Legal Definitions - lower-of-cost-or-market method

The lower-of-cost-or-market method is an accounting principle used by businesses to value their inventory. It dictates that inventory must be recorded on a company's financial statements at the lesser of two amounts: either the original price the company paid to acquire the inventory (its "cost") or its current market value (what it would cost to replace it or what it could be sold for today). This method is crucial for ensuring that a company's assets are not overstated and that potential losses from declining inventory values are recognized promptly.

Here are some examples to illustrate this concept:

• Example 1: Electronics Retailer

  Imagine a consumer electronics store that purchased 50 units of a specific gaming console for $400 each. A few months later, a newer, more advanced model of the console is released, causing the market demand and value for the older model to drop significantly. Now, the store could replace those same older consoles for $280 each, or sell them for $300.

  Using the lower-of-cost-or-market method, the store would value each remaining console at $280 (its current replacement cost), not the original $400. This adjustment reflects the loss in value due to technological obsolescence and prevents the company from showing an inflated asset value on its balance sheet.

• Example 2: Fashion Apparel Boutique

  Consider a fashion boutique that bought a collection of designer winter scarves for $75 each in October. By February, with spring approaching, the demand for winter accessories has plummeted. The boutique now estimates it could only sell the remaining scarves for $50 each, and it would cost them $45 to acquire similar scarves from a wholesaler today.

  Applying the lower-of-cost-or-market method, the boutique would value the inventory of winter scarves at $45 (the lower of its replacement cost or net realizable value), rather than the original cost of $75. This accurately represents the reduced value of seasonal inventory once its peak selling period has passed.

• Example 3: Chemical Distributor

  A chemical distribution company purchased a large volume of a particular industrial solvent for $10 per gallon. Shortly after, a new, more efficient manufacturing process for that solvent was discovered, leading to a significant drop in its market price. The current market price for the same solvent is now $7 per gallon.

  According to the lower-of-cost-or-market method, the distributor must value its inventory of the solvent at $7 per gallon, not the original $10. This adjustment acknowledges the decline in the commodity's market price and ensures the company's financial statements reflect the true, lower value of its assets, recognizing the potential loss immediately.