Lower of Cost or Market

FASB’s generally accepted accounting principles require that inventory be recognized at the lower of cost or market.

Market: The term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meets both of the following conditions: (a) market shall not exceed the net realizable value; and (b) market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin.¹

Net Realizable Value: Net realizable value is equal to the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal.¹

Thus the rule ‘lower cost of market’ requires a departure from the cost basis of accounting for inventory when the utility of the good is no longer as great as its cost.² For example, imagine a television retailer who purchases a number of high-end televisions for $1000, each which are expected to sell for $1500.  While many of the televisions sell quickly, a handful is still in inventory when a new model comes out. When this happens, the wholesale price falls from $1000 to $750, and the retail price falls from the expected $1500 to $1000.

In this scenario, the market price (or replacement value) is $750 and the net realizable value is $1000. In this case, the balance of inventory should be reduced to the market value ($750), which more truly represents the replacement cost of the inventory. As well, by reducing the value of inventory when the price drop occurs, this accounting method ensures that the drop in prices is recorded as an expense in the same period as it the drop in price occurs.


Reference:

1. FASB ASC 330-10-20
2. FASB ARB No. 43