income.
– Under U.S. GAAP the guidance for applying “market” was simplified by the FASB (ASU 2015-11); many companies now compare cost to net realizable value (NRV) rather than the traditional three-point “market” test. See FASB ASC 330 for authoritative guidance.
– Inventory write-downs reduce balance-sheet inventory and increase expense (often reported in cost of goods sold or a separate line); under U.S. GAAP write-downs generally are not reversed if the market recovers (IFRS allows reversals).
What LCM means (concept and purpose)
The LCM approach requires that inventory be reported at the lower of:
– Its recorded historical cost (what the company paid to acquire or produce it), or
– Its “market” value — historically interpreted as replacement cost subject to a ceiling and a floor — but more recently for many companies as net realizable value (NRV), which is estimated selling price less costs to complete and sell.
Purpose
– Conservatism: recognize losses when inventory will not yield the recorded cost.
– Provide readers of the financial statements a realistic view of recoverable inventory value.
– Prevent overstatement of assets and earnings when market conditions or obsolescence reduce inventory value.
Why LCM is used
– Product obsolescence, damage, or decline in selling prices can make inventory worth less than cost.
– LCM forces timely recognition of such losses, which improves comparability and reliability of reported financials.
– It helps avoid recognizing income that will not be realized and reduces the risk that assets are overstated.
GAAP status and recent FASB update
– LCM principles are embedded in U.S. GAAP via ASC 330 (Inventory).
– In 2015 the FASB issued ASU 2015-11 (effective in subsequent years) to simplify inventory measurement for many entities: it replaced the “market” concept with comparison to net realizable value (NRV) for companies using FIFO or average-cost methods. Consult ASC 330 and ASU 2015-11 for detailed application and effective dates.
– Note: differences remain in certain circumstances (e.g., LIFO, retail inventory method) — always check current ASC 330 guidance or your auditor for your company’s facts and circumstances.
Application of the LCM rule — practical steps
Step 1 — Identify the inventory items and the costing method used
– Is inventory measured using FIFO, average cost, LIFO, or the retail inventory method? The applicable LCM/NRV test depends on the method and guidance in ASC 330 and ASU 2015-11.
Step 2 — Determine historical cost
– For each inventory item (or logical group), determine the unit cost per your inventory costing method.
Step 3 — Determine the applicable “market” measure
– For entities that now follow the simplified guidance (many FIFO and average-cost users), compute net realizable value (NRV):
NRV = Estimated selling price − Costs to complete − Costs to sell (disposal).
– For entities applying the traditional LCM (e.g., where guidance still requires it), determine “market” as replacement cost, but limit it between:
• Ceiling = NRV, and
• Floor = NRV − Normal profit margin.
If replacement cost > ceiling, use ceiling; if replacement cost market/NRV: inventory is impaired — write it down to the lower value.
– If cost ≤ market/NRV: no write-down is required.
Step 5 — Record the write-down and make disclosures
– Journal entry (common approach):
Dr. Loss on inventory write-down (or COGS) XXX
Cr. Inventory XXX
– Under some practices the write-down is recorded as an increase to COGS; alternatively a separate line-item loss can be presented. Follow company policy and disclosure requirements.
– Disclose nature and amount of write-downs in the notes when material, and explain circumstances (obsolescence, declines in price, etc.).
Step 6 — Review grouping, frequency and tax/accounting treatment
– LCM/NRV tests are applied at the appropriate level — often by item, product line, or category depending on the nature of the inventory and materiality.
– Perform tests each reporting period (quarterly/annually) or whenever facts change materially.
– Tax reporting may differ from book treatment; consult tax rules for deductibility and reporting.
Example (simple numeric example)
Facts:
– Company A has 1,000 units of Part X with cost $15 each (total cost = $15,000).
– Estimated selling price is $16 per unit.
– Costs to complete and sell (packaging, shipping) are $2 per unit.
NRV per unit = 16 − 2 = $14
Compare cost ($15) to NRV ($14): NRV is lower → write-down required.
Journal entry:
Dr. Loss on inventory write-down (or COGS) 1,000
Cr. Inventory 1,000
(1,000 units × $1 write-down per unit)
Financial statement effects:
– Inventory on balance sheet reduced to $14,000.
– Income statement recognizes $1,000 loss, reducing net income and retained earnings.
Practical considerations and other factors
– Level of aggregation: Applying the test by individual item is most precise; grouping by category is acceptable if immaterial items can be offset by others. Disclose policy.
– Timing: Tests should be done each reporting period and when indicators suggest impairment (e.g., price declines, obsolete models).
– Cause of decline: Distinguish temporary market fluctuations from long-term declines; conservative recognition is required for probable loss of value.
– Reversals: Under U.S. GAAP, inventory write-downs generally are not reversed if market value later recovers (unlike IFRS, which may permit reversal). Verify current guidance for any limited exceptions.
– Impact on ratios: Write-downs reduce current assets and equity, raise cost of goods sold or loss, lower gross and net margins, and can affect covenants and tax positions—manage stakeholders’ expectations.
– LIFO layers and LIFO reserve: Companies using LIFO should evaluate LIFO layers and any related reserves when determining the overall effect of write-downs.
– Retail inventory method: Special rules apply; consult ASC guidance for applying lower of cost or market under retail method.
Presentation and disclosure best practices
– Disclose the method for measuring inventory (FIFO, average cost, LIFO, retail).
– Quantify material write-downs in the period and describe the events and circumstances that led to the write-down.
– Explain measurement bases used (LCM vs lower of cost and NRV) and any changes in method.
– If write-downs are reported as part of COGS, disclose that presentation policy.
Journal-entry options and presentation choices
– Two common approaches:
1) Charge the write-down to Cost of Goods Sold (COGS) — increases COGS in the period.
2) Present a separate loss line (e.g., “Inventory write-down”) — more transparent for users.
– Choose presentation consistent with company policy and disclose.
Practical checklist for accountants and finance teams
– Confirm your inventory costing method and whether ASU 2015-11 or other updates change the measurement.
– Identify slow-moving, obsolete, damaged, or price-declined items each period.
– Compute NRV (sell price minus costs to complete and disposition) for suspect items.
– For replacement-cost tests, compute replacement cost and apply ceiling and floor limits (if traditional market approach applies).
– Document assumptions, calculations, and the rationale for grouping level.
– Obtain management review and board/audit-committee sign-off for material adjustments.
– Update internal controls so LCM/NRV testing is repeatable and auditable.
The bottom line
LCM (or, in many cases under recent FASB guidance, lower of cost and NRV) enforces conservative measurement of inventory so that companies recognize losses when recoverable value declines below historical cost. Practical application requires careful measurement (cost, replacement cost, NRV), disciplined testing at an appropriate aggregation level, clear journal entries and disclosures, and awareness of presentation and tax implications. Consult ASC 330 and the FASB ASU 2015-11 guidance and your auditor for specifics tailored to your company’s facts and accounting policies.
Sources and further reading
– “Lower of Cost or Market (LCM) Definition,” Investopedia (Michela Buttignol).
– FASB Accounting Standards Update No. 2015-11, “Simplifying the Measurement of Inventory” (ASU 2015-11) and ASC Topic 330, Inventory (for authoritative U.S. GAAP guidance).
– Walk through a worked example using your company’s actual inventory items and numbers,
– Prepare sample journal entries and financial-statement extracts for a mock period-end, or
– Draft suggested disclosures for the notes to the financial statements. Which would be most useful?