Presentation on theme: "Introductory Financial Accounting"— Presentation transcript:
1 Introductory Financial Accounting Accounting for Current Assets
2 Learning outcomesDiscuss the significance of stock valuation for profit measurement and asset valuation.Explain and discuss the various accounting principles and conventions governing stock valuation in the UK.Calculate stock valuations using FIFO, LIFO and AVCO and demonstrate the impact of these methods on balance sheet values and profit figures in periods of changing prices.Explain the problem of recognising profit or loss on long-term contracts.Discuss the limitations of historical cost accounting and the concept of capital maintenance.
3 Stock Valuation Why is the valuation of stock important? It affects the calculation of (gross) profit (opening stock + purchases – closing stock = cost of goods sold)It affects balance sheet assets as closing stock is recorded thereStock valuation requires consideration ofThe cost of stockThe flow of stock
4 Ascertaining the cost of stock Cost = all the expenditure incurred in bringing the product or service to its present location and conditiontrading company = cost of purchasepurchase price plus all expenses incurred in bringing goods to place of sale e.g. including carriage in, insurance, dutiesmanufacturing company = cost of conversiona manufacturing company holds three different types of stock:raw materialswork-in-progressfinished goodsCost includes all costs of production (conversion), both direct costs e.g. raw materials, direct wages and overheads (indirect costs) e.g. depreciation of machinery and overheads, rent of factory (see manufacturing accounts)
5 Ascertaining the flow of costs There is a problem with the costing of goods sold and valuing stock when(a) the physical flow of stock cannot be directly observed and matched, and(b) there is a change in the price of the goodsAccounting requires assumptions to be made about the physical flow of stock to allow costing and valuation to take place:FIFO – first in first outLIFO – last in first outAVCO – weighted average cost
6 Example – JacquesOver an accounting year Jacques purchases 2,000 litres of a chemical fluid for resale. Three separate purchases were made:Lot 1: 500 litres @ £8.00 /litreLot 2: 1000 £10.00/litreLot 3: 500 litres @ £12.00/litreJacques stored the chemical in one special container.If 1,700 litres were sold over the year at a selling price of £12.00/litre, what was:The business’s gross profit?The value of the closing stock?
9 Adopting weighted average cost Total purchase costs:(500 x 8) + (1,000 x 10) + (500 x 12) = 20,000Weighted average cost/litres: 20,000=2,000Cost of sales: 1,700 x ,000Turnover ,400Cost of sales ,000Gross profit ,400Balance sheet:Closing stock: £ ,000
10 Comment When prices are rising, FIFO gives highest gross profit and LIFO lowestFIFO gives highest stock value and LIFO the lowestwhen prices are falling the reverse applies
11 FIFO Advantages: flow assumption often reflects reality balance sheet values more likely to reflect realityacceptable to tax authoritiesDisadvantages:with rising prices COGS will not reflect cost of replacing stockif the whole of the profit calculated on this assumption were to be distributed there would be insufficient funds retained to replace the same number of items sold i.e. capital maintenance would be affected e.g. Jacques Ltd
12 Example with further assumptions all transaction are for cash and all profits are withdrawn from the business(ii) the business was started with £20,000 capital which was spent on stockThe business’s opening balance sheet would be:Assets CapitalStock £20,000 Capital £20,000Subsequent cash flows from above example and assuming FIFO:Cash in: Sales £20,400Cash out: Drawings 4,000Cash balance: £16,400
13 To what extent would Jacques be able to replace his stock? £16,400/£12 = 1,366 units could be purchased.Original stock = 2,000 unitsNew stock = (closing stock)1,366 (new purchases)1,666Shortfall = 2,000 – 1,666 = 334
14 Which means…..The business has effectively ‘shrunk’ and while the original financial capital has been maintained (nominal financial capital maintenance), the business’s operational capital, as represented by its assets (physical capital maintenance), has not.The use of NIFO or replacement cost would resolve this physical capital maintenance problemThe historical cost measurement system and the maintenance of nominal financial capital have been the traditional approaches to financial accounting in the UK. There are a number of advantages and disadvantages to such a system (see reading).
15 LIFO Advantages: more accurate profit measurement less of a capital maintenance problemDisadvantages:with rising prices balance sheet stock value will not reflect current valuesflow assumption less likely to reflect realitynot acceptable to tax authorities in the UK
16 Which method of stock valuation should be adopted? UK accounting standards (SSAP 9 Stocks and long term contracts) allow FIFO, average cost or ‘unit’ cost and reject LIFO. The UK Companies Act allows FIFO, LIFO, weighted average price or ‘any other similar method’ (not defined)International accounting standards (IAS 2 Inventories) requires unit cost and ‘benchmarks’ (a statement of preference) FIFO or weighted average, but includes LIFO as an allowable alternativeAccounting standards and the law also apply the prudence principle with the basic valuation rule, for each group of similar items of stock, of:LOWER OF COST OR NET REALISABLE VALUE(Net realisable value = sales revenue – all selling costs)
17 Long-term contract costing Applying the realisation principle is problematic therefore matching takes precedenceprofit is recognised as estimated to have occurred throughout the life of the contractExample:Ash has, in the current financial year, undertaken a long-term contract. The contract value is £100. At the end of this financial year the state of the contract is:Costs to dateEstimated costs to completion 35Progress payments 46% complete %
18 Workings Calculation of foreseeable profit: Contract value 100 Costs to date 45Estimated costs 3580Foreseeable profit(ii) % complete recognised in the profit and loss account:Turnover to date (50%) 50Cost of sales to date 40Attributable profit 10(iii) Work-in-progress recognised in the balance sheet (stock)Costs to date 45Less transfer to p/l 40WIP(iv) Amounts recoverable on contracts recognised as debtors in the balance sheet: 50 – 46 = 4
19 How does the balance sheet balance? Assets CapitalStocks 5Debtors 4Cash (46-45) Profit 10Although profit is only recognised on the basis of percentage of completion, the influence of prudence requires that when a contract is expected to make a loss, the whole of that loss is recognised immediately, whatever stage of completion of the contract.
20 Stock Valuation Longer Example Stock Valuation.doc Stock valuation ans.xls