To determine the value of inventory, the lower-of-cost-or-market method is utilised. This method entails pricing the inventory at the lower of its acquisition cost or current market value. By doing so, the inventory is not overvalued and its true worth is accurately reflected.
The lower-of-cost-or-market method is a pricing or costing technique for inventory. It determines the value of inventory based on either the cost of acquisition or the market cost, whichever is lower. For instance, suppose a company has 100 units of a product in inventory, purchased at $10 each, resulting in a total cost of $1,000. However, the market value of the product has dropped to $8 per unit. By applying the lower-of-cost-or-market method, the company would value their inventory at $800 (100 units x $8 per unit) instead of the original cost of $1,000. Another example involves a company with 50 units of a product in inventory, purchased at $20 each, resulting in a total cost of $1,000. Due to decreased demand, the market value of the product is now $15 per unit. Using the lower-of-cost-or-market method, the company would value their inventory at $750 (50 units x $15 per unit) instead of the original cost of $1,000. This method ensures that inventory is not overvalued on a company’s balance sheet. It takes into account any decreases in market value that may occur after the inventory has been purchased, making it a conservative approach.
The Lower-Of-Cost-Or-Market Method is an accounting principle used to value inventory at the lower of its historical cost or its current market value.
This method is used when the market value of inventory falls below its historical cost, and it is necessary to adjust the value of the inventory on the balance sheet.
The market value is typically determined by comparing the current selling price of the inventory with its replacement cost or net realizable value.
This method allows for more conservative valuation of inventory, which can help prevent overstatement of assets and provide a more accurate representation of a company’s financial position.
One limitation is that it can be subjective and may require judgment in determining the market value of inventory.
The use of this method is not specifically required by law, but it is a generally accepted accounting principle and is often used to comply with financial reporting standards.
Yes, this method can be used for all types of inventory, including raw materials, work-in-progress, and finished goods.
The method should be applied at the end of each reporting period to ensure that the inventory is valued accurately.
Failure to use this method could result in overvaluing inventory and misstating a company’s financial position, which could lead to legal and financial consequences.
While there are no specific regulations, companies are expected to follow generally accepted accounting principles and financial reporting standards when using this method.
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This glossary post was last updated: 17th April 2024.
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