Introduction to Lower of Cost or Market (LCM)
Assume it is the end of December 2015 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 2016? Or, should the entire $300 of loss be reported in December 2015, 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 lower replacement 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.
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 2015 income statement. (In other words, the loss should be reported as a loss in 2015, and not as a reduction in profits in 2016 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.
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:
- 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.
- 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.