Question

Explain the lower-of-cost-or-market basis of accounting for inventories.

Answer 1

Companies use the the Lower of cost or market basis method of accounting for inventories.

The companies should use the lower of original cost or the market value/replacement cost of the inventory , which means that the inventory should be recorded at a lower value when comparing the cost at which it was initially purchased with the replacement costs of the inventory. This is done, because it does not make adequate sense to report an inventory at a price which is higher than what the inventory can recover.

Suppose, a retailer buys $20,000 worth of inventories, which is now worth $2000, the retailer has suffered a loss of $18,000.This method protects retailers form the loss although other inventory methods like LIFO and FIFO, would not recognise this loss as the inventory is unsold at this pojnt of time.

The LCM method will recognise this loss as a debiting the loss account by a figure of $18,000 and the inventory account should be credit by $18,000.

When the cost is equal to the market value there is no loss or gain recognised, when the cost is greater than the market value a loss is then recognised.