Inventory is valued at other than cost when (1) the cost of replacing items in in-
ventory is below the recorded cost, and (2) the inventory is not salable at normal sales
prices. This latter case may be due to imperfections, shop wear, style changes, or other
causes. In either situation, the method of valuing the inventories (cost or lower of cost
or market) should also be disclosed on the balance sheet.Valuation at Lower of Cost or Market
If the cost of replacing an item in inventory is lower than the original purchase cost, the
lower-of-cost-or-market (LCM) methodis used to value the inventory. Market, as used
inlower of cost or market, is the cost to replace the merchandise on the inventory date.
This market value is based on quantities normally purchased from the usual source of
supply. In businesses where inflation is the norm, market prices rarely decline. In busi-
nesses where technology changes rapidly (e.g., microcomputers and televisions), mar-
ket declines are common. The primary advantage of the lower-of-cost-or-market method
is that the gross profit (and net income) is reduced in the period in which the market
decline occurred, rather than waiting until the inventory is sold.
In applying the lower-of-cost-or-market method, the cost and replacement cost can
be determined in one of three ways. Cost and replacement cost can be determined for
(1) each item in the inventory, (2) major classes or categories of inventory, or (3) the
inventory as a whole. In practice, the cost and replacement cost of each item are usu-
ally determined.
To illustrate, assume that 400 identical units of Item A are in inventory, acquired
at a unit cost of $10.25 each. If at the inventory date the item would cost $10.50 to re-
place, the cost price of $10.25 would be multiplied by 400 to determine the inventory
value. On the other hand, if the item could be replaced at $9.50 a unit, the replacement
cost of $9.50 would be used for valuation purposes.
Exhibit 9 illustrates a method of organizing inventory data and applying lower-
of-cost-or-market to each inventory item. The amount of the market decline, $450
($15,520$15,070), may be reported as a separate item on the income statement or in-
cluded in the cost of merchandise sold. Regardless, net income will be reduced by the
amount of the market decline.280 Chapter 6 Inventories
Q.If the cost of an item is
$410, its current replace-
ment cost is $400, and its
selling price is $525, at
what amount should the
item be included in the in-
ventory according to the
LCM method?A.$400Unit Unit Total
Inventory Cost Market Lower
Commodity Quantity Price Price Cost Market of C or M
A 400 $10.25 $ 9.50 $ 4,100 $ 3,800 $ 3,800
B 120 22.50 24.10 2,700 2,892 2,700
C 600 8.00 7.75 4,800 4,650 4,650
D 280 14.00 14.75 3,920 4,130 3,920
Total $15,520 $15,472 $15,070Exhibit 9
Determining Inventory
at Lower of Cost or
MarketValuation at Net Realizable Value
As you would expect, merchandise that is out of date, spoiled, or damaged or that can
be sold only at prices below cost should be written down. Such merchandise should
be valued at net realizable value. Net realizable valueis the estimated selling price
less any direct cost of disposal, such as sales commissions. For example, assume that
damaged merchandise costing $1,000 can be sold for only $800, and direct selling ex-
penses are estimated to be $150. This inventory should be valued at $650 ($800 $150),
which is its net realizable value. For example, Digital Theater Systems Inc.provides