9.2 Lower of Cost or Market (LCM) and Lower of Cost or Net Realizable Value (LCNRV)

Lower of Cost or Market (LCM) and Lower of Cost or Net Realizable Value (LCNRV)

Subsequent to initial measurement at cost, US GAAP requires inventory to be written down if its utility or value has declined below its original cost. A decline in value can occur due to physical deterioration, obsolescence, changes in price levels, or damage. The subsequent measurement rules depend on the cost flow assumption used: Lower of Cost or Net Realizable Value (LCNRV) or Lower of Cost or Market (LCM).

1. Lower of Cost or Net Realizable Value (LCNRV)

Under ASC 330, the LCNRV rule applies to all inventories not measured using LIFO or the retail inventory method. This includes inventory valued under FIFO, Weighted Average, Moving Average, or Specific Identification.

• Net Realizable Value (NRV): This is the net amount that a company expects to realize from the sale of inventory. The formula is:

  NRV = Estimated Selling Price - Estimated Costs of Completion - Estimated Costs to Sell/Dispose

  Estimated costs to sell include sales commissions, shipping costs, and direct marketing expenses.

• Application: For each item, category, or the total inventory, the original cost is compared to the NRV. If the cost is lower, no write-down is recorded. If the NRV is lower, the inventory must be written down to its NRV, and a loss is recognized on the income statement.

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2. Lower of Cost or Market (LCM)

The LCM rule is used exclusively for inventory valued under the LIFO or the Retail Inventory Method under US GAAP. This rule limits the volatility of write-downs by restricting the "market value" within a defined range.

• Defining "Market": In LCM, "Market" refers to the current cost to replace the inventory (through purchase or reproduction). However, replacement cost is subject to a ceiling and a floor:

  1. Ceiling (Maximum Market Value): Equal to the Net Realizable Value (NRV). The ceiling prevents the overstatement of obsolete or damaged inventory and prevents deferring a loss to future periods.

  2. Floor (Minimum Market Value): Equal to NRV minus a normal profit margin:

     Floor = NRV - Normal Profit Margin

• The Designated Market Value: To find the designated market value, compare the three values: Replacement Cost, Ceiling, and Floor. The Designated Market Value is the middle (median) value of these three.

• Comparison: Once the designated market value is determined, compare it to the original cost. The inventory is valued at the lower of the original cost or the designated market value.

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3. Step-by-Step LCM Calculation Example

Let's walk through an LCM determination for three inventory products of Gamma Inc.:

• Step 1: Calculate the Ceiling (NRV)
  • Product A: $65.00 - $8.00 = $57.00
  • Product B: $95.00 - $10.00 = $85.00
  • Product C: $140.00 - $15.00 = $125.00
• Step 2: Calculate the Floor (NRV - Normal Profit)
  • Product A: $57.00 - $10.00 = $47.00
  • Product B: $85.00 - $15.00 = $70.00
  • Product C: $125.00 - $20.00 = $105.00
• Step 3: Determine the Designated Market Value (Middle of Replacement Cost, Ceiling, and Floor)
  • Product A: Middle of RC ($45), Ceiling ($57), Floor ($47) is $47.00 (Floor).
  • Product B: Middle of RC ($82), Ceiling ($85), Floor ($70) is $82.00 (Replacement Cost).
  • Product C: Middle of RC ($90), Ceiling ($125), Floor ($105) is $105.00 (Floor).
• Step 4: Compare Original Cost to Designated Market Value (Choose the lower)
  • Product A: Cost ($50) vs. Market ($47) -> Valued at $47.00 (Write-down of $3)
  • Product B: Cost ($75) vs. Market ($82) -> Valued at $75.00 (No write-down)
  • Product C: Cost ($120) vs. Market ($105) -> Valued at $105.00 (Write-down of $15)

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4. Accounting Entries for Write-Downs

When an inventory write-down is required, companies use one of two methods:

• Direct Method (Cost of Goods Sold Method): The loss is buried directly in Cost of Goods Sold.

Dr. Cost of Goods Sold                  $18,000
   Cr. Inventory                              $18,000

Evaluation: Simple and practical, but distorts the true COGS and gross profit margin, hiding the loss from inventory decline.

• Allowance Method (Loss Method): The write-down is recorded in a separate loss account and a contra-asset account.

Dr. Loss on Inventory Write-Down        $18,000
   Cr. Allowance to Reduce Inventory to Market/NRV   $18,000

Evaluation: Provides better transparency on the income statement and preserves the historical cost on the face of the balance sheet.

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5. Key US GAAP vs. IFRS Differences

GAAP and IFRS differ significantly on subsequent inventory measurements:

• LIFO Prohibition: IFRS prohibits LIFO. Consequently, the LCM rule does not exist under IFRS. All inventory under IFRS is measured using LCNRV.
• Reversal of Write-Downs: Under US GAAP, once inventory is written down, the new cost basis cannot be recovered. Reversals of write-downs are strictly prohibited. Under IFRS, if the value subsequently recovers, the write-down must be reversed (limited to the original cost) and credited to the income statement.