1. Stock Valuation

2. Stock Stock (which is also known as inventory) consists of : 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 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 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 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 Where the production is short, there will be little work in progress

3. Why value stock? Stock needs to be valued for 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 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 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 The problem is that the stock was bought in batches over time and probably at different prices Which value should we use? Which value should we use? The choice of method will affect the value of stock recorded in the balance sheet 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 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 The cost of sales is a negative item on the P&L Account Cost of sales is equal to 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 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 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 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 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: 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 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 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 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 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 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 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 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 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 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 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 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 Closing stock is valued on the cost of the oldest goods available LIFO is not acceptable for tax purposes because it understates profitability 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 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 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 Average costs = total stock value/no. of units in stock Weighting the average means taking into account the relative quantities involved 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 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? MarchReceiptsIssuesBalance Ist 50 @ £5 50 units 10 th 25 units 19 th 60@ £6 85 units 22nd 40 units 45 units 25th 60@ £7 105 units 27 th 55 units 50 units

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 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? 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 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 The closing balance consists of 50 units from the final batch Valuation : 50 x £7 = £350 Valuation : 50 x £7 = £350

13. Using LIFO Half the first batch of 50 units had been used up on the 10th March 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 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 All but 5 units of the final batch was used up on March 27th The closing balance consist of the residue from 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 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 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 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 Stock is issued at the weighted average costs and this impacts upon the weighted average in the next round of calculations

15. Using AVCO MarchReceipts Issue s Balance Balance £ 1 st 50@£5 50 units £250 10 th 25 25 units £125 19 th 60@£6 85 units £485 22 nd 40 45 units £256 25 th 60@£7 105 units £676 27 th 55 50 units £322

16. Using AVCO March 1 st The fist batch is valued at 50@£5=£250 10 th Half of the batch is issued leaving 25 units in stock- valued at £5 per unit 19 th The second batch is purchased at £6 per unit. Total value of the stock is (£6 x 60)+(£5 x 25) = £485 or £5.71 per unit 22 nd 40 units are issued at the average price from 19 th March. This leaves 45 units @ £5.71 or £256 25 th A batch is purchased at £7 per unit. Total value of the stock is now £256 + £420 =£676 or £6.44 per unit 27 th The final issue is made at the above average price per unit and it leaves 50 in stock. Total value =50 x £6.44 = £322

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

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

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

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