Are there two ABC methods in accounting?

Some accountants use ABC to mean Activity Based Costing. Under this ABC a manufacturer
will use many cost drivers to assign overhead costs to products. The objective of Activity Based
Costing is to assign the overhead costs based on their root causes rather than merely spreading
the costs on the basis of direct labor hours or production machine hours.

A second use of ABC involves categorizing inventory items into “A” items, “B” items, and “C”
items. The “A” items are a relatively small number of items which account for the majority of
the inventory’s value. For example, the “A” items might be 20% of the items in inventory which
account for 70% of the inventory value. At the other extreme the “C” items might be 60% of the
items in inventory but account for only 10% of the inventory value. The “B” items might be 20%
of the items accounting for 20% of the inventory value. Under this system, the “A” items will
receive the most attention since they account for 70% of the value. This ABC is sometimes
referred to as Pareto analysis or Pareto’s rule and it can be applied to more than inventory. For
example, 20% of a company’s customers might account for 70% of the company’s sales.

Learn more about Activity-based Costing.

Part 1 Introduction to Activity Based Costing, Activity Based Costing

with Two Activities

Part 2 Activity Based Costing with Four Activities

Introduction to Activity Based Costing

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more
logical manner than the traditional approach of simply allocating costs on the basis of machine
hours. Activity based costing first assigns costs to the activities that are the real cause of the
overhead. It then assigns the cost of those activities only to the products that are actually
demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same
company. Product 124 is a low volume item which requires certain activities such as special
engineering, additional testing, and many machine setups because it is ordered in small
quantities. A similar product, Product 366, is a high volume product—running continuously—
and requires little attention and no special activities. If this company used traditional costing, it
might allocate or "spread" all of its overhead to products based on the number of machine hours.
This will result in little overhead cost allocated to Product 124, because it did not have many
machine hours. However, it did demand lots of engineering, testing, and setup activities. In
contrast, Product 366 will be allocated an enormous amount of overhead (due to all those
machine hours), but it demanded little overhead activity. The result will be a miscalculation of
each product's true cost of manufacturing overhead. Activity based costing will overcome this
shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups,
and others are activities that cause costs—they cause the company to consume resources. Under
ABC, the company will calculate the cost of the resources used in each of these activities. Next,
the cost of each of these activities will be assigned only to the products that demanded the
activities. In our example, Product 124 will be assigned some of the company's costs of special
engineering, special testing, and machine setup. Other products that use any of these activities
will also be assigned some of their costs. Product 366 will not be assigned any cost of special
engineering or special testing, and it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing
overhead costs have increased significantly, (2) the manufacturing overhead costs no longer
correlate with the productive machine hours or direct labor hours, (3) the diversity of products
and the diversity in customers' demands have grown, and (4) some products are produced in
large batches, while others are produced in small batches.

Activity Based Costing with Four Activities

Let’s add two more activities to our example: procurement and material handling. The costs of
these two activities are not caused by—nor do they correlate with—machine hours. Rather, we
will assume that both of these activities are related to the physical weight of the direct material
used in making the product.

The company determines that $300,000 of its annual manufacturing overhead is associated with
procurement and material handling. As a result, the company removes $300,000 from the
manufacturing overhead that will be allocated via machine hours, and instead plans to allocate
the $300,000 to the products based on the weight of the materials used. The company expects
that during the year it will procure and handle 3,000,000 pounds of material. Under activity
based costing, the company will assign $0.10 ($300,000 divided by 3,000,000 pounds) per pound
of product weight to each unit manufactured. The end result is that the heavier parts will not only
have more direct material cost, they will also be assigned more factory overhead than the lighter
parts. By assigning some manufacturing overhead to a product based on the product’s weight, the
remaining manufacturing overhead assigned via machine hours will be reduced. These points are
illustrated in the following table:
 With ABC Without ABC
Mfg overhead costs assigned to setups $200,000 $–0–
Number of setups 400 Not applicable
Mfg overhead cost per setup $500 $–0–

