Inventory valuation is an essential accounting process that determines how a company's inventory is recorded on the financial statements. The chosen valuation method affects the cost of goods sold (COGS), profit margins, and taxable income.
One key principle in inventory accounting is the Lower of Cost or Market (LCM) rule, which ensures that inventory is not overstated in a company's financial statements. This rule requires businesses to report inventory at the lower value between its original cost and its current market value to reflect any declines in value due to obsolescence, damage, or changing market conditions.
Inventory is one of the largest assets for many businesses, especially in industries like retail, manufacturing, and wholesale. Proper valuation ensures:
✔ Accurate Financial Statements → Inventory is a major component of both the balance sheet and income statement.
✔ Correct Profit Measurement → Inventory affects COGS, which in turn affects gross profit and net income.
✔ Fair Tax Reporting → The way inventory is valued impacts taxable income and the amount of tax a business must pay.
✔ Investor and Lender Confidence → Overstated inventory values can mislead investors and creditors about a company’s financial health.
Before applying the LCM rule, a company must first determine how it calculates the cost of its inventory. The main inventory valuation methods are:
✔ FIFO (First-In, First-Out) → The oldest inventory is sold first, so the ending inventory reflects the most recent purchases.
✔ LIFO (Last-In, First-Out) → The newest inventory is sold first, so the ending inventory reflects the oldest costs.
✔ Weighted Average Cost → Inventory cost is averaged over all units, smoothing price fluctuations.
✔ Specific Identification → Used for high-value or unique items, where each item’s cost is tracked individually.
Each method affects a company’s reported profits, taxes, and inventory value differently.
The LCM rule ensures that inventory is not recorded at a higher value than what it is worth in the market. This protects investors and lenders from financial misstatements.
📌 How LCM Works:
A company must compare:
✔ The original cost of inventory (from FIFO, LIFO, etc.).
✔ The market value of inventory, which is determined as:
Replacement Cost (how much it would cost to buy the inventory today).
Net Realizable Value (NRV) (estimated selling price minus costs to sell).
NRV minus a Normal Profit Margin (ensures inventory is not valued too low).
The company must then record the inventory at the lower of these values.
A retailer purchases 500 smartphones at $300 each. A new model is released, and the market price drops to $250 each.
✔ Original Cost: $300 per unit
✔ Current Market Price: $250 per unit
✔ Action: The company must write down inventory to $250 per unit, recording a loss.
A clothing company buys 1,000 jackets for $50 each. Due to high demand, the selling price rises to $80.
✔ Original Cost: $50 per unit
✔ Current Market Price: $80 per unit
✔ Action: No adjustment needed—inventory remains recorded at $50 per unit.
✔ Balance Sheet Impact:
If inventory is written down, the total inventory value (current assets) decreases.
This reduces the company’s total assets.
✔ Income Statement Impact:
The write-down is recorded as an expense in COGS, reducing gross profit and net income.
✔ Tax Implications:
Lower net income means the company pays less in taxes.
However, frequent write-downs could indicate poor inventory management.
📌 Example:
A company has inventory worth $200,000 at cost. If the LCM rule requires reducing its value to $170,000, the company must recognize a $30,000 expense, lowering net income.
Different accounting standards govern how LCM is applied:
✔ GAAP (Generally Accepted Accounting Principles - US):
Inventory must be written down if the market value is lower than cost.
Once written down, inventory cannot be written back up even if market prices recover.
✔ IFRS (International Financial Reporting Standards):
Inventory is valued at the lower of cost or net realizable value (NRV).
Unlike GAAP, write-downs can be reversed if market prices rise again.
✔ Industries where LCM is commonly used:
Technology & Electronics: Rapid depreciation due to new product releases.
Fashion & Retail: Seasonal trends cause fluctuations in inventory value.
Manufacturing: Raw materials can decrease in value due to supply chain changes.
✔ Situations where LCM adjustments are needed:
When inventory becomes obsolete (e.g., unsold old-model smartphones).
When demand drops, reducing the expected selling price.
When economic conditions cause market prices to decline.
✔ Write-Down (Partial Loss):
Happens when inventory value declines but still has some value.
Recorded as an expense in the income statement.
✔ Write-Off (Complete Loss):
Happens when inventory is worthless (e.g., perishable food expires).
The full value is removed from the books.
📌 Example:
A company owns $50,000 worth of old laptops. If their market value drops to $30,000, the company writes down $20,000. However, if they become completely unsellable, the company writes off the entire $50,000.
The Lower of Cost or Market rule ensures that a company’s inventory is not overvalued, preventing misleading financial statements. It helps businesses:
✔ Maintain accurate financial reporting.
✔ Avoid inflating profits with overvalued assets.
✔ Reflect realistic inventory values based on market conditions.
✔ Provide investors and stakeholders with transparency.
Companies must regularly review their inventory and apply LCM adjustments when necessary to comply with accounting standards and maintain financial integrity.