What is the lower of cost or market rule?
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In the interest accurate accounting, businesses must sometimes report publicly that certain assets gained or lost value during a reporting period. In this context, the Lower of Cost or
Market Rule (LCM) is a GAAP-prescribed method for valuing inventory and, under certain conditions, securities holdings. The rule prescribes how owners can recognize publicly and officially that specific assets have a new book value. The Lower of Cost or Market Rule is a GAAP-approved method for revising the reported book value of certain assets, after asset values
change. Under the LCM rule, owners report the new book value of inventories or securities as the lesser of either (a) historical cost or (b) market value. Business taxpayers in all countries that follow GAAP apply the LCM rule essentially as this article shows. the
following sections illustrate. Government publications on LCM are generally very brief, with examples similar to the those in this article. Click the links below to open governmnet resources in a new tab. Sections below explain and illustrate the LCM rule in context with related concepts, focusing on three themes The lower of cost or market rule serves several purposes consistent with international accounting standards. These appear almost universally in Generally Accepted Accounting Principles (GAAP) for most countries. Inventories and some securities holdings contribute
to Balance sheet values for current assets. Current assets figures, in turn, play a central role in several important metrics for evaluating company performance and
financial position. Asset values, therefore, impact "metrics" such as working capital, current ratio, and return on assets. A fundamental principle in GAAP is that owners should report asset values that are realistic. Asset values, therefore, should reflect actual cost, replacement cost, or current market value. Owners who state unrealistic values risk presenting a misleading picture of company financial performance and
financial position. The matching concept is an accounting principle, whereby owners recognize revenues in the same accounting period they report the expenses that brought them. The lower of cost or market rule can help apply the
matching principle in several ways. Using the LCM rule, for instance, owners can be sure they report expenses for, say, loss of inventory value, in the same period they report revenues from sales of that inventory. GAAP in most countries incorporates the conservatism principle. This principle applies when there are acceptable alternative methods for reporting the value of an item. The rule directs owners to choose
the process that results in lower net income or lower asset value. The universal use of an objective LCM rule for choosing between alternative valuing methods means the following. Those who read financial reports can expect to see always the more conservative values for inventories and securities. Almost all assets enter the accounting system with a value equal to acquisition cost. GAAP prescribes many different methods for adjusting asset values in subsequent reporting periods. Which approach is preferred—or required—for any given asset? The answer can vary substantially, depending on several factors including the following. Examples in this article illustrate a few accounting principles in view with the LCM rule. Note especially, however, the article does not cover all situations. Keeping this in mind, we can now introduce
several costing and valuing terms that are involved in applying the LCM rule. Book value is the asset's Balance sheet value after making all adjustment's. These include adjustments for depreciation, amortization, "mark to market" accounting, and the Lower of cost or market rule. These three terms are more or less interchangeable when referring to initial asset value. Here, "cost" is what owners, in fact, pay for acquiring the asset. This cost includes purchase price, of course, but also any other acquisition costs such as brokerage fees or shipping costs. This definition for "cost" also means there are no adjustments due to inflation, no matter how long asset ownership life. Initial cost in this sense appears
in the "cost vs. market" choice under the LCM rule. This value is the cost of replacing an asset. Note that this cost to be either less or more than the asset's current selling price in the market. Consider for instance a merchant, selling goods in the retail market, while obtaining goods inventory from a wholesaler. In such cases, replacement cost is probably less than "market price." On the other hand, if a company must purchase inventory at
market prices, that plus additional acquisition costs put replacement cost above the market price. Market selling price is the price buyers currently pay in the market for inventory or securities. Those familiar with securities markets know that securities prices over time can fluctuate above or below historical. And, the same is true for the price of most kinds of inventory. When this stock consists of commodities such as oil, for instance, the
price will probably fluctuate widely over time, above and below purchase price. The current market selling price of the asset, minus any costs for selling, disposing of, or otherwise getting rid of the asset. This value is the "market value" figure to compare with "cost" when applying the LCM rule. For purposes of using LCM, market value equates to replacement cost (as explained above), except that the market value must fall
