Multiple Choice
When applying the lower-of-cost-or-market (LCM) rule to inventory with more than two types, which of the following methods is most commonly used under U.S. GAAP?
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5. Inventory
Lower of Cost or Market
Multiple Choice
Companies must ensure that they are reporting their inventory at the lower of cost or market. What does this principle require?
A
Inventory should be reported at the lower value between its historical cost and current market value.
B
Inventory should always be reported at its historical cost, regardless of market changes.
C
Inventory should be reported at its replacement cost only.
D
Inventory should be reported at the higher value between its historical cost and current market value.
Verified step by step guidance1
Understand the principle of 'Lower of Cost or Market' (LCM): This accounting principle requires companies to report inventory at the lower value between its historical cost (the original purchase price) and its current market value (the cost to replace or sell the inventory). This ensures that inventory is not overstated on the financial statements.
Identify the historical cost: Determine the original purchase price of the inventory, which includes the cost of purchase, shipping, and any other costs necessary to bring the inventory to its current condition and location.
Determine the current market value: Assess the current market value of the inventory, which is typically the replacement cost. However, market value is subject to certain constraints, such as being no higher than the net realizable value (selling price minus costs to complete and sell) and no lower than the net realizable value minus a normal profit margin.
Compare the historical cost and the market value: Once both values are determined, compare them to identify which is lower.
Report the inventory value: Use the lower of the two values (historical cost or market value) to report the inventory on the balance sheet. This ensures compliance with the LCM principle and prevents overstatement of assets.
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