Difficulty: Intermediate | Prerequisites: Basic inventory accounting, cost flow assumptions (FIFO, LIFO, weighted average)
This chapter sits at the intersection of inventory measurement and the conservatism principle. You already know how to assign costs to inventory using FIFO, LIFO, or weighted average. Now the question is: what happens when the inventory you hold is worth less than what you paid for it? GAAP requires you to write it down, but the rules differ depending on which cost flow method your company uses. If you are comfortable with basic inventory accounting and the income statement effects of COGS, you are ready for this material.
When inventory loses value, GAAP says you cannot keep it on the books at the original cost. Most companies compare cost to net realisable value (NRV) and take the lower figure. Companies using LIFO or the retail method get a different rule: they compare cost to a "designated market value" that is bounded by a ceiling (NRV) and a floor (NRV minus normal profit margin). Either way, the write-down hits the income statement, either through COGS or as a separate loss.
Net realisable value (NRV)
Estimated selling price in the ordinary course of business, minus reasonably predictable costs of completion, disposal, and transportation. Think of it as: what you would actually pocket if you sold the inventory, after subtracting the costs still needed to get it out the door.
Lower-of-cost-or-net-realisable-value (LCNRV)
The general rule under ASC 330: inventory is reported at cost unless NRV is lower, in which case you write inventory down to NRV. In simple terms, you always pick whichever number is smaller, cost or NRV, for the balance sheet.
Lower-of-cost-or-market (LCM)
The alternative valuation rule available only to companies using LIFO or the retail inventory method. Instead of comparing cost directly to NRV, you compare cost to a "designated market value" that is constrained by a ceiling and a floor. Think of it as: a more complex version of LCNRV with guardrails built in.
Designated market value
Under LCM, this is the replacement cost of the inventory, but it cannot exceed the ceiling or fall below the floor. In simple terms, it is the middle value in a three-way comparison.
Ceiling (NRV)
The upper limit on designated market value. Market value cannot be set higher than NRV. Think of it as: the most optimistic amount the inventory could fetch, net of selling costs.
Floor (NRV minus normal profit margin)
The lower limit on designated market value. Market value cannot be set below NRV minus the company's normal profit margin on that item. In simple terms, this prevents the write-down from being so large that it creates an artificially inflated profit when the goods are eventually sold.
Replacement cost
The current cost to purchase or reproduce the inventory item. Under LCM, this is the starting point for determining designated market value, before the ceiling and floor are applied.
Loss method
Recording an inventory write-down by debiting a separate "Loss Due to Decline in Inventory" account and crediting the inventory (or an allowance account). Used when the write-down is substantial and unusual.
COGS method
Recording an inventory write-down by debiting Cost of Goods Sold directly. Used when write-downs are a routine, recurring event for the company.
Allowance to Reduce Inventory to Market
A contra-asset account used under LCM to reduce the reported inventory balance without changing the underlying inventory account. Think of it as: a bucket that holds the cumulative write-down amount separately from the inventory ledger.
Under ASC 330, most companies value inventory at the lower of cost or net realisable value.
NRV = estimated selling price minus costs of completion, disposal, and transportation.
The comparison can be done by individual items, by category, or in total. The individual-item method is the most common and the most conservative.
When NRV drops below cost, you write the inventory down. This write-down is not reversible under US GAAP (unlike IFRS, which permits reversals up to original cost).
When an LCNRV adjustment is needed, two recording methods exist:
COGS method: Debit Cost of Goods Sold and credit Inventory. Use this when write-downs are routine and expected for the business.
Dr. Cost of Goods Sold $20,000
Cr. Inventory $20,000
Loss method: Debit a separate loss account ("Loss Due to Decline in Inventory") and credit Inventory. Use this when the write-down is substantial and unusual.
Dr. Loss Due to Decline in Inventory $20,000
Cr. Inventory $20,000
The choice between methods affects presentation on the income statement. The COGS method buries the write-down inside cost of goods sold. The loss method shows it as a separate line item, giving readers more transparency.
Ending inventory at cost: $415,000. Ending inventory at NRV (by individual items): $395,000. The adjustment is $20,000. The inventory account is credited by $20,000 to bring it down from $415,000 to $395,000.
The FASB grants an exception to the LCNRV approach for companies that use LIFO or the retail inventory method. These companies use the lower-of-cost-or-market (LCM) rule instead.
Under LCM, "market" is a designated market value determined through a three-step process:
Start with the replacement cost of the item.
Compare it to the ceiling (NRV). If replacement cost is above the ceiling, market = ceiling.
Compare it to the floor (NRV minus normal profit margin). If replacement cost is below the floor, market = floor.
If replacement cost falls between the ceiling and floor, market = replacement cost.
Once you have designated market value, compare it to cost. The lower of the two is the reported inventory value.
Given per unit: cost $270, replacement cost $225, selling price $292, costs to sell $52, normal profit margin $31.
Ceiling (NRV) = $292 minus $52 = $240
Floor = $240 minus $31 = $209
Replacement cost = $225. This sits between the ceiling ($240) and the floor ($209), so designated market = $225.
