Inventory Valued At Lower Of Cost

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Inventory Valued At Lower of Cost or Market [L.C.M. Rule]

[Price Declines]

Inventory should be also be shown below cost when there is a decline in the selling price of goods which are neither damaged nor have become obsolete. In simple words, even the normal inventory items will have to be reported below cost if they can be replaced new at a price that is less than the original cost. In such cases, the business enterprises use the lower of the cost or market basis (LCM) or more precisely lower of actual or replacement cost rule of accounting rather than cost basis. The cost of an inventory item is compared with the market price and lower of the two (cost of market price) is used for financial statements. Market price means the current replacement cost of the goods, which is cost to replace the inventory item by purchase (of new inventory item) or reproduction. Although it is true that the replacement cost seldom falls below cost in an inflationary period (that is, period of rising prices) yet there could be certain exceptions. The reason for using replacement cost to represent market price is that a decline in the replacement cost may be the best available measure of their net realizable value. For Example, Balaji Enterprises Ltd. sell color televisions costing Rs. 15,000 per unit at Rs. 20,000. At the balance sheet date, it is found that the current replacement cost of the same type of televisions has fallen or declined by 20% i.e., to Rs. 12,000 [Rs. 15,000 – 20% of Rs. 15,000] It means that under LCM rule the company must recognize a decline of utility of Rs. 3,000 (Rs. 15,000 – Rs. 12,000) in the current accounting period. If the company has 50 televisions in stock in hand at the end of the year, the following entry must be made:
            ____________________________________________________Rs.______    Rs
Loss on Revaluation Or Write down of Inventories Account ____Dr.     1,50,000
    To Inventory (or Stock in hand) Account                 __________________________1,50,000

As a result of LCM rule the loss on revaluation is reported in the income statement of the current year rather than the next year. The item may be reported in the balance sheet as:

    Current Assets
Inventories at lower of cost (Rs. 7,50,000) or market        600,000

As soon as the stock-in-hand is written down to replacement cost, this basis becomes the cost basis for future accounting periods. An increase in the market price of the inventory after it has been written down to replacement cost is not recognized in the books of accounts.

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