Financial Accounting: In an Economic Context

ENDING INVENTORY: APPLYING THE LOWER-OF-COST-OR-MARKET RULE

The inventory cost flow assumption determines the capitalized cost allocated to ending inventory. However, inventories on the balance sheet are not necessarily carried at this dollar amount. Based on conservatism, ending inventory is valued at cost or market value, whichever is lower.

Applying the lower-of-cost-or-market rule to ending inventory is accomplished by comparing the cost allocated to ending inventory with the market value of the inventory. If the market value exceeds the cost, no adjustment is made and the inventory remains at cost. If the market value is less than the cost, the inventories are written down to market value with an adjusting journal entry.

U.S. GAAP and IFRS use different market values when applying the lower-of-cost-or-market rule. Under U.S. GAAP, the market value is normally the replacement cost, the cost of replacing the inventory. Under IFRS, the market value is normally the realizable value, the amount at which the inventory could be sold.

Suppose, for example, that ABC Enterprises uses the FIFO assumption, which gives rise to an ending inventory of $100. If the market value of the inventory is $150, no adjusting journal entry need be recorded. The ending inventory remains at cost because cost ($100) is lower than market value ($150). If the market value of the inventories is $80, however, ...