Although cost is usually the most appropriate basis for valuation of inventory, inventory may at times be properly shown in the financial statements at less than its historical, or original, cost. If the market value of inventory falls below its historical cost because of physical deterioration, obsolescence, or decline in price level, a loss has occurred. This loss is recognized by writing the inventory down to market—that is, to its current replacement cost. For a merchandising company, market is the amount that it would pay at the present time for the same goods, purchased from the usual suppliers and in the usual quantities.
When the replacement cost of inventory falls below its historical cost (as determined by an inventory costing method), the lower-of-cost-or-market (LCM) rule requires that the inventory be written down to the lower value and that a loss be recorded. This rule is an example of the application of the conservatism convention because the loss is recognized before an actual transaction takes place. Under historical cost accounting, the inventory would remain at cost until it is sold. According to an AICPA survey, approximately 80 percent of 600 large companies apply the LCM rule to their inventories for financial reporting.