Stock ValuationStock Valuation

Stock Stock

• Stock (which is also known as inventory) consists of :Stock (which is also known as inventory) consists of :– Raw materials-goods not yet processedRaw materials-goods not yet processed– Work-in progress - partly completed goodsWork-in progress - partly completed goods– Finished goods - ready for saleFinished goods - ready for sale

• The relative proportions of each time of stock will vary The relative proportions of each time of stock will vary with the type of enterprisewith the type of enterprise

• Retailers’ stock consists mainly or even exclusively of Retailers’ stock consists mainly or even exclusively of finished goodsfinished goods

• Firms that manufacturer to order will carry little in the Firms that manufacturer to order will carry little in the way of stock of finished goodsway of stock of finished goods

• Where the production is short, there will be little work in Where the production is short, there will be little work in progressprogress

Why value stock?Why value stock?

• Stock needs to be valued forStock needs to be valued for– Costing purposesCosting purposes– To calculate cost of sales and therefore To calculate cost of sales and therefore

profitprofit– For the construction of a balance sheet in For the construction of a balance sheet in

which stock features as a current assetwhich stock features as a current asset

• The overriding principle is that stock The overriding principle is that stock should be valued at the lower of cost of should be valued at the lower of cost of acquisition or net realisable valueacquisition or net realisable value

Stocks and the balance Stocks and the balance sheetsheet• The balance sheet records the value of stocks at The balance sheet records the value of stocks at

the time the balance sheet was drawn upthe time the balance sheet was drawn up

• The problem is that the stock was bought in The problem is that the stock was bought in batches over time and probably at different pricesbatches 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 The choice of method will affect the value of stock recorded in the balance sheetrecorded in the balance sheet

• It will also affect the following aggregates in the It will also affect the following aggregates in the balance sheet: current assets, net current assets, balance sheet: current assets, net current assets, net assetsnet assets

Stocks and the P&L Stocks and the P&L Account Account • The cost of sales is a negative item on the P&L The cost of sales is a negative item on the P&L

AccountAccount• Cost of sales is equal to Cost of sales is equal to

– Opening stockOpening stock– plus Purchasesplus Purchases– minus Closing stockminus Closing stock

• Again the problem is what value to place on the Again the problem is what value to place on the stock when it is purchased at different prices stock when it is purchased at different prices over the yearover the year

• The choice of method will affect the firm’s The choice of method will affect the firm’s declared profitsdeclared profits

Changing the value of Changing the value of closing stockclosing stockSales revenue: £50,000 £50,000Sales revenue: £50,000 £50,000Less cost of sales Less cost of sales Opening stock £10,000 £10,000Opening stock £10,000 £10,000+ purchases £30,000 £30,000+ purchases £30,000 £30,000Minus closing stock £12,000 £15,000Minus closing stock £12,000 £15,000Gross Profits £22,000 £25,000Gross Profits £22,000 £25,000• In the right hand column closing stock has been In the right hand column closing stock has been

re-valued at a higher figurere-valued at a higher figure• Conclusion: any increase in the value of closing Conclusion: any increase in the value of closing

stock will raise the declared level of gross profitsstock will raise the declared level of gross profits

Methods of stock valuationMethods of stock valuation

• These are methods used to ascertain the year These are methods used to ascertain the year end valuation of stocks:end valuation of stocks:– FIFO - first in, first outFIFO - first in, first out– LIFO - last in, first outLIFO - last in, first out– AVCO - weighted average costAVCO - weighted average cost

• If stock is bought in at the same price If stock is bought in at the same price throughout the year the choice of method is throughout the year the choice of method is immaterialimmaterial

• In practice, stock is likely to be bought in at In practice, stock is likely to be bought in at different prices over the yeardifferent prices over the year

FIFO - first in, first outFIFO - first in, first out

• This assumes that stock is issued in the order in which it This assumes that stock is issued in the order in which it is delivered so that remaining stock is valued at the most is delivered so that remaining stock is valued at the most recent pricesrecent prices

• Stock is valued in terms of the earliest batch until all that Stock is valued in terms of the earliest batch until all that batch has been used up - then it will be valued at the batch has been used up - then it will be valued at the price of the next batch and so onprice of the next batch and so on

• Issues of stock (cost of goods sold) are based on the cost Issues of stock (cost of goods sold) are based on the cost of oldest remaining stock at the time of issueof oldest remaining stock at the time of issue

• This means that closing stock value is based on the price This means that closing stock value is based on the price of the most recent stockof the most recent stock

• This is acceptable to tax authorities because costs are This is acceptable to tax authorities because costs are related to those actually incurred and closing stock value related to those actually incurred and closing stock value is close to current market priceis close to current market price

