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):

	Cost (These amounts are in the accounting records.)	Market (These amounts are determined from information outside of the accounting records.)	Credit Balance needed in the Allowance account.
Inventory at Dec. 31, 2010	$80,000	$82,990	$       0
Inventory at Jan. 31 2011	76,000	75,000	1,000
Inventory at Feb. 28 2011	72,000	71,800	200
Inventory at Mar. 31, 2011	70,000	70,400	0

At December 31, 2010 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:

(balance sheet account)                          Inventory

Balance at Dec. 31, 2010	80,000

(bal. sheet account)         Allowance to Reduce Inventory to LCM

				0		Balance at Dec. 31, 2010

(inc. stmt. account)           Loss From Reducing Inventory to LCM

Balance at Dec. 31, 2010	0

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, 2011 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 2011 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:

(balance sheet account)                          Inventory

Balance at Jan. 31, 2011	76,000

(bal. sheet account)         Allowance to Reduce Inventory to LCM

				0		Balance at Dec. 31, 2010
				1,000		Adjustment at Jan. 31, 2011
				1,000		Bal. Needed at Jan. 31, 2011

(inc. stmt. account)           Loss From Reducing Inventory to LCM

Balance at Jan. 1, 2011	0
Adjustment at Jan. 31, 2011	1,000
Balance at Jan. 31, 2011	1,000

In general journal format, the adjusting entry at January 31, 2011 is:

Date	Account Name		Debit	Credit
Jan. 31, 2011	Loss from Reducing Inv to LCM		1,000
		Allowance to Reduce Inv to LCM		1,000

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, 2011? 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:

Inventory at cost	$76,000
Less: Allowance to Reduce Inv to LCM	–  1,000
Inventory at the lower of cost or market	$75,000

On February 28, 2011 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:

Inventory at cost	$72,000
Less: Allowance to Reduce Inv to LCM	–    200
Inventory at the lower of cost or market	$71,800

The journal entry needed at February 28 can be determined by using T-accounts:

(balance sheet account)                          Inventory

Balance at Feb. 28, 2011	72,000

(bal. sheet account)         Allowance to Reduce Inventory to LCM

				0		Balance at Dec. 31, 2010
				1,000		Adjustment at Jan. 31, 2011
				1,000		Bal. at Jan. 31, 2011
Adjustment at Feb. 28, 2011	800
				200		Bal. Needed at Feb. 28, 2011

(inc. stmt. account)           Loss From Reducing Inventory to LCM

Balance at Jan. 1, 2011	0
Adjustment at Jan. 31, 2011	1,000
Balance at Jan. 31, 2011	1,000
				800		Adjustment at Feb. 28, 2011
Balance at Feb. 28, 2011	200

In general journal format, the adjusting entry at February 28, 2011 is:

Date	Account Name		Debit	Credit
Feb. 28, 2011	Allowance to Reduce Inv to LCM		800
		Loss from Reducing Inv to LCM		800

This journal entry shows a recovery of $800 of the $1,000 loss recorded in January.

On March 31, 2011 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.

Inventory at cost	$70,000
Less: Allowance to Reduce Inv to LCM	–       0
Inventory at the lower of cost or market	$70,000

Again, the journal entry needed at March 31 can be determined by using T-accounts:

(balance sheet account)                          Inventory

Balance at March 31, 2011	70,000

(bal. sheet account)         Allowance to Reduce Inventory to LCM

				0		Balance at Dec. 31, 2010
				1,000		Adjustment at Jan. 31, 2011
				1,000		Bal. at Jan. 31, 2011
Adjustment at Feb. 28, 2011	800
				200		Bal. at Feb. 28, 2011
Adjustment at March 31, 2011	200
				0		Bal. Needed at March 31, 2011

(inc. stmt. account)           Loss From Reducing Inventory to LCM

Balance at Jan. 1, 2011	0
Adjustment at Jan. 31, 2011	1,000
Balance at Jan. 31, 2011	1,000
				800		Adjustment at Feb. 28, 2011
Balance at Feb. 28, 2011	200
				200		Adjustment at March 31, 2011
Balance at March 31, 2011	0

In general journal format, the adjusting entry at March 31, 2011 is:

Date	Account Name		Debit	Credit
March 31, 2011	Allowance to Reduce Inv to LCM		200
		Loss from Reducing Inv to LCM		200

Our March 31 journal entry shows the remaining $200 recovery from the $1,000 loss previously recorded in January 2011. (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.)

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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