Explain why the lower of cost or market rule is used to value inventory
“Lower of cost or market rule” (or shortly LCM) is an accounting method of inventory valuation which is used in financial reporting process. Lower of cost or market rule is an exception from the historical value principle. It is used if the inventory`s potential value is lower than the historical value of the asset. LCM rule is used for accounting of the loss of potential inventory value resulted from changes in price, obsolescence, etc. It should be applied to individual items, category or the entire inventory.
LCM rule refers to the accounting principle of conservatism. In other words, during preparation of financial statement you should rather be conservative, which means not to overstate income in the Statement of Earnings and assets in the Balance Sheet.
LCM rule states that an accountant must value the inventory with lower of cost or market value. In this rule cost means the inventory`s original cost and market refers to the cost of replacement. The cost of replacement should be between net realizable value minus disposal cost and net realizable value without a normal profit margin.
For example assume you have old floppy disks in your inventory that are 10 years old. In our day’s market, even if you paid a lot of money for them, they would be worthless.
Since there is no market for old floppy disks, you should reduce the history cost of inventory to the market value (or the lower of cost or market). This provides the effect of correction the depreciation of the inventory, stating assets and earnings “conservatively”.
So, when the inventory`s replacement cost is less than historical cost, the lower of cost or market rule states that the inventory should be valued to the lower cost and that a loss should be recorded.