Stock Valuation

1. Stock Valuation

2. Stock • Stock (which is also known as inventory) consists of : • Raw materials-goods not yet processed • Work-in progress - partly completed goods • Finished goods - ready for sale • The relative proportions of each time of stock will vary with the type of enterprise • Retailers’ stock consists mainly or even exclusively of finished goods • Firms that manufacturer to order will carry little in the way of stock of finished goods • Where the production is short, there will be little work in progress

3. Why value stock? • Stock needs to be valued for • Costing purposes • To calculate cost of sales and therefore profit • For the construction of a balance sheet in which stock features as a current asset • The overriding principle is that stock should be valued at the lower of cost of acquisition or net realisable value

4. Stocks and the balance sheet • The balance sheet records the value of stocks at the time the balance sheet was drawn up • The problem is that the stock was bought in batches over time and probably at different prices • Which value should we use? • The choice of method will affect the value of stock recorded in the balance sheet • It will also affect the following aggregates in the balance sheet: current assets, net current assets, net assets

5. Stocks and the P&L Account • The cost of sales is a negative item on the P&L Account • Cost of sales is equal to • Opening stock • plus Purchases • minus Closing stock • Again the problem is what value to place on the stock when it is purchased at different prices over the year • The choice of method will affect the firm’s declared profits

6. Changing the value of closing stock Sales revenue: £50,000 £50,000 Less cost of sales Opening stock £10,000 £10,000 + purchases £30,000 £30,000 Minus closing stock £12,000 £15,000 Gross Profits £22,000 £25,000 • In the right hand column closing stock has been re-valued at a higher figure • Conclusion: any increase in the value of closing stock will raise the declared level of gross profits

7. Methods of stock valuation • These are methods used to ascertain the year end valuation of stocks: • FIFO - first in, first out • LIFO - last in, first out • AVCO - weighted average cost • If stock is bought in at the same price throughout the year the choice of method is immaterial • In practice, stock is likely to be bought in at different prices over the year

8. FIFO - first in, first out • This assumes that stock is issued in the order in which it is delivered so that remaining stock is valued at the most recent prices • Stock is valued in terms of the earliest batch until all that batch has been used up - then it will be valued at the price of the next batch and so on • Issues of stock (cost of goods sold) are based on the cost of oldest remaining stock at the time of issue • This means that closing stock value is based on the price of the most recent stock • This is acceptable to tax authorities because costs are related to those actually incurred and closing stock value is close to current market price

9. LIFO - last in, last out • Assumes that the more recent deliveries are issued first so that closing stock is valued at older purchase prices • As the most recent stock is used up, the remaining stock is made up of earlier purchases made at older prices • Cost of goods sold (issues from stock) is based on the cost of the most recent purchases • Issues are valued at the latest stock price until it is all used up- then valuation is based on the next earliest batch • Closing stock is valued on the cost of the oldest goods available • LIFO is not acceptable for tax purposes because it understates profitability

10. AVCO - average costs • This is a method of stock valuation based on a weighted average of values of stock received over the accounting period • It involves calculating and re-calculating the average cost of total stock every time a new deliver is received • Average costs = total stock value/no. of units in stock • Weighting the average means taking into account the relative quantities involved • Because issues are at averaged cost, it follows that closing stock should be valued on the same average cost basis

11. How do we calculate the value of the closing balance?

12. Using on FIFO • The last stock figure is 50 units – the value of these 50 units will be recorded in an end of period balance sheet and will be the closing balance in the calculation of cost of sales • What value should we place on the 50 units? • On the FIFO principle we assume that the whole of the March 1ST and March 19th batches have been used up in the three stock issues recorded • The closing balance consists of 50 units from the final batch • Valuation : 50 x £7 = £350

13. Using LIFO • Half the first batch of 50 units had been used up on the 10th March • 40 out of 60 from the second batch was used up on the 22nd • All but 5 units of the final batch was used up on March 27th • The closing balance consist of the residue from • March 1st -25 units @ £5 • March 19th -20 units @ £6 • March 27th -5 units @ £7 • On the principle of valuing at the oldest remaining stock we conclude that the value of the closing balance is £125+£120+£35 =£280 • Notice that the closing stock figure is lower than when using FIFO

14. Using AVCO • AVCO calculations are more complex since they are continually updated • Stock is issued at the weighted average costs and this impacts upon the weighted average in the next round of calculations

15. Using AVCO

16. Using AVCO

17. Comparing the results • The closing balances were as follows: • FIFO - £350 • LIFO - £280 • AVCO - £322 • As it is based on an average it is not surprising that the AVCO figures is between the other two • Remember that the closing figure appears as a current balance on the balance sheet and as a positive item in the profit and loss account • The choice of stock valuation method will impact on the asset value in the balance sheet and on the profit figure in the profit and loss account

18. Advantages Realistic and logical Assumes goods are valued in order of receipt Easy to calculate closing stock Closing valuation is at the most recent price Acceptable under SSAP 9 and for tax purposes Ensures balance sheet stock valuation is more accurate Disadvantages Prices at which goods are issued are not necessarily the latest prices Cost of production relates to out of date prices In time of rising prices profits will be shown as being higher This goes against the concept of prudence And increase tax liability FIFO

19. Advantages Goods are issue at the most recent prices Production is charged with costs that are close to current economic values Disadvantages Illogical – assumes are issue in reverse order from that in which they are received Closing stock is not usually at the most recent prices- closing stock valued at out of date prices Not acceptable for tax purposes When stocks are being run down, issues will dip into old stock at out-of date prices LIFO

20. Advantages Smoothes profits over a number of accounting period Fluctuations in purchase price are evened out Logical – same units bought at different time have the same value Closing stock valuation close to current market value Disadvantages Difficult to calculate Issues and stock valuation may be at prices which never existed Issues may not be at current prices and in times of inflation will be below current prices AVCO

21. FIFO Shows lower costs. Gives a higher value for closing stock Gives a higher profit figure Ensures that stock is value at recent prices on the balance sheet LIFO Shows higher costs. Gives a lower value for closing stock Gives a lower value for profits Undervalues stock on the balance sheet In times of inflation…