between two limits Net realizable value (NRV) is the upper limit for the market value. If, say, replacement cost is higher than net realizable value, then LCM market value will be taken instead as the NRV. The lower limit for market value is the net realizable value minus ordinary profit. When replacement cost is less
than NRV minus "ordinary profit," "LCM market value" is taken instead as the market floor, that is NRV minus ordinary profit In the LCM market vs. cost comparison, the cost figure remains constant, no matter how long the ownership life of the inventory or securities. Market value, of course, can change with each reporting period. With the definitions established above, the LCM rule operates as follows. The "market" value for the comparison can, in
fact, turn out to be any one of three values. Table 1 below shows these rules in algebraic form. And, Table 2 below illustrates the LCM rule with a numerical example. How do you set "market" value for inventory, to apply the Lower of cost or market rule? And, how do accountants recognize changes in inventory value under the LCM rule? The following sections address these questions with examples. Under the LCM rule, inventory value is determined and reported each reporting period. The specific prescribed
accounting methods for doing so vary slightly from country to country and accountants applying the rule should be familiar with local policies and practices. For reporting inventory values in the United States, accountants should be familiar with US Government IRS Publication 946,"How to Depreciate Property." They should also
periodically review the Financial Accounting Standards Board (FASB) and APB Accounting Research Bulletin(ARBs), statements and updates. Chapter 4 of ARB 43, amendment FASB FAS 151, and subsequent amendments are especially relevant for the LCM rule. As an example, consider a business with a single inventory account to value at the end of each period. Table 2, below, shows how inventory data stand at the end for four successive fiscal year quarters. Table2. At the end of each reporting period (fiscal year quarters), an accountant chooses between "Market" or "Cost" as the appropriate value to report for inventory. Data in Table 2 enable owners to apply the LCM rule and report inventory value as either Cost or Market. Note that inventory levels can fluctuate from quarter to quarter. Also, the factors sitting in Rows2 through 8 of Table 2 can change from quarter to quarter. As each quarter ends, however, accountants find inventory value to report under the LCM rule as follows. At
the end of Q1, the company reports a replacement cost ($107,000, Row 1) as the Market value for LCM comparison (Row 8). At the end of Q1, the company reports a replacement cost ($107,000, Row 1) as the Market value for LCM comparison (Row 8). This value applies because Replacement cost is between the Market ceiling ($117,900, Row 6) and the Market floor ($105,700, Row 7). That is: Therefore, report Cost. At the end of Q2, the Market value for LCM Comparison (Row 8) turns out to be the Market ceiling, or NRV ($88,000, Row 6). This value is appropriate because Replacement cost ($107,000) is greater than the Market ceiling. That
is: Therefore, report Market. At the end of Q2, the Market value for LCM Comparison (Row 8) turns out to be the Market ceiling, or NRV ($88,000, Row
6). This value applies because Replacement cost ($107,000) is greater than the Market ceiling. That is: Therefore, report Market. At the end of Q4, the
replacement cost ($75,000, Row 1) is used as the Market value for LCM Comparison (Row 8), because Replacement cost is between the Market Ceiling ($78,200, Row 6) and the Market Floor($70,200) That is: Therefore,
report Cost. Inventory levels can change from reporting period to reporting period, due to product sales, inventory replenishment, spoilage, obsolescence, and other factors. With a double-entry accounting system (as used by the vast majority of businesses), bookkeepers and accountants recognize a change in inventory level from such factors with at least one pair of account transactions. Note especially, these may involve accounts for inventory, cash on hand, sales revenues,
accounts receivable, cost of goods sold expenses, or spoilage expense. For purposes of clarity and simplicity, however, examples in this section omit transactions due to changes in inventory level. Instead, this section focuses only on inventory values changing from "Cost" to "Market" or the reverse. Consider again the four end-of-period inventory reports above, in Table 2. Table 3 below repeats the same period-end Cost and Market figures. Also,
however, this table shows the balance to report for three accounts:
End of Q1: Inventory acquired, valued at costFrom acquisition through the end of Q1, inventory value was "cost." This value applies because "cost" was always lower than the "market."
End of Q2. Inventory re-values to marketDuring Q2, Market value (from the previous section) fell below cost. The cost value, moreover, is $7,000 greater than Market value. In applying the LCM rule to report a value below cost, accountants apply two adjusting transactions to recognize the loss of value.
End of Q3. Inventory re-values again to marketAt the end of Q3, both inventory market value and cost were below their previous quarter levels. The inventory value to report will again be market because this value is still below "cost." However, the difference between "market" and cost is smaller than it was at the end of Q2.
End of Q4. Inventory re-values to costAt the end of Q4, the inventory cost is again below market, which means that the owner once more reports the cost value. This report requires that both adjustment accounts return to 0 balance.
