This article describes the lower of cost or market rule.
Ending inventory is recorded and reported at its cost to the firm. This means that inventory reported on the balance sheet does not reflect its retail value. Does the failure to reflect the current retail value of inventory lead to a distorted view of a firm's economic condition?
A similar question was raised about the failure to reflect on the balance sheet the current market value of real estate a company owns. However, the situation is not exactly analogous. Real estate usually comes in large bundles, while inventory comes in much smaller packets. It is very feasible to sell all real estate holdings in a handful of transactions, but selling a company’s inventory would not be as simple.
Selling inventory generally requires engaging in many small transactions. These transactions create costs. In fact, selling a company’s entire inventory in bulk would almost certainly require giving the purchaser a large discount. Therefore, to realize the current market value of inventory, a business usually has to incur additional costs. For this reason, the failure to adjust ending inventory to fair market value does not distort the economic condition of a company to the degree that the failure to adjust real estate holdings does.
There is one circumstance in which GAAP requires a firm to adjust its inventory to its fair market value. GAAP requires that inventory must be carried on the books and reflected on the balance sheet at the lower of cost or market value. This means that inventory cannot be adjusted up to fair market value, but must be adjusted down when its fair market value declines below its cost.
When would the market value of inventory drop below its cost? Obsolescence, spoilage, changes in customer preferences, or dumb production and purchasing decisions are the usual culprits. If a business failed to adjust the carrying value of its inventory downward in such circumstances, its economic condition reflected on the balance sheet definitely would be distorted. In this case, the distortion would result in overstating a company’s value, rather than understating it.