Lower of Cost or Market (LCM) Rule: Calculation, Write-Downs, and Tax

The lower of cost or market rule is a conservative inventory valuation method that stops businesses from carrying inventory on the balance sheet at more than it is worth. When market value drops below what the company paid, the inventory gets written down to the lower figure and the loss hits the current period. Since 2017 the rule runs on two tracks. If you use LIFO or the retail inventory method, you still apply the traditional LCM calculation with a replacement cost, a ceiling, and a floor. If you use FIFO or average cost, you use a simpler test called lower of cost and net realizable value (LCNRV).¹

Which Track Your Business Is On

FASB’s Accounting Standards Update No. 2015-11 drew the dividing line. FIFO and average-cost inventory no longer use the traditional LCM rule at all; the measurement is lower of cost and net realizable value, with no ceiling, floor, or replacement cost step. LIFO and retail-method inventory still use the full traditional calculation. Running the wrong test wastes time at best and produces an incorrect carrying value at worst, so the first thing to check is which costing method the inventory sits under.¹

The Traditional LCM Calculation

For LIFO and retail inventory, “market” is not simply the current selling price. Under ASC Topic 330, market starts with replacement cost, meaning what it would cost today to buy or reproduce the same item. That replacement cost is then bracketed by two limits.

The upper limit, the ceiling, equals net realizable value: estimated selling price minus any remaining costs to complete and sell the goods. The lower limit, the floor, equals net realizable value minus a normal profit margin. The floor exists so a company cannot depress inventory values artificially and push profit into a later period.¹

The designated market value is whichever of the three figures falls in the middle:

If replacement cost is above the ceiling, use the ceiling.
If replacement cost is below the floor, use the floor.
If replacement cost is between the ceiling and the floor, use replacement cost.

Then compare that designated market value to the item’s historical cost. Whichever is lower becomes the carrying value. The mistake to avoid is comparing cost directly to replacement cost without checking the ceiling and floor, which can produce a materially different answer when profit margins have shifted.

The Simplified LCNRV Rule

FIFO and average-cost inventory skip the replacement-cost machinery entirely. Under ASC 330-10-35-1B, you compare cost to net realizable value and record the lower.¹

Net realizable value means the estimated selling price in the ordinary course of business, minus reasonably predictable costs of completion, disposal, and transportation. That is the entire calculation. FASB adopted the simpler test because the three-part market check added complexity without meaningfully improving accuracy for non-LIFO inventory. A company moving from the old LCM approach to LCNRV treats the shift as a change in accounting principle and discloses the nature and reason in the first interim and annual period after adoption.¹

What Counts as Cost

Historical cost is the total investment to acquire inventory and get it ready for sale. It starts with the invoice price and adds freight to the warehouse, transit insurance, receiving-dock handling, and any import duties or taxes. That cumulative figure is the benchmark on the cost side of the comparison.

For tax purposes the figure can be broader. Businesses subject to the uniform capitalization rules under IRC Section 263A must capitalize certain indirect costs into inventory as well, including purchasing costs, storage expenses, and allocable administrative overhead. The result is that the “cost” number on the tax return may be higher than the cost number in the financial statements, which changes where the comparison lands for each purpose.

Item by Item, by Category, or in Total

For financial reporting under GAAP, you can apply the comparison at three levels:

Item by item, comparing cost and market for each SKU. This is the most conservative because every decline gets captured.
By product category, grouping similar items and comparing total cost against total market for each group. Gains on one item can offset losses on another inside the group.
In total, comparing aggregate cost against aggregate market. This is the least conservative because strong products mask weak ones.

The item-by-item approach fits businesses that carry unique or high-value goods with distinct markets. Category or total works better for retailers with thousands of interchangeable products.

Tax rules are stricter. Treasury Regulation 1.471-4(c) requires item-by-item comparison: “the market value of each article on hand at the inventory date shall be compared with the cost of the article.”² You may have more flexibility on the financial statements than on the return.

