Writing Down Inventories
Recall that the balance sheet shows assets, including inventories, at their historical (acquisition) cost in conjunction with the historical cost principle. Inventories may deteriorate physically or become obsolete, causing their value to fall. What happens when the value of inventories falls below their historical cost?
Lower of cost-or-market (LCM) rule dictates that if the market value (or replacement cost) of inventories falls below their historical cost, they must be written down to this lower market value, and the loss must be recognized immediately:
Inventory Write-Down = Historical Cost (Book Value) – Market Value
The LCM rule is an example of the conservatism principle.
Unlike inventory losses, inventory gains can only be recognized when that inventory is sold.
Recalling our lemonade stand example, suppose that lemons sitting in inventories rot and are determined to be unsellable; a $5 write-down has to take place. Here is how it affects the financial statements:
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