Mfg O/H costs caused by procurement/handling $300,000 $–0–

Pounds of material in products 3,000,000 Not applicable
Mfg O/H per pound of product material $0.10 $–0–

Mfg O/H costs caused by producing the items:

Total manufacturing overhead costs $2,000,000 $2,000,000
Less: Cost traced to machine setups – 200,000 $–0–
Less: Costs traced to procurement/handling – 300,000 $–0–
Mfg costs to be allocated on machine hours $1,500,000 $2,000,000
Machine hours (MH) 100,000 100,000
Mfg overhead costs allocated per MH $15 $20

$500 setup cost

per batch +
Mfg Overhead Cost Allocations $20 per MH
$0.10 per lb. +
$15 per MH

In the table below we can see how ABC would assign costs to the following:

1. A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a rate of 50
per hour.
2. A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a rate of
50 per hour.
3. No activity based costing allocations—all manufacturing overhead costs are allocated
entirely via machine hours.

(1.) ABC (2.) ABC (3.) No ABC

Mfg overhead for setting up machine $500 $500 $–0–

No. of units in batch 50,000 50,000 Not applicable

Mfg O/H caused by Setup – Per Unit $0.01 $0.01 Not applicable

Mfg overhead costs per lb. of product $0.10 $0.10 Not applicable

Lbs of material in product 0.5 1.5 Not applicable

Mfg O/H caused by Weight – Per Unit $0.05 $0.15 Not applicable

Mfg overhead costs per machine hour $15 $15 $20

No. of units produced per machine hour 50 50 50
Mfg O/H caused by Production – Per Unit $0.30 $0.30 $0.40

Total Mfg O/H Allocated – Per Unit $0.36 $0.46 $0.40

If the manufacturing overhead costs are caused by a number of activities such as setup,
procurement, handling, and production, then using the activity based costing method of
determining costs will give you a result that is closer to the true costs. As you can see, the
product that weighs 0.5 pound is assigned $0.36 of manufacturing overhead, while the product
weighing 1.5 pounds is assigned $0.46 of manufacturing overhead. Under the traditional costing
allocations the procurement and handling costs would be assigned on production hours. Keep in
mind that whenever manufacturers have a diverse lineup of products, allocating costs on a single
basis (such as machine hours) will result in inaccurate per-unit manufacturing overhead costs.

If you want to learn more about overhead and activity based costing, we have prepared a short
list of books that we have read and found to be very helpful. You can view our listing of
recommended books by going to the following page: Recommended Books.

allowance to reduce inventory to LCM

This is a valuation account for the asset Inventory. A credit balance should be reported in the
allowance account for the amount that the market value of inventory is less than the cost reported
in the Inventory account. The credit entered into the Allowance for Reduction of Cost to Market
will mean a debit is entered into the income statement account Loss from Reducing Inventory to
LCM. To learn more, see Explanation of Lower of Cost or Market.
Introduction to Lower of Cost or Market (LCM)

We also have Drills, Crosswords, and Q&A for the topic Lower of Cost or Market.

Assume it is the end of December 2009 and your retail store has 20 digital cameras in inventory.
You purchased the cameras directly from the manufacturer at a cost of $150 each and you
planned to sell the cameras at a retail price of $200, a price that is in line with competing
retailers.

Unexpectedly, on December 31, the camera manufacturer announces a permanent price

reduction–you and the other retailers can now purchase the cameras for $135 instead of $150.
You know that your competitors will buy up these cameras and pass the savings on to their
customers by immediately advertising a retail price reduction–selling the cameras for $185
instead of $200. If you drop your retail price to $185, however, your gross profit will be just $35
each on the 20 cameras you already have in stock, instead of the $50 per camera that you had
planned on. This means your profits will be $300 less than you projected ($15 less profit times
20 cameras). Much to your dismay, you will have to drop your price to meet that of your
competitors. There is nothing you can do to avoid this "holding loss" of $300.

