In accounting for inventories, generally accepted accounting principles require departure from the historical cost principle when the utility of inventory has fallen below cost. Under the “lower-of-cost-or-market” rule, the term “market” means
A.Replacement cost of the inventory.
B.Original cost plus normal profit margin.
C.Original cost minus allowance for obsolescence.
D.Original cost minus cost to dispose.
The correct answer and explanation is:
The correct answer is A. Replacement cost of the inventory.
Under the “lower-of-cost-or-market” (LCM) rule, accounting principles require that inventories be reported at the lower of either their historical cost or their market value. Market value, in this context, refers to the replacement cost of the inventory. This means that if the market price of inventory has fallen below its original cost, the inventory must be written down to reflect its reduced value.
Explanation:
The rationale behind the LCM rule is to ensure that inventory is not overstated on the balance sheet. This rule acknowledges that inventory may lose value due to factors such as obsolescence, damage, or a decrease in market demand. If the market value (or replacement cost) of inventory drops below its historical cost, it is more prudent to recognize the loss in value and adjust the inventory’s reported value to reflect the current economic reality.
Replacement cost is the cost to replace the inventory at current market prices, considering the current conditions. If this replacement cost is lower than the original cost of the inventory, then the company needs to account for the loss by writing down the inventory. This write-down is typically recognized as a loss in the period when the decline in market value occurs.
It is important to note that market is not the selling price of the inventory, nor is it the cost to dispose of the inventory. Selling price and disposal costs are not directly involved in determining the market value for LCM purposes. Instead, market simply refers to what it would cost to replace the inventory in its current condition.
Thus, if the replacement cost of an inventory item is lower than the historical cost, an inventory write-down must occur, reflecting the principle of conservatism in accounting, which aims to prevent overstatement of assets.