Compare cost ($270) to market ($225). Market is lower, so the item is valued at $225.
Answer: (a) $225.
Under LCM, write-downs are often recorded using a contra-asset allowance account rather than crediting Inventory directly:
Dr. Loss Due to Decline of Inventory to Market $65,000
Cr. Allowance to Reduce Inventory to Market $65,000
The allowance account sits on the balance sheet as a deduction from the inventory balance, leaving the original cost in the inventory account intact.
\text{NRV} = \text{Estimated Selling Price} - \text{Costs of Completion} - \text{Costs of Disposal}\text{Ceiling} = \text{NRV}\text{Floor} = \text{NRV} - \text{Normal Profit Margin}\text{LCNRV Adjustment} = \text{Inventory at Cost} - \text{Inventory at NRV}\text{Designated Market (LCM)} = \text{middle value of } \{\text{Ceiling, Replacement Cost, Floor}\}For the designated market value under LCM: if replacement cost is above the ceiling, use the ceiling. If replacement cost is below the floor, use the floor. Otherwise, use replacement cost as is.
Students often think LCNRV and LCM are interchangeable. They are not. LCNRV is the default rule for most companies. LCM is only available to companies using LIFO or the retail inventory method.
Students frequently confuse which number is the ceiling and which is the floor. The ceiling is NRV (the higher boundary). The floor is NRV minus normal profit margin (the lower boundary). Replacement cost is then squeezed between these two.
A common error is forgetting that under LCM, you first determine designated market value (the middle of the ceiling, floor, and replacement cost), and then compare that to cost. Some students skip the middle step and compare replacement cost directly to cost.
Students sometimes assume inventory write-downs can be reversed in future periods under US GAAP. They cannot. Once written down, the new lower value becomes the new cost basis. (IFRS does allow reversals up to original cost, so watch for questions that specify the reporting framework.)
The conservatism principle (prudence concept) is the driving rationale behind both LCNRV and LCM. Expect conceptual questions asking you to explain why inventory is written down but not up.
LCM ceiling/floor calculations are a very common exam question format. You will be given a handful of figures (cost, replacement cost, selling price, costs to sell, normal profit margin) and asked to determine the correct inventory valuation. Practise until you can run through the three-step process quickly.
Know when to use which method. If the question says LIFO or retail method, you are in LCM territory. Everything else is LCNRV.
Journal entry questions may ask you to choose between the loss method and the COGS method. Read the question stem carefully for cues like "substantial and unusual" (loss method) or "common for that company" (COGS method).
The allowance method (contra-asset approach) is specific to LCM and tends to show up on exams. Be ready to journalise using the "Allowance to Reduce Inventory to Market" account.
True or False: Under US GAAP, all companies must use LCNRV to value inventory.
Answer: False. Companies using LIFO or the retail inventory method may use LCM instead.
Fill in the blank: The ceiling under LCM is equal to ________.
Answer: Net realisable value (NRV).
True or False: Once inventory has been written down under US GAAP, the write-down can be reversed if prices recover.
Answer: False. The new lower value becomes the new cost basis.
Fill in the blank: Under LCM, the floor equals NRV minus ________.
Answer: Normal profit margin.
True or False: The loss method debits Cost of Goods Sold when recording an inventory write-down.
Answer: False. The loss method debits a separate loss account. The COGS method debits Cost of Goods Sold.
Q: A company using FIFO has inventory with a cost of $50,000 and an NRV of $47,000. What value should appear on the balance sheet, and what journal entry is recorded if write-downs are routine?
A: Balance sheet value is $47,000. Journal entry: Dr. Cost of Goods Sold $3,000, Cr. Inventory $3,000 (COGS method, because write-downs are routine).
Q: Under LCM, given cost $100, replacement cost $85, NRV $95, and NRV minus normal profit margin $80, what is the designated market value and the reported inventory value?
A: Ceiling = $95, floor = $80. Replacement cost of $85 falls between the ceiling and floor, so designated market = $85. Compare to cost ($100): market is lower. Reported value = $85.
Q: Same facts as above, but replacement cost is $98. What changes?
A: Replacement cost ($98) exceeds the ceiling ($95), so designated market = ceiling = $95. Compare to cost ($100): market is lower. Reported value = $95.
Q: Same facts, but replacement cost is $75. What changes?
A: Replacement cost ($75) falls below the floor ($80), so designated market = floor = $80. Compare to cost ($100): market is lower. Reported value = $80.
Q: Why does the FASB allow LCM as an alternative to LCNRV for LIFO users?
A: LIFO inventory layers can carry very old, very low costs. Comparing those costs directly to NRV could produce misleading results. LCM, with its ceiling and floor constraints, gives a more meaningful comparison for companies whose inventory costs do not reflect current prices.
This material connects directly to inventory cost flow assumptions (FIFO, LIFO, weighted average) covered earlier in the course. The choice of cost flow method determines whether you use LCNRV or LCM, so you need both sets of rules in your toolkit. It also ties into the conservatism principle and the conceptual framework, which appear in financial accounting theory questions. If your course covers IFRS differences, note that IFRS uses NRV only (no LCM equivalent) and permits reversals of write-downs.
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