Lower of Cost or Market is the approach to valuing inventory. Recent events, particularly in the energy industry are causing economic uncertainty. This economic uncertainty is affecting the entire supply chain in the energy industry. Many companies are experiencing increasing pricing pressures and they are finding the recorded cost of inventory may be higher than current market prices.
Ordinarily, cost is the basis of pricing the inventory because it achieves the objective of a proper matching of costs against revenues. However there are certain circumstances where costs are not a proper amount to be charged against the revenues of future periods— cost does not account for changes in utility over time. If there are indications that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, the difference shall be recognized as a loss in the current period. A departure from cost is required in these circumstances because cost is satisfactory only if the utility of the goods has not diminished since their acquisition; a loss of utility shall be reflected as a charge against the revenues of the period in which it occurs.
The rule of lower of cost or market is intended to provide a means of measuring the residual usefulness of an inventory expenditure. The term market is therefore to be interpreted as indicating utility on the inventory date and may be thought of in terms of the equivalent expenditure which would have to be made in the ordinary course at that date to procure corresponding utility, not necessarily what you can sell the product for in the market. As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. There are exceptions to such a standard.
Replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility. In applying the rule, judgment must always be used as no loss shall be recognized unless the evidence clearly indicates that a loss has been sustained.
It seems that one of the trickiest parts of Lower of Cost or Market is determining what the market value actually is. Remember, the market price is not the selling price but the cost to reproduce or replace the inventory. Most of the time the market price will not be an exact number but it must fall within a range. The “ceiling” of the market value is known as the Net Realizable Value (NRV) and the NRV is calculated as the selling price, minus the completion and disposal costs of the inventory. The “floor” is the NRV, minus normal profit on the item. In accordance with GAAP, the market value must be within the range of the ceiling and floor.
In reality the application of lower of cost or market can be very confusing but relief may be on the way. The Financial Accounting Standards Board (FASB) has proposed to simplify the lower of cost or market rule by changing it to the lower of cost or net realizable value rule which could eliminate the unnecessary complexity of the current rules.