Lower of Cost or Market by Item, Category, or Total

Q: How does IFRS handle item and category grouping?

IFRS ( IAS 2, Inventories ) generally measures inventory at the lower of cost and net realizable value. LIFO is not permitted. Write-downs are usually made item by item. Grouping similar or related items is sometimes appropriate, but writing down an entire classification, such as all finished goods, is not.

Lower of cost or market (LCM) by item means comparing each inventory line’s cost with its designated market value, keeping the smaller amount, and adding the results. The category approach compares totals within each group. The total approach compares grand totals once. The item approach gives the lowest inventory value because no surplus offsets another line’s decline.

In the example below, one set of goods costs $12,000. It produces a write-down of $1,550 by item, $900 by category, or $700 in total. The difference comes entirely from which amounts the accountant compares together.

Video walkthrough of item comparisons

Start at 5:35 for the item comparisons. At 8:16 Professor Farhat turns to grouping, followed by the write-down entry. Watch the segment on YouTube.

Should you apply LCM by item, by category, or to total inventory?

Under U.S. generally accepted accounting principles (GAAP), the lower of cost or market rule applies only to inventory measured using last-in, first-out (LIFO) or the retail inventory method. Inventory measured using first-in, first-out (FIFO) or average cost follows the lower of cost and net realizable value (LCNRV) rule instead, a change FASB made in ASU 2015-11. The good news: the item, category, and total-inventory choices on this page work the same way under both rules. Our example assumes the company uses LIFO.

Designated market is current replacement cost, kept between two limits. The ceiling is net realizable value (NRV), meaning the expected selling price minus the costs to complete and sell the goods. The floor is NRV minus a normal profit margin. For the calculation behind that amount, see how to find designated market using the ceiling and floor.

Testing individual items is common. The appropriate level depends on how the goods are used and which grouping best reflects periodic income. Balanced quantities of components used in the same finished product may support a broader comparison. A surplus of one component or unrelated goods with materially different turnover calls for separate attention. Apply the selected approach consistently. See FASB ASC 330-10-35-8 through 35-11. For the 2015 change that limited LCM to LIFO and the retail method, see FASB ASU 2015-11, Simplifying the Measurement of Inventory.

LCM ceiling and floor practice quiz

The ceiling for designated market is net realizable value (NRV). The floor is NRV less a normal profit margin. Try five questions on these limits before using designated market in the item, category, and total inventory comparisons below.

One inventory schedule for all three comparisons

Suppose a bicycle-light manufacturer holds components for its front-light and rear-light ranges. The controller has already calculated designated market and multiplied unit prices by the quantities on hand. Every number below is the total for that inventory line. The three calculations illustrate the effect of grouping. Whether a total-inventory comparison is appropriate in practice requires evidence about how the parts are used.

Hypothetical year-end component balances
Component	Cost	Designated market	Lower by item
Front housing	$4,000	$2,800	$2,800
Front lens	$2,000	$2,300	$2,000
Rear housing	$3,500	$3,150	$3,150
Rear lens	$2,500	$3,050	$2,500
Total	$12,000	$11,300	$10,450

How do the item, category, and total methods compare?

Carrying amount means the value reported on the balance sheet after any write-down. Here is how to apply LCM by item in four steps:

Find designated market for each line: replacement cost, kept between the NRV ceiling and the NRV-minus-normal-profit floor.
Compare cost with designated market for that line.
Keep the smaller of the two amounts for each line.
Add the line amounts. The difference between total cost and that sum is the write-down.

For the category or total approach, add cost and market for the group first, then compare the two totals.

Calculating lower of cost or market by item

Read across each row before moving down the table. The front housing loses $1,200 and the rear housing loses $350. Each lens stays at its cost. Add the two losses to obtain $1,550. Subtracting that from the $12,000 beginning point gives the same $10,450 as the last column.

Major categories

For front-light parts, compare cost of $6,000 with market of $5,100. The front lens absorbs $300 of the front housing’s decline, leaving a $900 loss. For rear-light parts, cost totals $6,000 and market totals $6,200. Carry that category at $6,000. It contributes zero loss. The two category balances add to $11,100.

Total inventory

Compare the $12,000 cost of all four lines with their $11,300 combined market. The result is an ending carrying amount of $11,300 and a $700 loss. The rear category’s $200 market surplus now offsets part of the $900 decline in the front category. No separate gain appears in earnings.

Reconcile the ending balance to the loss
Comparison level	Ending inventory	Write-down
Each item	$10,450	$1,550
Each major category	$11,100	$900
Inventory as a whole	$11,300	$700

How does an LCM write-down affect income?

Assume the company’s established policy is to test individual items. Using the loss method, debit Loss Due to Decline of Inventory to Market for $1,550 and credit Inventory for $1,550. Some companies credit a contra account called Allowance to Reduce Inventory to Market instead of crediting Inventory directly. Under the cost-of-goods-sold method, the debit goes to Cost of Goods Sold instead of a separate loss account. See recording inventory write-downs with both methods for side-by-side entries. Ending assets and current pretax income each decrease by $1,550. The category and total amounts above are alternative measurements of the same goods. Recording all three entries would count the decline more than once.

