Accurate inventory valuation is critical for auto dealerships, influencing financial statements, tax liabilities, and business strategy. This blog explores the pros and cons of using the Lower of Cost or Market (LCM) approach for valuing used and parts inventory and highlights the importance of parts reconciliations.
What Is Lower of Cost or Market (LCM)?
The Lower of Cost or Market (LCM) method helps auto dealerships value used cars and parts at the lower of their original cost or current market value, reflecting their rapid depreciation and obsolescence. This approach ensures inventory is valued realistically, avoiding overstatements that could mislead financial decision-making. For example, if a dealership values a used car at its cost of $15,000, and the market value drops to $12,000, the dealer will write off $3,000 to COGS to ensure inventory is properly valued.
How Does LCM Work?
LCM works by adjusting inventory to the lower level of cost or market value. Cost refers to the historical cost of the asset, while market value can be determined by using software like V-Auto or Galves for used autos. Specific rules govern how replacement cost is compared to net realizable value and net realizable value minus a normal profit margin. Auto dealers have flexibility when determining a normal profit margin for used autos. Historical profits for similar used vehicles, industry averages, market conditions, and the dealerships cost structure are all factors in determining a normal profit margin. When replacement cost exceeds the net realizable value, the net realizable value must be used. If the replacement cost falls below net realizable value minus a normal profit margin, the value must be adjusted to this lower amount. If the replacement cost is between these two benchmarks, the replacement cost is used.
Once a market value is established, it is compared to historical cost. If the historical cost of inventory is lower than the replacement cost, a write-down is unnecessary. Conversely, if the cost of inventory exceeds the replacement cost, inventory must be written down to the replacement cost. The difference between cost and market value is credited to an inventory reserve account nested in the inventory pool, with the offsetting debit reflected in the cost of goods sold. Inventory can only be written down under LCM. A Form 3115 is required to report the change in accounting method when switching to LCM.
Importance of Parts Reconciliations
Parts reconciliations are essential for maintaining accurate inventory records and financial statements. Regular reconciliations help identify discrepancies between physical inventory, recorded amounts, and OEM price tapes, ensuring that the inventory valuation is accurate. This process involves comparing the actual count of parts on hand with the inventory records, reviewing costs against OEM price tapes, investigating any differences, and making necessary adjustments.
Effective parts reconciliations can prevent issues such as overstocking, stockouts, financial misstatements, shrinkage due to theft, and obsolescence detection. Leveraging technology, such as inventory management software, can simplify reconciliations, especially for large dealerships managing extensive parts inventories. By integrating parts reconciliations into the LCM approach, dealerships can achieve a more precise and reliable inventory valuation.
Benefits of Using LCM
The LCM approach offers several advantages. It ensures accurate financial reporting by providing a realistic view of an auto dealership’s financial health and prevents inflated asset values that can mislead stakeholders. By valuing inventory at the lower of cost or market, dealerships can reflect true market conditions, which is especially important in an industry subject to rapid changes. Additionally, LCM helps manage the risk of inventory obsolescence and price drops, ensuring inventory is not overvalued. Tax advantages may also arise, as writing down inventory to its market value may reduce taxable income and provide financial relief during downturns.
Challenges of Using LCM
Despite its benefits, the LCM method presents challenges. Determining the market value of used cars and parts can be complex and time-consuming, requiring constant monitoring due to fluctuation. For instance, market conditions might shift dramatically within months, necessitating frequent updates. Additionally, assessing inventory’s market value involves subjectivity, as appraisers might value the same inventory differently, leading to inconsistencies. While caution in accounting is generally advisable, overly cautious valuations might undervalue inventory, impacting business decisions and financial ratios.
The Road Ahead
The decision to use LCM for valuing used and parts inventory in auto dealerships depends on factors such as dealership size, market conditions, and financial strategy. Dealerships should weigh these factors and consult with accounting professionals to determine the best approach for their specific needs. Incorporating regular parts reconciliations can further enhance the accuracy and reliability of inventory valuations. By balancing the benefits and challenges of LCM, dealerships can position themselves for financial stability and long-term success.
Chris Nicholson is an Associate II Accountant at ARB specializing in taxation for auto dealerships and family offices. His comprehensive understanding of tax regulations and best practices ensure our clients receive the highest level of advisory support.