When and how should this loss be reported on your store's income statement? Should the loss be
reported as a smaller gross profit when the cameras are sold in January 2010? Or, should the
entire $300 of loss be reported in December 2009, when the manufacturer announced the lower
price? Should your December 31 balance sheet report inventory at $3,000 (20 cameras at the
actual cost of $150) or at $2,700 (20 cameras at the lower replacement cost of $135)?

The conservatism principle and a specific accounting pronouncement, Accounting Research

Bulletin No. 43 (ARB No. 43) leads to an accounting valuation method known as the lower of
cost or market, or LCM. In this method the term "market" includes both the market in which
the company purchases its merchandise as well as the market in which it sells its merchandise.
We will discuss the details of the rule later, but for now, think of the lower of cost or market rule
as the lower of cost or replacement cost–with certain limitations placed on the replacement cost
amount.

How to Calculate the Lower of Cost or Market (LCM)

We will use the information in the following table to calculate the net realizable value and the
lower of cost or market for five products:

Product: A B C D E

$ $ $ $ $
Cost
6.00 5.00 8.00 8.75 2.00

Replacement cost 4.50 3.00 8.50 9.00 2.50

10.0 12.0 10.0

Expected selling price 4.50 4.00
0 0 0

Cost to complete &

3.00 1.00 2.50 1.50 1.00
dispose

Normal profit* 2.00 0.90 2.40 2.00 0.80

*We will assume a normal profit equal to 20% of the selling price

Recall the lower of cost or market (LCM) rule: LCM is the lower of cost or replacement cost,
with the replacement cost being no higher than NRV and no lower than NRV minus the
normal profit.

Since the replacement cost was given, we will begin by calculating the net realizable value
(NRV) of each of the products. Recall that net realizable value is the expected selling price in the
ordinary course of business minus the cost to complete and dispose. NRV will be the upper limit
(the ceiling) for the replacement cost.

Net Realizable Value (NRV): The Ceiling in

LCM

Product: A B C D E

10.0 4.5 12.0 10.0 4.0

Expected selling price
0 0 0 0 0

Less: Cost to complete & 3.00 1.0 2.50 1.50 1.0

 dispose 0 0

Net realizable value = 7.0 3.5 9.5 8.5 3.0

CEILING* 0 0 0 0 0

*If the replacement cost is greater than this ceiling, use this ceiling as the market amount.

Next we will calculate the NRV minus the normal profit. This amount will be the lower limit
(the floor) for the replacement cost.

NRV minus the Normal Profit: The Floor in

LCM

Product: A B C D E

7.0 3.5 9.5 8.5 3.0

Net realizable value = CEILING*
0 0 0 0 0

Less: normal profit (20% of 2.0 0.9 2.4 2.0 0.8

selling price) 0 0 0 0 0

NRV - normal profit = 5.0 2.6 7.1 6.5 2.2

FLOOR* 0 0 0 0 0

*If the replacement cost is lower than this floor, use this floor as the market amount.

The following chart displays the four relevant amounts used in the lower of cost or market rule:
(1) cost, (2) the upper limit, or ceiling, for the replacement cost, (3) replacement cost, and (4) the
lower limit, or floor, for the replacement cost. The lower of cost or market amount appears in
bold font:

Product: A B C D E

$ $ $ $ $
Cost
6.00 5.00 8.00 8.75 2.00
 Market information:

NRV (ceiling) 7.00 3.50 9.50 8.50 3.00

Replacement cost 4.50 3.00 8.50 9.00 2.50

NRV - normal profit

5.00 2.60 7.10 6.50 2.20
(floor)

Let's review the lower of cost or market for each of the five products shown in the above table:

Product A

Cost vs. Market

$6.00 vs. $7.00 NRV (ceiling)

$5.00 NRV - normal profit (floor)

$4.50 Replacement cost

As you can see, the $4.50 replacement cost is less than the floor of $5.00. Because
it is below the floor, the replacement cost cannot be used as the market amount.
Instead, the floor of $5.00 is used as the market amount for Product A.

