Inventories: Additional Issues
REPORTING-LOWER OF COST OR MARKET
Normally ending inventory is stated at historical cost, but there are times when the original cost
of the ending inventory is greater than the cost of replacement. Under this circumstance, the
inventory has lost value. When preparing the financial statements, many companies go through a
process to determine if their inventory has lost value. If the inventory has maintained value equal
to historical cost, or increased in value, then the inventory is reported at historical cost. If the
inventory has decreased in value below historical cost then the inventory is reduced in value on
the balance sheet. The criterion for reporting inventory value is the lower of historical cost or
market value. Any loss resulting from the decline in the value of inventory is charged to cost of
goods sold in the accounting period that it is discovered.
Determining Market Value
To determine the market value of an inventory item we use three parameters. These parameters
include the replacement cost of the item, and two calculated items called the ceiling and the
floor.
 Current replacement cost represents the current cost of the inventory item and may be
obtained through manufacturers or suppliers.
 The ceiling (also called the upper limit) is the net realizable value of the inventory item. Net
realizable value is calculated as the selling price of the item less the estimated cost of
completion and disposal.
 The floor (also called the lower limit) is the ceiling (net realizable value) less an allowance
for normal profit margin.
The market value chosen is called the designated market value.
Example: Spencer Company purchased dog runs from a manufacturer for $550 and sells them
for $1,200. Therefore, the normal gross profit on the dog runs is $650 ($1,200-$550). The
selling costs (costs of disposal) are estimated to be $20 per unit. According to the manufacturer,
the replacement cost of the dog run at year-end is $500. Based upon this information, at what
amount will one unit be reported on the balance sheet using lower of cost or market?
Selling Price
Historical Cost
Gross profit
$
Selling Price
Less: Cost to Dispose
Ceiling
Less: Normal Profit
Floor
$
$
$
$
1,200
550
650
1,200
20
1,180
650
530
To determine the designated market value we must compare replacement cost to the ceiling and
the floor. The designated market value will be the middle value of the three parameters. In our
example, the parameters are as follows:
D:\687290766.doc 2/5/2016
1
Inventories: Additional Issues
Replacement Cost
Ceiling
Floor
Designated Market
500
1,180
530
530
In the above example the designated market will be the floor amount of $530 because it is the
middle of the three market value parameters.
Reporting Inventory – Historical Cost versus Designated Market Value
Most business organizations have a large number of inventory items with replacement prices
changing on a daily basis. At year end the company will count and price inventory at historical
cost. At this point the test for lower of cost or market is performed, normally on the entire
inventory. A designated market value is determined as described above and then compared to
historical cost. The final inventory is reported at the lower amount.
Example: Spencer Company carries six categories of inventory. The following is an analysis of
the lower of cost or market of the entire inventory.
Spencer Company
Analysis of Lower of Cost or Market
For the Year Ended September 30, 2000
Inventory Historical Replacement
Category
Cost
Cost
A
20,000
22,000
B
60,000
55,000
C
90,000
85,000
D
45,000
50,000
E
30,000
30,000
F
100,000
75,000
$ 345,000
Ceiling
32,000
96,000
80,000
75,000
60,000
70,000
Lower of
Designated Cost or
Market
Market
Floor
12,000
22,000
20,000
59,000
59,000
59,000
60,000
80,000
80,000
60,000
60,000
45,000
25,000
30,000
30,000
65,000
70,000
70,000
$ 304,000
For Inventory Category A:
 Designated market value is determined using the middle amount of the three parameters:
replacement cost, the ceiling, and the floor. The designated market value is the replacement
cost of $22,000.
 The designated market value is then compared to the historical cost of the inventory item and
the lower value is called the lower of cost or market. Designated market value is $22,000 and
historical cost is $20,000. Therefore, the lower of cost or market for Inventory Category A is
$20,000.
D:\687290766.doc 2/5/2016
2
Inventories: Additional Issues
This process is carried out for each inventory category. Finally, the total historical cost of the
inventory ($345,000) is compared to the total lower of cost or market value of the inventory
($304,000). The lower amount is reported on the balance sheet.
Adjusting the Inventory Balance in the General Ledger
Currently the ending inventory in the general ledger is $345,000. The company will need to
make a year-end adjusting journal entry to record the loss as a result of the inventory valuation.
If the loss has a material effect on the cost of goods sold it would be recorded as follows:
Date
Account
Debit
Credit
12/31/06 Loss on reduction of inventory to LCM
$41,000
Inventory
$41,000
To record the loss in writing inventory down to LCM at 12/31/06.
If the loss does not have a material effect on the cost of goods sold it would most likely be
recorded as follows:
Date
Account
Debit
Credit
12/31/06 Cost of goods sold
$41,000
Inventory
$41,000
To record a charge to cost of goods sold for the loss in writing inventory
down to LCM at 12/31/06.
D:\687290766.doc 2/5/2016
3