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Inventories - Lower of Cost or Market Considerations

Accounting for the cost of inventory is one of the most complex financial and management accounting challenges that manufacturers face. That said, accounting policies, which are required to be disclosed in financial statements, often sound similar. In most cases, an organization will indicate that inventories are valued at the “lower of cost or market,” and under ordinary circumstances, market values exceed cost. Therefore, goods are normally valued at cost, which can include materials, outside processing, labor and overhead.

Unfortunately, current market conditions are anything but ordinary. The demand for many finished goods has deteriorated, and there have been significant levels of volatility in raw material prices. When circumstances of this nature exist along and cause the market value of goods to be below cost, inventories must be written down to their market values. The purpose of reducing inventory to market value is to accurately reflect the income of the period. The rule of lower of cost or market is intended to provide a means of measuring the residual usefulness of inventory expenditures.

For most organizations, a lower of cost or market adjustment is a rather unusual event. For this reason, management teams might wish to provide an explanation for such an adjustment in their financial statement footnotes. This type of disclosure brings additional transparency to the financial statements and could be useful to readers, but is generally not required by accounting principles generally accepted in the United States (GAAPUSA).

The determination of “market value” might not always be certain. Adverse or unusual market conditions usually cause lower of cost or market adjustments. Under ordinary circumstances, a market value is determined based on recent sales prices paid by customers. If current sales data is unavailable, other methods must be used to estimate market value. GAAPUSA tells us that market value is defined as current replacement cost (by purchase or reproduction) provided that such current replacement cost meets both of the following conditions:

• Market shall not exceed net realizable value
• Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin

The most common practice is to apply the lower of cost or market rule separately to each inventory item. However, if there is only one end-product category, the cost utility of the total stock (i.e., the inventory in its entirety) might have the greatest significance for accounting purposes. Accordingly, the reduction of individual items to market might not always lead to the most useful result if the utility of the total inventory to the business is not below its cost. The most common example is when a manufacturer supplies a customer with a “family” of parts. The cost of some parts might exceed market, but the family of parts as a whole could have a positive margin. The lower of cost or market rules would generally be applied to the family of parts rather than to the individual parts as long as the customer continues purchasing all parts as a group. This practice is rather common within automotive supply chains.

When writing down inventories as a result of lower of cost or market conditions, it’s important to remember that, unlike setting reserves of obsolete inventories, a lower of cost or market adjustment might result in a deduction for income tax purposes if certain conditions are met. Please contact us for more information on this type of deduction for income tax purposes.

For more information, please contact Kevin Loudon, Senior Manager at 312-980-3358 or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.