The lower of cost or market is $5.00 (the lower of the $6.00 cost vs. the $5.00
market).

Product B

Cost vs. Market

$5.00 vs. $3.50 NRV (ceiling)

$3.00 Replacement cost

$2.60 NRV - normal profit (floor)

The $3.00 replacement cost is between the floor of $2.60 and the ceiling of $3.50.
As a result the $3.00 replacement cost is used as the market amount for
Product B.

The lower of cost or market is $3.00 (the lower of the $5.00 cost vs. the $3.00
market).

Product C

Cost vs. Market

$8.00 vs. $9.50 NRV (ceiling)

$8.50 Replacement cost

$7.10 NRV - normal profit (floor)

The $8.50 replacement cost is between the ceiling of $9.50 and the floor of $7.10.
This means the $8.50 replacement cost is the market amount for Product C.

However, lower of cost or market is $8.00 (the lower of the $8.00 cost vs.
$8.50 market).

Product D

Cost vs. Market

$8.75 vs. $9.00 Replacement cost

$8.50 NRV (ceiling)

$6.50 NRV - normal profit (floor)

The $9.00 replacement cost is above the ceiling of $8.50. Because it is above the
ceiling, the replacement cost cannot be used as the market amount. Instead, the
ceiling of $8.50 is used as the market amount for Product D.

The lower of cost or market is $8.50 (the lower of the $8.75 cost vs. the $8.50
market).
Product E

Cost vs. Market

$2.00 vs. $3.00 NRV (ceiling)

$2.50 Replacement cost

$2.20 NRV - normal profit (floor)

Because the $2.50 replacement cost is between the ceiling of $3.00 and the floor of
$2.20, the $2.50 replacement cost is used as the market amount for Product
E.

However, the lower of cost or market is $2.00 (the lower of the $2.00 cost vs.
the $2.50 market).

Lower of Cost or Market - Quick and Easy

An easy way to apply the lower of cost or market (or to check your calculations) is to arrange the
four relevant amounts (cost, replacement cost, NRV, and NRV minus normal profit) in
descending order of amount. The third amount is the lower of cost or market, unless cost is
lower. (When cost is the fourth amount, the lower of cost or market is the fourth amount.) To
illustrate:

Product A's relevant amounts arranged from highest to lowest:

#1 $7.00 NRV

#2 $6.00 Cost

#3 $5.00 NRV - normal profit

#4 $4.50 Replacement Cost

The lower of cost or market is the third amount: $5.00

(since cost is not lower).
Product B's relevant amounts arranged from highest to lowest:

#1 $5.00 Cost

#2 $3.50 NRV

#3 $3.00 Replacement Cost

#4 $2.60 NRV - normal profit

The lower of cost or market is the third amount: $3.00

(since cost is not lower).

Product C's relevant amounts arranged from highest to lowest:

#1 $9.50 NRV

#2 $8.50 Replacement Cost

#3 $8.00 Cost

#4 $7.10 NRV - normal profit

The lower of cost or market is the third amount: $8.00

(since cost is not lower).

Product D's relevant amounts arranged from highest to lowest:

#1 $9.00 Replacement Cost

#2 $8.75 Cost

#3 $8.50 NRV

#4 $6.50 NRV - normal profit

The lower of cost or market is the third amount: $8.50
(since cost is not lower).

Product E's relevant amounts arranged from highest to lowest:

#1 $3.00 NRV

#2 $2.50 Replacement Cost

#3 $2.20 NRV - normal profit

#4 $2.00 Cost

The third amount is $2.20. However, cost is lower. Therefore, the lower of
cost or market is $2.00.

To recap this quick and easy approach to finding the lower of cost or market...

1. Arrange the four relevant amounts in descending order.

2. The lower of cost or market is the third amount, unless cost is lower.

Applying Lower of Cost or Market To Inventory

Generally accepted accounting principles allow for the lower of cost or market rule to be applied
in one of three ways: (1) on an inventory totals basis, (2) on an inventory categories basis, or (3)
on an item-by-item basis.

