Lower of Cost or Market (LCM) Rule (With Criticism)

In this article we will discuss about Lower of Cost or Market (LCM) Rule:- 1. Subject Matter of Lower of Cost or Market (LCM) Rule 2. Arguments in Support of LCM Rule 3. Criticism.

Subject Matter of Lower of Cost or Market (LCM) Rule:

The different methods of inventory costing such as FIFO, LIFO determine the value of inventory in terms of historical cost. However, according to conservatism concept, inventory should be reported on the balance sheet at the lower of its cost or its market value.

Generally speaking, inventory is valued in terms of cost. But there should be a departure from the cost basis of valuing inventory and it should be reduced below cost when the utility of goods has declined and its sale proceeds or value of the items will be less than their cost.

The decline in the value of inventory below cost can be due to different causes such as physical deterioration, obsolescence, drops in price level etc. In these situations, inventory is reported at market value. The difference in value (cost – market value) is recognised as a loss of the current period.

It should be understood that the market value of inventory needs to be estimated as the inventory has not in fact been sold. As a rule, the market value concept is used in terms of current replacement cost of inventory, that is, what it will cost currently to purchase or manufacture the item. Thus, the LCM rule recognises a holding loss in the period in which the replacement cost of an item dropped, rather than in the period in which the item actually is sold.

The holding loss, as stated earlier, is the difference between purchase cost and the subsequent lower replacement cost. If applicable, the LCM rule simply measures inventory at the lower (replacement) market figure.

As a result of it, net income decreases by the amount that the closing inventory has been written down. When the closing inventory becomes part of the cost of goods sold in a future period when selling prices are low, the lower carrying value of closing inventory helps in maintaining normal profit margins in the period of sale.

While applying the rule of ‘lower of cost or market’ the following upper and lower boundaries are used with regard to market value (current replacement cost) concept:

(1) Market value should not be higher than the estimated net realisable value, that is, the estimated selling price of the item less the costs associated with selling it.

(2) Market value should not be lower than the net realisable value less a normal profit margin.

The above rules on ‘lower of cost or market’ is summarised as follows:

“Use historical cost if the cost price is lowest; otherwise, use the next-to-lowest of the other three possibilities.”

The example presents the application of ‘lower of cost or market’ in different situations. In this example four possible situations A. B, C and D are assumed and historical cost, current replacement cost, net realisable value and net realisable value less profit margin figures of inventory are given.

The value at which inventory will be valued in these different situations is indicated by star (*):

The above example proves that not all decreases in replacement prices are followed by proportionate reductions in selling prices (net realisable value).

Therefore, the application of LCM rule is subject to the following additional guidelines:

(i) If selling price is not expected to drop, inventory may be priced at cost even though it exceeds replacement cost.

For example, assume that an item costing Rs. 80 are being sold for Rs. 100 during the year, yielding a gross profit of 20% on sales. If the selling price remains at Rs. 100 and the replacement cost drops to Rs. 60 (a 25% decline), inventory will not be written down.

However, if there is a proportionate decrease in the selling price, i.e., selling price also declines by 25% and becomes Rs. 75, then inventory will be shown at Rs. 60 replacement cost.

In this case, after showing the inventory at Rs. 60, the current period’s income will be less by Rs. 20 (the difference between the historical cost and replacement cost). Further, when this item valued at Rs. 60, is sold in a subsequent period for Rs. 75, a normal gross profit of 20% on sales will be reported (Rs. 75 – Rs. 60 = Rs. 15 gross profit margin).

(ii) If selling price is expected to drop—but less than proportionately to the decline in replacement cost—inventory is written down only to the extent necessary to maintain a normal gross profit in the period of sale. Taking the above example, if the selling price drops from Rs. 100 to Rs. 90 and the replacement cost declines to Rs. 60, inventory will be shown at Rs. 72 (Rs. 90 – 20% of Rs. 90). This amount maintains a 20% gross profit margin when the item is sold for Rs. 40.

Arguments in Support of LCM Rule:

Supporters of the LCM Rules argue that an exception to the historical costs basis is desirable because it (LCM) serves the useful purpose of achieving better matching of costs and revenues and contributes to usefulness of periodic income measurement.

The arguments in favour of LCM rule is that no assets should appear on a business enterprise’s balance sheet in an amount greater than is likely to be recovered from the use or sale of that asset in the normal course of events. Unrecoverable amounts have no value and therefore are not assets.

International Accounting Standards Committee observes:

“The historical cost of inventories may not be realisable if their selling prices have declined, if they are damaged, or if they have become wholly or partially obsolete. The practice of writing inventories down below historical cost to net realisable value accords with the view that current assets should not be carried in excess of amounts expected to be realised. Declines in value are computed separately for individual items, groups or similar items, an entire class of inventory (for example, finished goods), or items relating to a class of business, or they are computed on an overall basis for all the inventories down based on a class of inventory, on a class of business, or on an overall basis results in offsetting losses incurred against unrealized gains.”

Depending on the character and composition of the inventory, the rule of cost or market, whichever is lower may properly be applied either directly to each item or to the total of the inventory (or in some case to the total to the components of each major category). The method should be that which most clearly reflects periodic income.

Criticism of LCM Rule:

At the outset, it may be noted that lower of cost or market is not a method of inventory costing but rather one of recognising measurable expected loss.

The cost or market concept when applied to inventories is tied closely to the concept of realisation of revenue at the time of sale, but with the recognition of loss as soon as evidence of loss appears. The principal objections to the rule center around its violation of the historical cost principle.

LCM rule is criticised on many grounds:

(i) It violates the concept of consistency because it permits a change in valuation base from one period to another and even within the inventory itself. It treats value increases and value decreases differently. If the market value of goods is greater than its cost, there is no recognition of the increased value on the balance sheet.

(ii) It is said to be a major cause of distortion of profit and loss.

(iii) Although it may be considered conservative with respect to the current period, it is un-conservative with respect to the income of future period.

(iv) The current period may be charged with the result of inefficient purchasing and management, which should be included in the measurement of operating performance at the time of sale. However, it may also be argued that these should be recorded in the current period rather than in the period of sale.

(v) An increase in the market price in a subsequent period may result in an unrealized gain if the original cost is always used as the basis for comparison with the current market price (assuming, of course, that market in both periods is below the original cost).

(vi) The cost or market rule is said to permit excessive subjectivity in the accounts. This is based on the assumption that market is always more subjective than cost.