In: Accounting
Accountants generally follow the lower of cost or market (LCM) basis of inventory valuations.
Required:
1. Define cost as applied to the valuation of inventories.
2. Define market as applied to the valuation of inventories
3. Why are inventories valued at the lower of cost or market? Discuss.
4. List the arguments against the use of the LCM method of valuing inventories.
1) Cost is the main component when there is inventory, as valuation of inventory is done on the basis of cost, and cost always includes all those expenses which incurred from conversion of raw material into work in progress and then into finished product, but it does include cost incurred after that , like selling and distribution expenses.
2) Market may be defines as price which paid in exchange of any unit of inventory with the same product having identical qualities, market always have limit on the price or amount. Ceiling is the upper limit also it is the net realisable value of inventory.
3) The LCM rule says that inventory should value at market price or cost whichever is lower, cost the value of that product incurred and market price is the price of identical product in the market, the unit remains in the balance (inventories) valued for the purpose of closing stock,
And this stock will be the opening for the upcoming period, valuation of that stock must be done on a fair basis that will cover all the components of cost, and also this rule plays fair role in most of the times, sometime when the product becomes obsolete or market price has declined then there may be loss.
4) Arguments
i) This rule ignore the principal of consistency, as it will value inventory on LCM basis which may be cost in one period or market price in other period
ii) This rule is not conservative for future profit purpose
iii) Most of the time it ignores the cost and allows the market price which leads that market is more substantive than cost