Accounting For Dummies®, 4th Edition

7.4. Recording Inventory Losses under the Lower of Cost or Market (LCM) Rule

Acquiring and holding an inventory of products involves certain unavoidable economic risks:

• Deterioration, damage, and theft risk: Some products are perishable or otherwise deteriorate over time, which may be accelerated under certain conditions that are not under the control of the business (such as the air conditioning going on the blink). Most products are subject to damage when they're handled, stored, and moved (for example when the forklift operator misses the slots in the pallet and punctures the container). Products may be stolen (by employees and outsiders).

• Replacement cost risk: After you purchase or manufacture a product, its replacement cost may drop permanently below the amount you paid (which usually also affects the amount you can charge customers for the products).

• Sales demand risk: Demand for a product may drop off permanently, forcing you to sell the products below cost just to get rid of them.

Regardless of which method a business uses to record cost of goods sold and inventory cost, it should apply the lower of cost or market (LCM) test to inventory. A business should regularly inspect its inventory very carefully to determine loss due to theft, damage, and deterioration. And the business should go through the LCM routine at least once a year, usually near or at year-end. The process consists of comparing the cost of every product in inventory — meaning the cost that's recorded for ...