What does the lower of cost or market method of inventory valuation assess?

The lower of cost or market method of inventory valuation is a key accounting principle used to value inventory. This method involves comparing the actual cost of inventory to its market value, which is defined as the replacement cost or the net realizable value.

By assessing both actual cost and replacement cost, the lower of these two values is chosen for reporting on the financial statements. The rationale behind this method is to ensure that inventory is not overstated on the balance sheet. If the market value falls below the cost due to factors like decreases in demand or excess supply, recognizing this loss is important for accurate financial reporting.

This approach provides a more conservative and realistic view of inventory, which can affect both the balance sheet and income statement. It does not solely consider the cost of the merchandise purchased, nor does it solely focus on the market value or potential selling price, as these would not capture the comprehensive assessment necessary for proper financial reporting under this method.