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Lower of cost or market (LCM) is an accounting term to describe a situation where inventory is valued at either the replacement cost or the original cost, depending on which is lower. This allows businesses to account for losses caused by a drop in the value of inventory so they can record their financial situations more accurately. It is also an example of conservative accounting, an approach where people err on the side of undervaluing rather than overvaluing to avoid overstating a company's value.
There are numerous reasons inventory can decline in value. A common situation can be seen on car lots, where the dealer buys a group of cars at a set price, and then the manufacturer rolls out the next year's line. The older cars have lost value sitting on the lot because people want to the new cars. If businesses value the inventory at the original cost, they will be inflating their total business value on a statement; that car from the previous year is no longer worth that much, and the dealer will take a loss on the sale. Recording the lower of cost or market allows the business to account for the loss immediately, rather than at the time of sale.
In lower of cost or market accounting, the business first determines the original cost of the asset, using accounting records to provide information. Then, it finds the replacement cost for the asset, which is the amount the business would pay if it went out on the open market to buy another one. Accountants compare the two numbers to determine the lowest number, and record the asset's value as the lower of cost or market.
Accountants need to follow generally accepted accounting procedures when they perform activities like inventory valuation. In situations where people have several ways of completing an accounting task, they must select a method and be consistent. If a business chooses to use lower of cost or market in its accounting, it needs to do this with all inventory. This eliminates confusion created with accounting data based on different numbers.
Businesses typically work hard to avoid situations where their inventory loses value before it sells. If inventory sits around, not only does the value decline, but the business also needs to pay money associated with maintenance, including rent, climate control, cleaning, and so forth. The goal is to create very rapid turnover for items in inventory so the business is never sitting on items for too long. Businesses may also establish return agreements, allowing them to return unsold products to a manufacturer or distributor. They will still take a loss because they had to store and display the inventory, but returning for a refund may be better than trying to sell the produce at a loss.