The timing matters when reading next year’s results. Suppose the front housings written down to $2,800 are used in goods that sell next year. Their $2,800 carrying amount flows into the cost of those goods. If actual selling prices recover, next year’s gross margin can look unusually strong. The $1,200 loss on those housings already affected this year’s earnings. Under U.S. GAAP, that write-down becomes the housings’ new cost basis. If prices recover next year, the company does not write the inventory back up or record a gain. If the same inventory’s market value recovers in a later interim period of the same fiscal year, recognize the recovery up to the amount of the loss previously recorded.

Estimates also affect the comparison. A supplier quote measures current replacement cost, while expected sales prices, completion costs, and a normal margin help determine the limits. A controller can compare actual clearance prices with earlier estimates and check whether slow-moving parts still have the same demand as recent models. Slower turnover is a good reason to investigate, but it doesn’t measure the write-down on its own.

Common mistakes on exam questions

Comparing cost with raw replacement cost without first applying the ceiling and floor.
Choosing comparison levels solely to minimize the write-down without considering inventory characteristics or applying a consistent policy.
Letting a market surplus offset a decline under the item approach. By item, a line with market above cost simply stays at cost.
Recording a gain when market is above cost. LCM never writes inventory up above cost.
Using LCM for FIFO or average-cost inventory on a U.S. GAAP question. Those methods use LCNRV.

Exam tip: read the question for the comparison level first. Words like “by item,” “by major category,” or “in total” control the answer. Then check the cost flow method to confirm whether LCM or LCNRV applies.

Key takeaways

Under U.S. GAAP, LCM applies to LIFO and retail-method inventory. FIFO and average cost use LCNRV.
By item: compare each line, keep the lower amount, then add the results.
By category or in total: add first, then compare, so surpluses offset declines inside the group.
The item approach always gives the lowest inventory value and the largest write-down.
In our example, the same $12,000 of parts produces write-downs of $1,550 by item, $900 by category, or $700 in total.
Pick the level that best reflects periodic income and apply it consistently. Never record all three.

Practice questions with answers

1. What happens if you add first?

Two lines cost $500 each. Their designated markets are $420 and $550. By item, inventory is $920 ($420 + $500). Tested together, cost is $1,000 and market is $970, so inventory is $970. The second line offsets $50 of the first line’s decline only in the group comparison.

2. What entry follows the category method?

Use the bicycle-light figures and assume category testing is justified and consistently used. Debit Loss Due to Decline of Inventory to Market $900 and credit Inventory $900. This reconciles the $12,000 cost balance to the $11,100 category carrying amount.

3. When will all three methods agree?

Suppose every line has designated market below its cost. All three methods produce the sum of the designated markets. Every line has a decline, so there is no surplus available to offset another line’s loss.

Frequently asked questions

Can management choose the smallest loss each year?

The method should reflect the inventory’s character and the income of the period. A smaller expense this year is not evidence that the goods belong in the same group. Consistency gives readers a meaningful comparison across periods.

Why does the item approach always give the lowest inventory value?

Each line absorbs its own loss, while a line with market above cost is capped at cost. Broader grouping can yield the same carrying amount or a higher one because more offsetting is possible. So the item total can equal the category or total-inventory result, but it can never be higher.

Is lower of cost or market by item required under U.S. GAAP?

No. FASB ASC 330-10-35-8 allows the comparison by item, by major category, or for total inventory, whichever most clearly reflects periodic income. Item by item is the most common practice. Whatever level a company picks, it should apply it consistently from year to year.

Does lower of cost or market still apply after ASU 2015-11?

Yes, but only for inventory measured using LIFO or the retail inventory method. Inventory measured using FIFO or average cost follows the lower of cost and net realizable value rule, which compares cost with NRV and skips the ceiling and floor.

Can an LCM write-down be reversed if prices recover?

Not under U.S. GAAP. A year-end write-down becomes the inventory’s new cost basis, so a later recovery is not recorded as a gain. If the same inventory’s market value recovers in a later interim period of the same fiscal year, recognize the recovery up to the amount of the loss previously recorded. IFRS is different: it requires reversing a write-down when NRV recovers, limited to the amount originally written down.

How does IFRS handle item and category grouping?

IFRS (IAS 2, Inventories) generally measures inventory at the lower of cost and net realizable value. LIFO is not permitted. Write-downs are usually made item by item. Grouping similar or related items is sometimes appropriate, but writing down an entire classification, such as all finished goods, is not.

What if market is above cost for every item?

Then all three approaches give the same answer: total cost, with no write-down. LCM never writes inventory up above cost, so a market surplus is simply ignored.

Want more practice with inventory problems like this one? Start with the Farhat Lectures free sample course.