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August 16, 2026·Accounting & Finance·Pasento

Elements of lower of cost or market

A rule requiring inventory to be carried at the lower of its cost or what it can actually be sold for.

Definition

Lower of cost or market is the rule that inventory cannot sit on the books above what it can actually be sold for. On the books, this is a ceiling on the carrying amount, not a new valuation method.

You first assign cost with FIFO, LIFO, or a weighted average. Then you compare that cost to a ceiling, and you keep the lower of the two.

Under US GAAP, the ceiling depends on your method. For FIFO or average cost, it is net realizable value: what the goods should sell for, less costs to finish and sell them. The older market test now applies only to LIFO and the retail inventory method.

If the ceiling is above cost, you leave the cost alone. If it is below cost, you write the inventory down.

Where it shows up

Balance Sheet: Related to the inventory line when the ceiling is below cost.

P&L: Related to the write-down when the ceiling is below cost.

See also: Inventory Valuation · Inventory Write-Down · Inventory

When you look at your Balance Sheet, inventory sits with the other current assets. After this rule, that line should not be higher than what the goods can reasonably sell for.

The Income Statement does not list the rule by name. It picks up the write-down in the period you recognize that the ceiling is below cost.

The write-down is a non-cash entry. Cash already moved when you bought the goods; this rule only lowers the book value that remains.

A small write-down can hide inside cost of goods sold. A larger one is often shown as its own loss so a reader can see it.

How it works

The test runs in four steps:

  1. Start with cost: Use the cost already assigned by your valuation method. That cost is the first number in the comparison.
  2. Find the ceiling: For FIFO or average cost, use net realizable value: a realistic selling price after markdowns, less costs to finish and sell. For LIFO or the retail method, use market: current replacement cost, capped at net realizable value and floored at net realizable value less a normal profit margin.
  3. Compare: Test cost against that ceiling for the goods that need it. Some businesses test item by item; others test a group, such as one season's stock.
  4. Write down if lower: If the ceiling is lower, reduce inventory to that amount. The other side of the entry is a write-down on the P&L.

US GAAP narrowed the market test to LIFO and the retail method in a 2015 update (ASU 2015-11). Either way, the idea stays the same: do not carry stock above what it is worth.

You do not write inventory up if prices recover later, except in limited cases your framework allows. The conservative step is the write-down, not a later mark-up.

A physical count still tells you what is on hand. This rule only decides whether those units may stay at cost.

Example

A vintage clothing shop uses FIFO. It bought 20 winter jackets at $50 each, for $1,000. By March the season is over, and after markdowns and selling costs the jackets will only bring $20 each, or $400 in total.

Because the shop uses FIFO, its ceiling is net realizable value. Cost is $1,000 and net realizable value is $400. The rule requires the lower amount, so the shop writes the jackets down by $600.

The write-down is recorded:

Debit: Inventory write-down $600

Credit: Inventory $600

Inventory on the Balance Sheet falls from $1,000 to $400. The P&L takes a $600 write-down in the same period.

Assets are lower by $600, and equity is lower through the loss. Cash does not move, because the jackets were paid for when they arrived.

The shop still has 20 jackets on the rack. The rule changed only the cost those jackets are allowed to carry.

Common mix-ups

Lower of cost or market is not a valuation method like FIFO. FIFO, LIFO, and average cost assign the starting cost; this rule only caps that cost.

A write-down is not a cash refund. The vendor already has the money; you are only lowering the book value of what is left.

Market is not the original selling price on the tag. For FIFO or average cost, the ceiling is what the leftover goods can actually bring now, less costs to sell. "Market," with its replacement-cost cap and floor, is only for LIFO or the retail method.

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