1. Applying LCM to inventory totals is the least conservative application since it

results in the smallest writedown or reduction of inventory from cost and the
smallest loss on the income statement.
2. Applying LCM to inventory categories results in values that fall somewhere
in between the other two methods of applying LCM.
3. Applying LCM on an item-by-item basis is the most conservative application
since it results in the largest writedown or reduction of inventory from cost
and the largest loss on the income statement.
Let's use the information below to illustrate the three ways of applying LCM:

Categor Item Units on Cost per Market Total Total LCM by LCM Item-
y Number Hand Unit per Unit* Cost Market Category By-Item

A 101 10 $ 4.00 $ 4.10 $ 40 $ 41 $ 40

A 102 40 6.00 6.00 240 240 240

A 108 100 8.00 7.00 800 700 700

Total A 1,080 981 $ 981

B 202 5 13.00 13.00 65 65 65

B 212 8 20.00 21.00 160 168 160

B 250 60 15.00 14.00 900 840 840

B 260 10 17.00 20.00 170 200 170

Total B 1,295 1,273 1,273

C 302 20 50.00 51.00 1,000 1,020 1,000

C 305 30 38.00 39.00 1,140 1,170 1,140

C 310 10 56.00 50.00 560 500 500

C 315 15 32.00 32.00 480 480 480

C 327 20 35.00 36.00 700 720 700

Total C 3,880 3,890 3,880

D 404 40 30.00 31.00 1,200 1,240 1,200

D 406 50 40.00 38.00 2,000 1,900 1,900

Total D 3,200 3,140 3,140

Grand $9,45
$9,284 $9,274 $9,135
Total 5
 *The "Market per unit" amounts that are less than cost appear in bold

The Total Cost column shows a grand total of $9,455. This is the cost of the items held in
inventory. In most industries, the inventory reported on the balance sheet cannot exceed this
amount. However, because of the lower of cost or market rule, the inventory reported on the
balance sheet might be smaller than this amount. The smaller amount could be based on the
lower of cost or market applied to the inventory totals, inventory categories, or each individual
item in inventory.

If the LCM rule is applied to the inventory totals, the Grand Total Cost ($9,455) is compared
to Grand Total Market ($9,284). The lower of cost or market is the lower of these two amounts.
Therefore $9,284 is the amount to be reported on the company's balance sheet. The difference of
$171 ($9,455 minus $9,284) is reported as a loss on the company's income statements in the
accounting periods when the loss took place.

If the LCM rule is applied to the inventory categories, the lower of each category's total cost
and total market amount is selected. For example, the Category A Total Market amount of $981
is selected over Category A Total Cost amount of $1,080 and is entered in the column "LCM by
Category." The Grand Total LCM by Category of $9,274 is less than the Grand Total Cost of
$9,455. Therefore, $9,274 is the amount reported on the company's balance sheet. The amount of
the writedown or reduction from $9,455 to $9,274 is $181. This $181 will be reported on the
income statements in the periods when the market amount dropped below cost.

If the LCM is applied on an item-by-item basis, the lower of each item's total cost and total
market amount is selected. For example, the Item 212 Total Cost amount of $160 is selected over
Item 212 Total Market amount of $168 and is entered in the column "LCM Item-by-Item." The
Grand Total LCM Item-by-Item of $9,135 is the amount reported on the company's balance
sheet. The difference between this amount and the Grand Total Cost of $9,455 is $320. This
$320 reduction from cost is reported as a loss on the company's income statements in the
accounting periods when the loss took place. As mentioned earlier, this is the most conservative
way in which to apply the lower of cost or market rule.

