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What is lower of expense or sector (LCM)?

Lower of expense or sector (LCM) is an inventory valuation technique required for service providers that monitor U.S. GAAPGAAPGAAP, typically Accepted audit Principles, is a recognized collection of rules and procedures that govern corporate accounting and financial. In the reduced of cost or market inventory valuation method, as the name implies, perform is valued in ~ the lower of original expense or industry value.

You are watching: Lower-of-cost and net realizable value as it applies to inventory is best described as the

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Summary

Lower of expense or sector (LCM) is an list valuation technique required for carriers that monitor U.S. GAAP.Cost describes the purchase price of inventory, and also market value refers to the replacement price of inventory.The replacement price cannot exceed the network realizable worth or be reduced than the net realizable value much less a normal profit margin.


Rationale Behind reduced of expense or industry (LCM)

When perform is purchase by a company, it sits on the balance sheetBalance SheetThe balance sheet is just one of the three basic financial statements. The gaue won statements are vital to both jae won modeling and also accounting. In ~ cost. However, end time, the worth of the inventory may depreciate or appreciate. To increase the dependability of jae won statements, the an altering value the inventory, to an extent, have to be accounting for.

For example, if a firm purchased inventory at the price of $100,000 but the sector value the the inventory is $20,000, customers of jae won statements would desire the reduced value to be reflected in the books. If the inventory value were not reassessed come the suitable value, it would certainly overstate the company’s assets and also mislead users. However, as will certainly be debated below, the reduced of price or industry inventory valuation an approach is not as an easy as simply comparing cost and market.

Valuing perform at reduced of cost or market (LCM)

In the lower of expense or sector inventory valuation method, the company’s list purchased at expense is compared against the industry value of the inventory. The industry value of inventory is basically the replacement expense of that inventory or the quantity of money it would take to replace the perform in the open up market. However, there space some caveats for understanding replacement value:

The replacement expense cannot be lower than net realizable value much less a normal profit margin.

Net realizable worth is the sale price the the perform minus any costs occurs to prepare the inventory for sale. A common profit margin is the mean spread in between the cost and also sale price the the inventory. Together caveats because that replacement expense establish a floor and also ceiling because that replacement cost. It is portrayed as follows:

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Here are the steps to valuing inventory in ~ the lower of expense or market:

1. First, determine the historic purchase cost of inventory.

2. Second, recognize the replacement cost of inventory. It is the exact same as the industry value that inventory.

3. To compare replacement expense to network realizable value and also net realizable worth minus a normal profit margin.If:

Replacement expense > net realizable value, use net realizable worth for replacement cost.Replacement expense Net realizable value minus a normal profit margin

4. Compare the expense of inventory to replacement cost.Lastly, if:

Historical price of inventory cost of list > replacement cost, write-down list to replacement cost.

To totally understand the concepts, a comprehensive example is all set below.

Examples of reduced of price or industry (LCM)

Example 1

ABC company sells wallets. Cost information regarding the list of ABC agency is gift below:

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The purchase cost: $250The instead of cost: $150The network realizable value: $160 ($200 – $40)The net realizable value minus a normal profit margin: $140 ($160 – $20).

In this example, replacement cost falls between net realizable value and net realizable value minus a common profit margin. Therefore, the replacement expense used is $150. Comparing the amount to the purchase price of $250, a $100 write-down is necessary.

Example 2

ABC agency sells wallets. Price information regarding the perform of ABC firm is gift below:

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The purchase cost: $250The replacement cost: $120The network realizable value: $160 ($200 – $40)The net realizable value minus a common profit margin: $140 ($160 – $20)

In this example, replacement price falls listed below the net realizable value minus a common profit margin. Therefore, the replacement expense used is $140. Comparing the amount to the purchase price of $250, a $110 write-down is necessary.

Example 3

ABC firm sells wallets. Price information concerning the list of ABC company is gift below:

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The purchase cost: $250The instead of cost: $240The network realizable value: $160 ($200 – $40)The net realizable worth minus a regular profit margin: $140 ($160 – $20)

In this example, replacement price is above net realizable value. Therefore, the replacement expense used is $160. Compare the amount come the purchase cost of $250, a $90 write-down is necessary.

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Recording lower of expense or Market

If the market expense is reduced than the cost, a write-down is necessary. The journal entry would certainly be as follows:

Loss native the decrease in list value Dr. XX
InventoryCr. XX

The loss from the decline in inventory value would be reflected in the revenue statementIncome StatementThe income Statement is just one of a company"s main point financial explanation that shows their profit and loss end a period of time.The benefit or and reduce network income. Inventory would certainly be reflect in the balance sheet and reduce the worth of inventory.

The newspaper entry because that the 3 examples above would be:

Example 1
Loss from the decline in list value Dr. 100
InventoryCr. 100

Example 2
Loss native the decrease in perform value Dr. 110
InventoryCr. 110

Example 3
Loss from the decline in inventory value Dr. 90
InventoryCr. 90

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