0:00
Today we are breaking down the lower of cost or market rule
0:07
Like many things in accounting, it sounds more complicated than it is. Welcome to accounting how-to
0:12
I'm your host Carolyn Grimm, and that's my sidekick Terrence. We're here to put the fun in accounting fundamentals
0:19
Now, lower of cost or market rule is part of our generally accepted accounting principles. Gap
0:25
It exists to help us deal with some interesting inventory situation. that can arise. And usually when we're talking about inventory, we say we record inventory at cost
0:36
or historical cost, which is what we actually paid for the thing, whatever it is. Now, in other
0:43
videos, we've talked about different methods of tracking the value of our inventory using
0:49
FIFO, first in, first out, or LIFO, last in, first out, or average cost, weighted average
0:56
cost, and we determine the order of costs assigned based on one of those three methods. So if we're
1:02
using FIFO, we're using the oldest costs first. If we're using LIFO, we're using the newest costs
1:10
first. And weighted average spreads it out over all of the items that we bought. But the net result
1:15
is that it's always the true cost, the historical cost of the item. The only differences are in the
1:23
order in which we apply the costs. Are we taking the oldest? costs first, are we using the latest costs first? Or are we averaging the costs over a certain
1:32
period of time But it always ends up being true cost of what we purchase that item for And that all well and good until something like this happens Let say we have a business selling iPhones on eBay We buy them at a wholesale price
1:50
That's our historical cost for inventory purposes. And we sell them at retail price to our customers
1:56
And let's say your wholesale price is $200. I'm making up a number here. And you sell them for $800
2:03
You have a closet full of the iPhone 4. It was a good phone
2:08
I liked this phone a lot. Well, time passes, and next thing you know, the iPhone 8 comes out
2:15
Suddenly, your closet full of iPhone 4s isn't worth as much. Yeah, I know
2:21
We're way beyond the iPhone 8, okay? I know. But here's the thing
2:26
I'm an accountant, and we are notoriously frugal. so I always buy an older version. But you could see where this could happen, particularly in a tech product or in the hottest toy of last year category, right
2:43
Everybody had to have one last year and this year you can't give them away. So you can see the same thing happening in a yard sale
2:50
That exercise bike you bought for $300 or $1,800 last January is worth $20 when you sell it at a yard sale
3:00
you can even get that. So your inventory cost, what you paid for that iPhone or that exercise bike
3:09
is far less than what you paid for it Enter the lower of cost or market rule The lower cost or market rule says hey is your inventory less than what you paid for it We got your back It says you can record your inventory value either at cost
3:30
what you paid for it, or at current value, the market value of that item, what is worth today
3:38
And then you're going to take whichever one of those is lower and use that as your inventory
3:43
valuation. So in our iPhone example, let's say the market value is $100 and you paid $200. The lower of cost or market
3:54
value is $100. So what you could do at that point in time with your closet full of iPhone 4s is you can do a
4:03
write-down of your inventory. And you can do that in a couple of different ways. So you can set up and
4:09
use an account called something like loss on lower of cost or market, loss on LCM. That would be a
4:18
contra inventory account. And I'll link to my contra account video in the description if you need
4:24
to know more about contra accounts. So we would debit this new contra account, loss on LCM, lower of cost
4:31
or market, and we would credit our inventory. So we're moving this value out of our inventory account
4:37
and into this contra account to keep track of the write down that we did of our inventory
4:43
The second way that you could do this is you could use the cost of goods sold account
4:48
to reduce your inventory and increase your expense. So it has the same impact on your financial statements You reducing your inventory and you increasing an expense But using that cost of goods sold account can skew your cost of goods account by
5:05
increasing it for something that's odd and hopefully uncommon. It's an out of the ordinary expense
5:11
that increases your regular cost of goods. So that will make the rest of your cost of goods for all
5:18
those other items that you didn't take a write down on. So the advantage of using that loss
5:23
on LCM account is that it calls it out as being something that's out of the ordinary
5:29
We're looking at our inventory and we're looking at an inventory write down right below that
5:34
on our balance sheet. Now, you'd only want to do a write down on inventory in a very rare
5:39
unusual circumstances. Obviously, it's much better to sell the inventory at a profit. But the
5:45
goal is always to be transparent and accurate about the value of a company's assets. And so we have
5:52
lower of cost or market to help in a situation like this
5:57
Now, one final caveat for using lower of cost or market, it can only be used by companies that track their inventory value
6:04
using FIFO or average cost, not LIFO, which is also known. One final caveat, lower of cost or market can only be used by companies
6:17
that track their inventory value using FIFO or average cost, not LIFO
6:22
which is also known as the retail method. For LIFO users, we have a different method
6:27
called the lower of cost or net realizable value. There's a video for that too
6:32
and I will link it down in the description. Until next time, stay balanced, my friends