Recording the Write-Down

When market drops below cost, the write-down is recognized in the period the decline occurred. Most businesses record it by increasing Cost of Goods Sold, which reduces gross profit for the period. If the loss is large enough to distort normal operating results, it should be reported as a separate line item on the income statement.¹

On the balance sheet, inventory is either credited directly or reduced through a contra-asset allowance account. The written-down figure becomes the new cost basis going forward.

Write-Downs Cannot Be Reversed

Under US GAAP, a write-down creates a new cost basis that stays in place even if market prices recover. ASC 330-10-35-14 is explicit. If you wrote inventory down from $50 to $35 last quarter and the market price rebounds to $48 this quarter, the carrying value remains $35.¹ Companies that also report under IFRS should note that IAS 2 handles this differently and can require reversal up to original cost.

How the Tax Rule Differs

The IRS allows the lower-of-cost-or-market method for tax purposes, but the definition of market and the evidentiary standard both differ from GAAP. Under Treasury Regulation 1.471-4, “market” for tax means the current bid prices of the basic elements of cost: direct materials, direct labor, and any indirect costs required under Section 263A. That is a replacement-cost concept, not net realizable value or selling price.²

LIFO Users Cannot Use LCM on the Return

If your business has elected LIFO, you cannot use LCM for tax. Section 472 of the Internal Revenue Code requires LIFO taxpayers to value inventory at cost, and the statute extends that requirement to financial statements provided to shareholders, partners, or creditors. A market-based write-down in any of those reports can put the LIFO election itself at risk.³

The Evidence the IRS Wants to See

The IRS holds a higher evidentiary bar than GAAP. In Thor Power Tool Co. v. Commissioner, the Supreme Court held that taxpayers need objective evidence of a decline in value, not management judgment. Acceptable evidence includes actual sales below cost, bona fide offerings at reduced prices, or contract cancellations. Internal aging schedules, flat-percentage markdowns, and estimates based on business experience are not enough.⁴

For goods that are damaged, obsolete, or unsalable at normal prices, the regulation requires a bona fide selling price based on actual offerings made within 30 days after the inventory date. The taxpayer bears the burden of proving the reduced valuation and must keep records showing how the goods were ultimately disposed of.²

Changing the Method

Switching to or from LCM on the tax return requires filing IRS Form 3115, Application for Change in Accounting Method. Automatic changes are attached to the timely filed return with a copy sent to the IRS National Office and no user fee. Non-automatic changes require a separate filing, a user fee, and IRS approval through a letter ruling. Either way, the IRS will generally require a Section 481(a) adjustment so income is not double-counted or skipped during the transition.⁵

Disclosures on the Financial Statements

Companies must disclose the inventory valuation method in the footnotes. When an inventory write-down produces a substantial or unusual loss, ASC Topic 330 calls for separate disclosure of that loss on the income statement, identified apart from normal cost of goods sold.¹ Write-down estimates involve management judgment, so consistent underestimates or unsupported assumptions invite audit adjustments and restatement risk.

The Narrow Exception for Reporting Above Cost

A small category of inventory can be reported at selling price rather than cost. Under ASC 330-10-35-16, this applies to agricultural products, minerals, and similar commodities, and only when three conditions are met: the units are interchangeable, they have an immediate market at quoted prices, and appropriate costs are difficult to determine. When inventory is stated at selling price under this exception, the carrying value is reduced by estimated disposal costs. The SEC staff has noted that the third condition is almost never satisfied given modern cost accounting systems, so very few companies actually qualify. Work-in-process that still needs refining does not qualify, and precious metals used in industrial manufacturing rather than held for sale do not qualify either.

1
Financial Accounting Standards Board (FASB). Accounting Standards Update No. 2015-11: Simplifying the Measurement of Inventory
2
eCFR. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever Is Lower
3
Office of the Law Revision Counsel. 26 USC 472 – Last-In, First-Out Inventories
4
Legal Information Institute (LII). Thor Power Tool Co. v. Commissioner, 439 U.S. 522
5
Internal Revenue Service. Instructions for Form 3115