How do you value inventory using the LCM rule?

1 What is the LCM rule?

The LCM rule is a principle of accounting that states that inventory should be valued at the lower of its cost or its market value. Cost refers to the amount that the business paid to acquire or produce the inventory. Market value refers to the amount that the business can sell the inventory for in the current market conditions. The LCM rule ensures that inventory is not overstated on the balance sheet and that the business recognizes any losses due to inventory impairment.

2 How does the LCM rule work?

To apply the LCM rule, the business needs to compare the cost and the market value of each inventory item or group of items. The market value can be determined by using different methods, such as replacement cost, net realizable value, or net realizable value less a normal profit margin. The business then records the lower of the two values as the inventory value on the balance sheet. If the market value is lower than the cost, the business also records an inventory write-down as an expense on the income statement. This reduces the net income and the equity of the business.

3 Why is the LCM rule useful?

The LCM rule is useful for inventory management because it reflects the economic reality of inventory. It prevents the business from overstating its assets and income by recognizing any losses due to inventory impairment. It also provides a more accurate picture of the profitability and liquidity of the business. By using the LCM rule, the business can make better decisions about inventory purchases, sales, and pricing. It can also avoid paying taxes on inventory that has lost value.

4 What are the advantages and disadvantages of the LCM rule?

The LCM rule has some advantages and disadvantages for inventory management. Advantages include consistency with the conservatism principle of accounting, simplicity and ease of application, and widespread acceptance. However, this rule can also result in inconsistent inventory values over time, create a mismatch between inventory and cost of goods sold, and distort business performance and ratios. As market values can fluctuate due to supply and demand, competition, or other factors, inventory is valued at the lower of cost or market while cost of goods sold is based on the actual cost. This can reduce net income and equity, and affect measures such as gross margin, return on assets, and inventory turnover.

5 How do you apply the LCM rule in practice?

To apply the LCM rule in practice, you need to identify the inventory items or groups of items that you want to value, and determine their cost and market value. Different methods can be used to calculate the cost, such as FIFO, LIFO, or weighted average. You can also use different methods to determine the market value, such as replacement cost, net realizable value, or net realizable value less a normal profit margin. The lower of the two values should then be selected as the inventory value and recorded on the balance sheet. If the market value is lower than the cost, an inventory write-down should be recorded as an expense on the income statement, reducing both net income and equity of the business.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?