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Lower of Cost or Market Method Explained – Definition
In the United States, the GAAP rules (Generally Accepted Auditing Principles) describe the lower of cost/market method. The purpose of this method is to estimate the cost of sold products. This calculation is done on a common accounting pattern called the balance sheet. It is when the present market value of the stock of an organization is less as compared to the historical cost of the stock.
Now, what is the historical cost of the stock? It means the original buying cost of the stock. The present value of the stock may differ from the historical cost. When a thing has more ‘net realisable value’ than the selling price of the inventory, the company has to face losses. This method is helpful for the companies in order to keep a record of the loss in the form of a balance sheet because of this variation in value.
A Little More on Market Method Accounting
Currently, the Financial Accounting Standards Board (FASB) has made an update to the standards and code. It has a great influence on companies that use the First In First Out method and the average cost method of stock accounting.
These techniques should be applied using the net realisable value or the lower of cost method. Now, there is more consistency with the rules of the International Financial Reporting Standards (IFRS).
The concept can be explained from an example. Let’s say, a company name is XYZ. It buys several properties in the United States a hundred years before at the worth of fifty thousand USD.
Now, after a hundred years, the evaluator of real estate checks all properties. He gets the result that the estimated market value is fifty million USD. However, let’s suppose, the firm uses rules of historical accounting, then the cost of assets will still be recorded as fifty thousand USD in the balance sheet.
A majority of people may think that the record of the value of the properties particularly and the assets of the company generally is not correct in the balance sheets. This discrepancy forces some of the accountants to keep a record of the assets of the company on the basis of Mark-to-Market technique of accounting when they will prepare a report of their financial statements.
Now, to explain the Mark-to-Market technique, let’s continue with the same example. The company XYZ buys several properties at the price of fifty thousand US dollars and now, they are valued as fifty million US dollars. If it uses the Mark-to-Market accounting method, then on the balance sheet, the recorded properties cost will increase to fifty million US dollars. This is to reflect the value of the properties as accurate as possible in the current market.
However, the issue with this accounting technique arises, if the prices in the market fluctuate all of a sudden. This happened in 2007 to 2008 period during the course of “Subprime Mortgage Meltdown”.
This caused a big recession and depressed prices of the real estate for years. When this financial crisis was not there, banks and companies used accounting method of Mark-to-Market. It led to an increase in the metrics of performance for the organizations.
References for Lower of Cost Method
Academic Research on Lower of Cost or Market Method
- The impact of standard setting on relevance and reliability of accounting information: lower of cost or market accounting reforms in China, Yang, Z., Rohrbach, K., & Chen, S. (2005). Journal of International Financial Management & Accounting, 16(3), 194-228. In the era 1998-2000, China applied many new asset rules that makes the lower of cost or LCM for assets which are noncash. The paper studies the link of the value of net assets to the market value of capital and the link of accounting revenues with the inventory return on the basis of HCA (Historical Cost Accounting) and LCM. A model that controls the impacts of year and industry effects are named as Fixed Effects Model. It is used in the sample of a balanced panel. Its regressions indicate high explanatory power. The comparative evaluations of non-nested overlapping model famous as J and Cox measure the reliability. LCM reforms are related but the reliability doesn’t increase.
- Where does the Information in Mark-to-Market Come from, Bleck, A., & Gao, P. (2010). Chicago Booth Research Paper# 10, 6. This paper investigates the data in MtM (Mark-to-Market) and from where it comes.
- Measuring reporting conservatism, Givoly, D., Hayn, C. K., & Natarajan, A. (2007). The Accounting Review, 82(1), 65-106. This paper presents a review of accounting in the perspective of estimating the conservatism in reporting.
- Control of international joint ventures, Groot, T. L., & Merchant, K. A. (2000). Accounting, Organizations and Society, 25(6), 579-607. This research states that several IJVs (International Joint Ventures) got no success. Some authors are of the view that control issues are its main reason. However, little International Joint Ventures research stresses on control problems. The results of big explanatory research involve in 3 successful IJ Ventures. But, it noticed fairly large differences in using the disputes settling policies, control tightness and focus as well. In short, the study provides a base for the contingency theory of Control Systems of International Joint Ventures.
- On cost tradeoffs between conservative and market value accounting, Bachar, J., Melumad, N. D., & Weyns, G. (1997). Review of Accounting Studies, 2(1), 7-34. The authors of this paper compare alternative accounting authorities. They point out a cost trade-off related to this comparison, which includes losses of equilibrium deadweight because of making transactions and audits across the LCM (Lower of Cost/Market), historical cost, and regimes of the market value. The authors give conditions for all these regimes to overcome others. Accounting of the market value spreads in the inflationary system as well as optimal in deflation. Finally, the historical cost persists only if the changes in the price of the asset is high enough.
- The capital market implications of the frequency of interim financial reporting: an international analysis, Mensah, Y. M., & Werner, R. H. (2008). Review of Quantitative Finance and Accounting, 31(1), 71-104. This is an empirical analysis of how many times the meantime financial reporting influences the vitality of the inventory price in 4 countries (Canada and the US with quarterly reporting), Australia and the UK with interim reporting on a semiannual basis during the fiscal year with numerous regimes of the interim reporting. The interim reporting of the semiannual basis will have lesser volatility of the price after other effects accounting. Further tests indicate higher volatility of the industries as compared to the domestic industries on their home SEs (Stock Exchanges).
- Examining the differences between United States Generally Accepted Accounting Principles (US GAAP) and International Accounting Standards (IAS): implications for …, Ampofo, A. A., & Sellani, R. J. (2005, June). In Accounting forum(Vol. 29, No. 2, pp. 219-231). Elsevier. Modern trends show a continuous move to the accounting standards’ harmony. But it is not without any problem and concern. The pressure of the financial and political market push this move reversely. The frameworks of GAAP (Global Generally Accepted Principles), the United States GAAP and IAS (International Accounting Standards) have been discussed with many transactional examples. The implementation of accounting standards for the harmony comprise the arguments of GAAP as “for and against”.
- Lower of cost or market inventory valuation: IFRS versus US GAAP, Gray, D., & Ehoff Jr, C. (2014). Journal of Business & Economics Research. This paper takes under discussion the stock valuation of LCM (Lower of Cost/Market) in detail.
- Recoverable cost: the basis of a general theory of financial accounting measurement, Salvary, S. C. (1992). This research revolves around the measurement of financial accounting, which is stated in the rules of diverse valuation. Is it hodgepodge (miscellanies argument theory) or developed logically? The author highlights the recoverable cost being a measurement of financial accounting. He explains with strong evidence the recoverable cost is the focus of economic gravity. It can be derived from advanced axioms. He describes the difference in measurement theory and decision theory. So, we can conclude that the measurement of financial accounting is developed logically.
- SFAS No. 12 and the conceptual framework, Foran, N. J., & Foran, M. F. (1987). Accounting Horizons, 1(4), 43.This paper is about the Summary of Statement Number 12 and its underlying conceptual framework.
- Conservatism research: Historical development and future prospects, Basu, S. (2009). The conservatism of Chinese accounting has been under research made empirically in the last ten years. Bell, Wu (2000) and Robin initiated this research to use the latest research techniques for Chinese information. The author conducts a survey on its background. He gives suggestions for future research on Chinese conservatism. Lastly, he explains how his research is relevant to conservative accounting.