The lower of cost and market (LCM) rule is that the cost of the inventory is compared with its net realizable value at the end of the period. If the net realizable value of the inventory is less than its historical cost, the inventory is written down to net realizable value and a loss is reported. In contrary, the cost method is to record the historic cost of the inventory, while the market method is to record the net realizable value as a replacement cost.
The application of the LCM rule results in a loss in inventory value being recorded in the period in which the decline in value occurs rather than in a subsequent period when the inventory is sold in cost method. The market method depends on the net realizable value that is frustrated with the market price. Whether the differences between them depend on the industry the entity is in. For example, it is material for industries such as technology and software as the inventory value is significant and frustrates time to time; while it is immaterial for industries such as button or thread manufacturers as the inventory value is insignificant and stable over the time.
Back to Accounting and Finance Article List