Accounting For Lower of Cost or Market

For companies reporting inventory under the lower of cost or market rule, it is common to use
the contra asset inventory account Allowance to Reduce Inventory to LCM. This balance
sheet account is used to report the amount that the inventory's market amount is below the
inventory's cost amount. In other words, the combination of the Inventory account balance and
the Allowance account balance will equal the lower of cost or market. The result is the account
Allowance to Reduce Inventory to LCM will have a credit balance for the amount that the
market value of the inventory is less than the cost shown in the Inventory account. If the market
value of the inventory is greater than cost, a zero balance appears in the account Allowance to
Reduce Inventory to LCM. (There cannot be a debit balance in Allowance account because of
the cost principle and the revenue recognition principle.)

Because of the rules of double-entry accounting, whenever the balance in the Allowance account
is adjusted, a second account is needed. The second account will be an income statement
account, such as Loss from Reducing Inventory to LCM.

We'll use the following information to illustrate accounting for lower of cost or market (LCM):

Credit
Cost Market
Balance
(These amounts are (These amounts are determined
needed in the
in the accounting from information outside of the
Allowance
records.) accounting records.)
account.

Inventory at
Dec. 31, $80,000 $82,990 $ 0
2009

Inventory at
76,000 75,000 1,000
Jan. 31 2010

Inventory at
72,000 71,800 200
Feb. 28 2010

Inventory at
Mar. 31, 70,000 70,400 0
2010
At December 31, 2009 the company's balance sheet will report Inventory of $80,000 since this
amount is the lower of cost ($80,000) or market ($82,900). The general ledger accounts show
these balances:

(balance sheet account) Inventory

Balance at Dec. 31,

80,000
2009

(bal. sheet account) Allowance to Reduce Inventory to

LCM

Balance at Dec. 31,

0
2009

(inc. stmt. account) Loss From Reducing Inventory to

LCM

Balance at Dec. 31,

 2009 0

No adjustment was needed at December 31 because 1) market was greater than the cost, and 2)
the balance in the Allowance account was previously at $–0–.

At January 31, 2010 the company's balance sheet needs to report Inventory of $75,000 since
this amount is the lower of cost or market on that date. The company's income statement for the
month of January 2010 should report a Loss of $1,000, since the decline below market occurred
in January and the market is expected to remain lower than cost. If the company uses the
Allowance account for valuation, the pertinent general ledger accounts will have the following
adjustment:

(balance sheet account) Inventory

Balance at Jan. 31,

76,000
2010

(bal. sheet account) Allowance to Reduce Inventory to

LCM
 Balance at Dec. 31,
0
2009

1,00 Adjustment at Jan.

0 31, 2010

1,00 Bal. Needed at Jan.

0 31, 2010

(inc. stmt. account) Loss From Reducing Inventory to

LCM

Balance at Jan. 1, 2010 0

Adjustment at Jan.
1,000
31, 2010

Balance at Jan. 31,

1,000
2010

In general journal format, the adjusting entry at January 31, 2010 is:

Date Account Name Debit Credit

Jan. 31, 2010 Loss from Reducing Inv to LCM 1,000

Allowance to Reduce Inv to

1,000
LCM
This entry is similar to other adjusting entries (see Explanation of Adjusting Entries) in that it
involves a balance sheet account (Allowance to Reduce Inventory to LCM) and an income
statement account (Loss from Reducing Inventory to LCM).

We used the T-accounts to make certain we got the correct amounts into the balance sheet
account. We asked ourself: What should the balance be in the account Allowance to Reduce Inv
to LCM at January 31, 2010? The answer is that the balance at January 31 should be a credit
balance of $1,000 because the market value at that date is $1,000 below the cost being reported
in the Inventory account. The second question we asked was: What is the present balance in the
Allowance account? The answer was that prior to an adjustment on January 31, the balance was
$-0-. So how do we get the Allowance account from a balance of $-0- to the $1,000 credit
balance that is needed as of January 31? The solution is to enter a credit of $1,000 in the
Allowance account. (That of course means a debit of $1,000 will be entered into the Loss
account.) After we record that January 31 adjusting entry the balance sheet will report the ending
account balances as follows:

