Lower of Cost or Market Rule

Apr 02, 2015

The other day, I was speaking with a CFO who was describing his current year issues with the commodity that is a major part of the products he manufactures. He was specifically referring to the issues he has with the value for inventory. This commodity is subject to volatile price swings, some of which are material in relationship to the overall financial results of the company. As a result, the outside accountants are making adjustments every year to adjust this commodity inventory to market prices. This recently resulted in a large write-down in the inventory value from the original cost because commodity prices had declined so significantly at December 31st.

His question to me related to the specific rules associated with lower of cost or market adjustments and when those adjustments can be avoided, specifically related to commodity inventories. There are several cases where commodity price swings do not have to be reflected in the financial statements of the company.

Inventory105In one case, if there are several different types of commodities that are being used to manufacture a given product, and one of those commodities has a significant price reduction and the other commodity does not, then it is likely that the overall price of the final product has not been materially affected. Therefore, the commodity with the price change that is held in inventory (as long as it is in correct proportion with the other commodities relative to its portion of the finished goods) does not need to be booked in the current year.

The rule of lower cost or market can be applied to each item in inventory or to the total inventory, whichever method most clearly reflects income. This can be something that is quite beneficial when there are large swings in different directions that offset each other.

There are also changes in product pricing that even in a single commodity product are not required to be booked. If there is sufficient latitude on selling price adjustments to project the margins in the company, then adjustments in raw material prices that are easily offset by selling price adjustments also do not need to be booked at year end.

Yet another example where an adjustment would not be needed is related to price adjustments in commodity prices that dip at December 31st, but then quickly recover in the early stages of the new year, before the financial statements are finalized. Substantial evidence exists that market prices will recover before the inventory is sold.

It is important to understand all the different scenarios possible and look at your specific situation to determine if any adjustment is needed.

Categories: Cost Accounting