Examples in this and the previous section show valuation and reporting for a single inventory account. Note that the reporting accountant usually has the freedom to choose between
The latter is generally the most conservative of these approaches. That is, the latter approach is least likely to overstate income or asset values. LCM changes impact the Income statement and Balance sheetThe Balance sheetimpacts occur when the contra asset allowance account has a non-zero balance. The allowance account balance reduces the book value of inventory by the balance amount. Income statement impacts occur when the loss expense account carries a non zero balance. This expense (account balance), like other Income statement expenses, is subtracted from net sales revenues to lower reported profits. Investment Securities vs. Marketable SecuritiesSecurities that companies hold as assets include both debt instruments (corporate bonds, government bonds, and treasuries, for example) and equity instruments (such as corporate stock shares). The term "securities" also covers derivative instruments such as options, futures, and swaps.. Precisely how firms value and report securities can depend on several factors. These include the purpose of acquiring them and the length of time they will hold them. Note that the valuing and reporting of securities is an area of controversy. And, this area has ample room for judgment and choice by accountants. For the accounting practice in the United States, see, for example, US Financial Reporting Standard 25 (FRS 25) "Accounting for Investments," from the Council on Corporate Disclosure and Governance (CCDG). Accountants in the US should also be familiar with 'Financial Accounting Standards Board publication FAS 115" Accounting for Certain Investments in Debt and Equity Securities" and its subsequent amendments. This publication has been the moving force behind a strong trend in the US towards valuing marketable securities at Market ("mark to market" rule) instead of "lower of cost or market." In the US, in fact, the LCM RULE is rarely used now for securities. Summary of Securities Valuing MethodsWith these cautions in mind, the following summary presents a sample of valuing methods that may apply in different situations.
Which Securities Are Eligible for LCM Treatment?Table 4 below shows the LCM rule in context with other securities valuing approaches. As a result, this article describes assessing methods for a wide range of securities holdings.
Investment Securities vs. Marketable SecuritiesFor accounting purposes, the majority of debt and equity securities assets are classified either as investments in securities or marketable securities. Securities assets are considered marketable securities if two conditions apply:
If either condition does not apply, regulators assume that the securities serve for long-term objectives and the firm must report them as long-term assets. Equity securities held for the long-term which do not meet both of the above criteria are called "Investment in Securities assets," not "marketable securities." Investments in Securities: Minority Passive InvestmentsWhen Company A owns less than 50% of the voting stock in Company B, and when Company A does not attempt or intend to try to use its minority ownership to influence or control actions or decisions company B, A may be said to have a minority passive investment interest in B. In fact, However, the only time the "minority-passive" designation usually applies is when one company owns 20% or less of another company's stock: there is a presumption that 20% ownership or greater implies an "active" interest. The minority
passive owner initially records the investment at acquisition cost. In many countries other than the United States, minority passive securities holdings are valued and reported under the lower of cost or marketing rule. For the US, however, the "rule" may or may not be applicable, depending on local policies and practices. In some US locales, the following values will be reported at Market value, regardless of whether Market is above or below cost. In any case, for reports on minority passive
investment securities in subsequent periods the following apply:
Investments in Securities: Minority Active InvestmentsThe classification "minority active investments" usually applies to companies owning between 20% and 50% of the voting stock in another company, which do attempt to use this ownership to influence or control that company. In such cases, Company A is said to have a minority active investment interest in B. Even though Company A does not have majority ownership of B, Company A can
still attempt to exert influence by acting in concert with other minority owners to form a majority voting block (for example, enlisting other shareholders in a proxy fight). Or, minority owners may exert influence by merely threatening to acquire enough additional stock to give them majority ownership (i.e., threaten takeover). When Company A takes an Active investments interest in influencing or controlling Company B, even though it has minority ownership, A must use the equity method of accounting for valuing and reporting is securities assets (Company B stock shares). As with the passive investment situation, active owners first record minority ownership stock at cost. Equity Securities Held as Minority Active InvestmentsFirms that report "minority active investment" equity securities holdings, usually initially value them at Cost. At the end of following reporting periods, however, owners apply the equity valuation method to adjust amounts if necessary.
Investments in Securities: Majority Active InvestmentsWhen company A owns more than 50% of Company B, A is in a position to exercise absolute control over B. In such cases, A is said to be the parent company, and B is its subsidiary. In such cases. Because one economic entity can control several legal bodies and there is a risk that commercial transactions between the legal entities might manipulate income. To ensure that such operations are transparent, U.S. GAAP requires the following: Financial statements of the legally separate entities must be combined and reported as parts of a Consolidated Financial Statementfor the governing economic body. Consequently, Company A and Company B can be separate legal entities, but for Financial Accounting purposes (at least in the US), they must report together through one consolidated financial statements. What Are the Major Classes of Marketable Securities? How Are Trading Securities Valued?Securities holdings qualify as marketable securities if they meet two criteria.