$76,0
Inventory at cost
00

Less: Allowance to Reduce Inv to –

LCM 1,000

Inventory at the lower of cost $75,0

or market 00

On February 28, 2010 the balance sheet needs to report the lower of cost or market of $71,800.
(Earlier, we assumed that on Feb. 28 the cost was $72,000 and the market was $71,800.)
Throughout February there were transactions in the Inventory account that resulted in the ending
cost balance on February 28 of $72,000. In order for the balance sheet to report the correct lower
of cost or market of $71,800 as shown next, the balance in the Allowance account at February 28
will need to be a credit balance of $200:

Inventory at cost $72,0

 00

Less: Allowance to Reduce Inv to –

LCM 200

Inventory at the lower of cost $71,8

or market 00

The journal entry needed at February 28 can be determined by using T-accounts:

(balance sheet account) Inventory

Balance at Feb. 28,

72,000
2010

(bal. sheet account) Allowance to Reduce Inventory to

LCM

0 Balance at Dec. 31, 2009

Adjustment at Jan. 31,

1,000
2010

1,00 Bal. at Jan. 31, 2010

0
 Adjustment at Feb.
800
28, 2010

Bal. Needed at Feb.

200
28, 2010

(inc. stmt. account) Loss From Reducing Inventory to

LCM

Balance at Jan. 1, 2010 0

Adjustment at Jan. 31,

1,000
2010

Balance at Jan. 31,

1,000
2010

Adjustment at Feb.
800
28, 2010

Balance at Feb. 28,

200
2010

In general journal format, the adjusting entry at February 28, 2010 is:

Date Account Name Debit Credit

Feb. 28, 2010 Allowance to Reduce Inv to LCM 800

Loss from Reducing Inv to

800
LCM
This journal entry shows a recovery of $800 of the $1,000 loss recorded in January.

On March 31, 2010 the balance sheet needs to report the lower of cost or market of $70,000.
(Recall that our assumptions were cost of $70,000 and market of $70,400.) Throughout March
there were transactions in the Inventory account and our assumptions meant that the ending
balance in Inventory at March 31 was $70,000. In order for the balance sheet to report the correct
LCM of $70,000, the balance in the Allowance account at March 31 will need to be a balance of
$0.

$70,0
Inventory at cost
00

Less: Allowance to Reduce Inv to –

LCM 0

Inventory at the lower of cost $70,0

or market 00

Again, the journal entry needed at March 31 can be determined by using T-accounts:

(balance sheet account) Inventory

Balance at March 31,

70,000
2010
(bal. sheet account) Allowance to Reduce Inventory to
LCM

0 Balance at Dec. 31, 2009

Adjustment at Jan. 31,

1,000
2010

1,000 Bal. at Jan. 31, 2010

Adjustment at Feb. 28,

800
2010

200 Bal. at Feb. 28, 2010

Adjustment at March
200
31, 2010

Bal. Needed at March

0
31, 2010

(inc. stmt. account) Loss From Reducing Inventory to

LCM

Balance at Jan. 1, 2010 0

Adjustment at Jan. 31,

1,000
2010

Balance at Jan. 31,

1,000
2010

Adjustment at Feb. 28,

800
2010

Balance at Feb. 28,

200
2010
 Adjustment at March
200
31, 2010

Balance at March 31,

0
2010

In general journal format, the adjusting entry at March 31, 2010 is:

Date Account Name Debit Credit

March 31, 2010 Allowance to Reduce Inv to LCM 200

Loss from Reducing Inv to

200
LCM

Our March 31 journal entry shows the remaining $200 recovery from the $1,000 loss previously
recorded in January 2010. (Note: We did not report the recovery as a "gain" of $200 during
March nor did we report a "gain" of $800 in February. We avoided the word "gain" since the
company did not increase its inventory carrying amount above its cost; it merely restored the
inventory amount back to its cost.)

Additional Information and Resources

Because the material covered here is considered an introduction to this topic, many complexities
have been omitted. You should always consult with an accounting professional for assistance
with your own specific circumstances.