Lower of cost or market is the inventory rule that carries goods at cost unless their usefulness has fallen below cost, in which case they are written down to a lower figure the guidance calls market. On the books it is now a minority rule: it applies to inventory measured using LIFO or the retail inventory method, while everything else moved to the lower of cost and net realizable value, a split set out in net realizable value.
The word market is doing unusual work in that sentence, and it does not mean the same thing on a tax return as it does in the financial statements. Both meanings are below.
Why a Departure From Cost Is Required at All
The reasoning runs through utility rather than through price. Cost is satisfactory only if the utility of the goods has not diminished since their acquisition, so a loss of utility is reflected as a charge against the revenues of the period in which it occurs, and for inventory measured using LIFO or the retail inventory method that loss is measured by applying the rule of pricing inventories at the lower of cost or market (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-2).
Market is therefore a proxy for utility, not a price the goods could fetch. The term market is to be interpreted as indicating utility on the inventory date and may be thought of in terms of the equivalent expenditure that would have to be made in the ordinary course at that date to procure corresponding utility (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-3).
The Starting Number, and the Two Fences Around It
The starting number is replacement cost. As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-4).
That figure then gets fenced from above. Replacement or reproduction prices are not appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-4). A replacement cost above what the goods will actually net on sale overstates their usefulness, so the sale figure wins.
And it gets fenced from below. When the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss is recognized even though replacement or reproduction costs are lower, which might be true in the case of production under firm sales contracts at fixed prices, or when a reasonable volume of future orders is assured at stable selling prices (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-5). A drop in what it would cost to buy the goods again means nothing if the goods are already committed at a profitable price.
There is also a standing instruction not to over-apply the rule. In applying it, judgment must always be exercised and no loss is recognized unless the evidence indicates clearly that a loss has been sustained (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-4).
It Is a Guide Rather Than a Literal Rule
The guidance says so about itself. Because of the many variations of circumstances encountered in inventory pricing, the definition of market is intended as a guide rather than a literal rule, to be applied realistically with due regard to the form, content and composition of the inventory (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-7).
Two consequences follow in the same paragraph. The retail inventory method, if adequate markdowns are currently taken, already accomplishes the objectives the rule exists to serve. And where a business is expected to lose money for a sustained period, the inventory is not written down to offset a loss inherent in the subsequent operations (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-7). A write-down has to be a loss in the goods, not a forecast about the business.
The Tax Code Runs Its Own Version, on Different Numbers
A return can use a rule with the same name and reach a different figure, because the regulation defines market from the buying side only.
Under ordinary circumstances and for normal goods, market means the aggregate of the current bid prices prevailing at the date of the inventory of the basic elements of cost reflected in inventories of goods purchased and on hand, goods in process of manufacture, and finished manufactured goods on hand, and those basic elements of cost include direct materials, direct labor and the indirect costs required to be included in inventories by the taxpayer (26 CFR 1.471-4(a)(1)). There is no selling-price ceiling and no normal-profit floor in that definition. Market on a return is a rebuilt cost, priced at what those cost elements bid today.
Three mechanics travel with it. Goods on hand or in process for delivery on firm sales contracts at fixed prices entered into before the inventory date, under which the taxpayer is protected against actual loss, must be inventoried at cost (26 CFR 1.471-4(a)(2)). Where no open market exists or quotations are nominal because the market is inactive, the taxpayer uses the best available evidence of a fair market price at the nearest date, such as specific purchases or sales in reasonable volume made in good faith (26 CFR 1.471-4(b)). And the comparison is made one item at a time: the market value of each article on hand at the inventory date is compared with the cost of that article, and the lower of the two values is taken as its inventory value (26 CFR 1.471-4(c)).
The Two Rulebooks Point at Opposite Inventories
This is the part that catches a preparer moving between the trial balance and the return.
On the books, lower of cost or market is what LIFO and retail-method inventory use, and everything else has left it. On a return, a taxpayer on LIFO cannot use it at all, because the statute requires that a LIFO taxpayer inventory the goods at cost (26 U.S.C. 472(b)(2)), a statute whose election mechanics and conformity condition are set out in LIFO.
So the same client, on the same goods, can be inside the book rule precisely because it is on LIFO and outside the tax rule for precisely the same reason. A book-to-tax difference on inventory is the normal outcome there, not a sign that somebody made an error.
Common Questions
Yes, for two populations. On the books it survives for inventory measured using LIFO or the retail inventory method (FASB Accounting Standards Update 2015-11, paragraph 330-10-35-2). On tax returns the regulation still stands for taxpayers who elect to value inventories at cost or market, whichever is lower, and are not on LIFO (26 CFR 1.471-4(a)(1); 26 U.S.C. 472(b)(2)).
Price the goods at cost, then price the same goods at market, then take the lower. For the book rule, market starts at current replacement cost, is capped at estimated sales value less the costs of completion and disposal, and is abandoned entirely where cost will still be recovered with an approximately normal profit (FASB Accounting Standards Update 2015-11, paragraphs 330-10-35-4 and 330-10-35-5). For the tax rule, market is the aggregate of current bid prices for the cost elements, compared article by article (26 CFR 1.471-4(a)(1) and (c)).
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own inventory valuation and book-to-tax work through a trial task before a client engagement depends on it.
