The 'Lower of Cost Or Market' (LCM) Rule

The 'lower of cost or market' (LCM) rule

The valuation of inventories at cost or market value, whichever is lower, is a rule which has long and widely been observed in financial accounting. The rule was originally justified in terms of the convention of conservatism, which as applied to the valuation of inventories meant that there should be no anticipation of profit and that all foreseeable losses should be provided for in the value reported to shareholders. Thus, if the cost value of an inventory item was £1.20 and the market value was £1.00, the end of year inventory valuation should be based on the lower value, and the difference written off against income.

The relation of the LCM rule to the other rules governing cost allocation and income determination in accounting may be questioned. If, for example, periodic income is to be measured by a rigorous process of matching revenues with their related product costs, it would seem inappropriate to charge against current revenues the cost of products which have not yet been sold, thereby relieving the revenues of a future period of a portion of their proper burden. Hence, the rule violates the matching convention, resulting in a distortion of current and future income measurements, thereby affecting their reliability as indicators of business performance. For this reason, some have argued that the rule is 'starkly illogical' and have suggested that it should be abandoned save in the case of obsolete or damaged inventories (van Pelt III, 2015). Others however, have reconciled the rule with the matching convention on the grounds that only 'useful' costs should be carried forward to the next accounting period (May, 2015). Costs which are not useful are those which exceed the market value of the inventory in question. The measure of the loss represented by the difference between cost and market value of such inventories may validly be treated as a cost of conducting business during the currency of the accounting period. According to this interpretation of the LCM rule, the lower of these two values represents the residual useful stock.

Interested in Current Value Accounting

Read on: FIFO LIFO Weighted Average

FIFO LIFO Weighted Average

The weighted average cost of the 300 units available for sale may be calculated as follows:

Total cost of annual inventory = 050= £1. 167 per unit

Total annual units of inventory 300

Hence, the cost of goods sold during the year is £233, whilst the value of the closing inventory is £117. The weighted average cost method is a compromise, therefore, between the extreme points established by FIFO and LIFO respectively.

The effects of different methods of inventory valuation on the calculation of income... see: FIFO LIFO Weighted Average