Answer
Conceptually, the disadvantages of the cost or market method include:
1. The drop in the value of the asset and the charge to expense are recognized in the period in which loss in utility occurs rather than the period of sale. On the other hand, increases in the value of the asset are recognized only at the point of sale. This can easily lead to distortions in the presentation of income information.
2. There is difficulty in defining “market” value. Normally, three different types of valuation can be used: net realizable value, replacement cost and, net realizable value less a normal markup. A reduction in the replacement cost of an item does not mainly indicate a corresponding reduction in the utility/price of the item.
3. Net realizable value also reflects the future service potential of the asset and, for that reason, it is conceptually sound. But net realizable value cannot often be measured with any certainty. Therefore, we return to replacement cost because net realizable value less a normal markup is even more uncertain than net realizable value.
Work Step by Step
From a theoretical standpoint, is little to justify the lower of cost or market rule. Although conservative from the balance sheet point of view, it permits the income statement to show a larger net income in future periods than would be justified if the inventory were carried forward at cost. The rule is applied only in those cases where strong evidence indicates that market declines in inventory prices have occurred that will result in losses when such inventories are disposed of.
