GAAP requires that inventories be valued at lower of cost or market rule (LCM rule). Inventory cost is determined based on one of the cost flow assumptions discussed earlier. Market is defined as the current replacement cost, which is the amount that would be required to replace the firm’s inventory on the balance sheet date.
The LCM rule is based on the rationale that a decline in replacement cost indicates that the inventory’s utility to the firm has decreased. Conservatism would dictate that this loss should be reflected immediately in the financial statements, rather than postponing such recognition until the time of sale. When inventory is written down to market, the loss is sometimes disclosed separately on the income statement, but more frequently, it is included in the cost of goods sold.