When the owner first acquires marketable securities, the Balance sheet values of these securities are equal to acquisition cost. (Most asset categories, in fact, use acquisition cost for initial value). Acquisition cost for securities includes purchase price, of course, but also other purchase-related costs, such as brokerage commissions. For late reporting periods, however, the owner reports a value for marketable securities that may be subject to the lower of cost or market rule. Or, they may instead be subject to the "mark to market" rule, depending on local policies and practice. Marketable securities belong to several classes:
Marketable Securities: Valuing Trading SecuritiesTrading securities may be either equity securities or debt securities. Presumably, investors hold these securities for short-term gains. As a result, owners use trading security portfolios for active buying and selling, hoping to earn profits. Because investors typically hold them for the short-term, trading securities appear on the Balance sheet as Current assets. The vast majority of trading securities belong to financial institutions. Owners first record trading securities in a Balance sheet assets account, valued at cost. For example, consider a $100,000 equity securities cash purchase. If the owner intends to hold these securities as trading securities, the purchase transactions are as follows. Note that the acquisition occurs in the middle of a reporting period, Q4
FY2012.
Trading Securities After Market Value ChangesIf, for example, market value increases by $5,000 by the end of the quarterly period, and if the accounting policy is "mark to market," accountants recognize the change in value with two account entries. At the end of, Q4:
If instead the market value of these securities decreases, the adjusting transactions include a "credit transaction" (reduction) to Marketable securities and a debit (decrease) to Unrealized holding gain. Trading Securities Impact On the Income StatementNet gains and losses for trading securities impact "Income statement earnings" for the period the firm reports them, even if the firm does not realize the gains or losses in that period. Regulators presume that the firm will "realize" them in the short-term. If the owner sells these securities during Q1 for $120,000, that brings a net gain of $20,000 over their original cost of $100,000. Of this gain, however, $5,000 have already been closed to income as unrealized gains (above). A $120,000 debit (increase) to a cash account, recognizing receipt of funds from the sale.
The company realizes a gain of $15,000, which appears as income on the Income statement. What is the lower of cost or margin rule?What is the Lower of Cost or Margin? The lower of cost or market rule states that a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price. This situation typically arises when inventory has deteriorated, or has become obsolete, or market prices have declined.
What is the lower of cost or market rule for inventory?Lower of Cost or Market Rule for Inventory. Lower of cost or market is a term used to refer to the method by which inventory is valued and shown in the balance sheet of a business. Under the historical cost accounting concept, all balance sheet assets should be shown at cost, however, the lower of cost or market basis is an exception to this rule.
What is lower of cost or market rule (LCM)?What is the Lower of Cost or Market Rule? Lower of cost or market (LCM) is the conservative way through which the inventories are reported in the books of accounts which states that the inventory at the end of the reporting period is to be recorded at the original cost or the current market price of the inventory, whichever is lower.
What is meant by lower of cost or market price policy?The lower of cost or market price policy follows this closely. The stock can be in the form of raw material inventory Raw Material Inventory Raw materials inventory is the cost of products in the inventory of the company which has not been used for finished products and work in progress inventory.
What is lower of cost or market rule discuss with examples?Rationale Behind Lower of Cost or Market (LCM)
For example, if a company purchased inventory at the cost of $100,000 but the market value of the inventory is $20,000, users of financial statements would want the lower value to be reflected in the books.
What does market mean in the lower of cost or market?Lower of cost or market is a method of valuing assets where the asset is valued at either the historical cost or the fair market value, whichever is lower. When the value of the inventory has declined below its cost, a firm may choose the lower of cost or market method.
Why is the lower of cost or market rule used in valuing inventory?If the value of the stock decreases below the historical price of the product causing loss to the company, then the market or lower of cost method can be applied to record the damage. The lower of cost or market method assumes that if the items purchasing price falls, its selling price will also go down.
Is lower of cost or market required by GAAP?The Lower of Cost or Market Rule is a GAAP-approved method for revising the reported book value of certain assets, after asset values change. Under the LCM rule, owners report the new book value of inventories or securities as the lesser of either (a) historical cost or (b) market value.
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