## 4. Lower of cost or market rule definition and example

So far we have been looking at methods used to determine inventory costs (more specifically, the cost of goods sold and the ending inventory). Once the cost of ending inventory is calculated, it is required to be compared with the current market value. Comparing the cost to market is the procedure for the lower of cost or market rule.

The market value is the amount that would have been paid to replace the merchandise.

Lower of cost or market rule states that if the market value of ending inventory is lower than the book value of such inventory, the resultant loss must be recognized in the current period.

The lower of cost or market rule can be applied to:

a) Each individual inventory item
b) Major classes or categories of inventory
c) Entire cost of all inventory items

For example, look at the table below:

Illustration 13: Examples of the lower of cost or market rule

 Item Cost Market Value Lower of Costor Market A \$500 \$520 \$500 B \$650 \$590 \$590 C \$50 \$50 \$50 D \$12 \$13 \$12 Total \$1,212 \$1,173 \$1,152

For individual item A, the cost is lower than the market value, so the lower of cost or market is the cost of \$500. For B the market value is lower, so the lower of cost or market is the market value of \$590. For item C both the cost and market value are the same, so there is no difference. For item D the cost is lower, so the lower of cost or market is the cost of \$12.

As for the aggregate, the total cost of the four items is \$1,212, and their total market value is \$1,173. So, when applying the lower of cost or market rule to all inventory items in aggregate, the market value of \$1,173 needs to be used to adjust the ending inventory balance.

If the market value of an item (or items in aggregate) is lower than its cost, the company has to reduce (write down) the ending inventory balance. For example, in our illustration the difference between the cost in aggregate and the total market value is \$39 (i.e., \$1,212 - \$1,173). If the perpetual inventory system is used, the entry to record this reduction acts to decrease assets (Inventory) and equity (by increasing Cost of Goods Sold or Inventory Loss):

Illustration 14: Effect of inventory costs write-down in the horizontal model

 Assets = Liab. + Equity Rev. - Exp. = Net Inc. Cash Flows (39) = n/a + (39) n/a - (39) = (39) n/a

Illustration 15: Journal entry to write-down inventory costs under perpetual system

 Account Titles Debit Credit Dr Cost of Goods Sold (Inventory Loss) 39 Cr Inventory 39

The loss should be shown as an operating expense on the income statement. However, if the amount is immaterial, the loss can be included in the cost of goods sold.

Under periodic inventory system, the amount of ending inventory is automatically shown at the lower of cost or market. The cost of goods sold is computed as the difference between the cost of goods available for sale and the ending inventory. Thus, any decrease in the ending inventory balance due to the application of the lower of cost or market rule increases the cost of goods sold. Assume the following situation:

Illustration 16: Example of the lower of cost or market rule under periodic system

 Before Applying Rule After Applying Rrule Beginning Inventory 1,000 1,000 Plus: Purchases 2,300 2,300 Cost of Goods Available for Sale 3,300 3,300 Less: Ending Inventory (500) (450) Cost of Goods Sold 2,800 2,850

Before application of the lower of cost or market rule, the ending inventory was \$500. However, after performing a recalculation of the ending inventory by applying the lower of cost or market rule, the ending inventory was determined to be \$450. The difference of \$50 is included into the cost of goods sold for the period and no additional adjustment is necessary.

Related accounting material
Not a member?