LIFO - last in, last outLIFO - last in, last out

• Assumes that the more recent deliveries are issued first Assumes that the more recent deliveries are issued first so that closing stock is valued at older purchase pricesso that closing stock is valued at older purchase prices

• As the most recent stock is used up, the remaining stock As the most recent stock is used up, the remaining stock is made up of earlier purchases made at older pricesis made up of earlier purchases made at older prices

• Cost of goods sold (issues from stock) is based on the Cost of goods sold (issues from stock) is based on the cost of the most recent purchasescost of the most recent purchases

• Issues are valued at the latest stock price until it is all Issues are valued at the latest stock price until it is all used up- then valuation is based on the next earliest used up- then valuation is based on the next earliest batchbatch

• Closing stock is valued on the cost of the oldest goods Closing stock is valued on the cost of the oldest goods availableavailable

• LIFO is not acceptable for tax purposes because it LIFO is not acceptable for tax purposes because it understates profitabilityunderstates profitability

AVCO - average costs AVCO - average costs

• This is a method of stock valuation based on a This is a method of stock valuation based on a weighted average of values of stock received over the weighted average of values of stock received over the accounting periodaccounting period

• It involves calculating and re-calculating the average It involves calculating and re-calculating the average cost of total stock every time a new deliver is receivedcost of total stock every time a new deliver is received

• Average costs = total stock value/no. of units in stockAverage costs = total stock value/no. of units in stock

• Weighting the average means taking into account the Weighting the average means taking into account the relative quantities involvedrelative quantities involved

• Because issues are at averaged cost, it follows that Because issues are at averaged cost, it follows that closing stock should be valued on the same average closing stock should be valued on the same average cost basiscost basis

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

March March ReceiptsReceipts IssuesIssues Balance Balance

Ist Ist 50 @ £550 @ £5 50 units50 units

1010thth 25 units25 units 25 units25 units

1919thth 60@ £660@ £6 85 units85 units

22nd22nd 40 units 40 units 45 units45 units

25th25th 60@ £760@ £7 105 units105 units

2727thth 55 units55 units 50 units50 units

Using on FIFOUsing on FIFO

• The last stock figure is 50 units – the value of The last stock figure is 50 units – the value of these 50 units will be recorded in an end of these 50 units will be recorded in an end of period balance sheet and will be the closing period balance sheet and will be the closing balance in the calculation of cost of salesbalance 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 On the FIFO principle we assume that the whole

of the March 1ST and March 19th batches have of the March 1ST and March 19th batches have been used up in the three stock issues recordedbeen used up in the three stock issues recorded

• The closing balance consists of 50 units from The closing balance consists of 50 units from the final batchthe final batch

• Valuation : 50 x £7 = £350 Valuation : 50 x £7 = £350

Using LIFOUsing LIFO

• Half the first batch of 50 units had been used up on the Half the first batch of 50 units had been used up on the 10th March10th March

• 40 out of 60 from the second batch was used up on the 40 out of 60 from the second batch was used up on the 22nd22nd

• All but 5 units of the final batch was used up on March All but 5 units of the final batch was used up on March 27th27th

• The closing balance consist of the residue fromThe closing balance consist of the residue from– March 1st -25 units @ £5March 1st -25 units @ £5– March 19th -20 units @ £6March 19th -20 units @ £6– March 27th -5 units @ £7March 27th -5 units @ £7

• On the principle of valuing at the oldest remaining stock On the principle of valuing at the oldest remaining stock we conclude that the value of the closing balance is we conclude that the value of the closing balance is £125+£120+£35 =£280£125+£120+£35 =£280

• Notice that the closing stock figure is lower than when Notice that the closing stock figure is lower than when using FIFOusing FIFO

Using AVCOUsing AVCO

• AVCO calculations are more complex AVCO calculations are more complex since they are continually updatedsince they are continually updated

• Stock is issued at the weighted Stock is issued at the weighted average costs and this impacts upon average costs and this impacts upon the weighted average in the next the weighted average in the next round of calculationsround of calculations

Using AVCOUsing AVCOMarchMarch Receipts Receipts IssueIssue

s s Balance Balance Balance Balance

££

11stst 50@£550@£5 50 units50 units £250£250

1010thth 2525 25 units25 units £125£125

1919thth 60@£660@£6 85 units85 units £485£485

2222ndnd 4040 45 units45 units £256£256

2525thth 60@£760@£7 105 units105 units £676 £676

2727thth 5555 50 units50 units £322£322

Using AVCO Using AVCO

March 1March 1stst The fist batch is valued at 50@£5=£250The fist batch is valued at 50@£5=£250

1010thth Half of the batch is issued leaving 25 units in Half of the batch is issued leaving 25 units in stock-valued at £5 per unitstock-valued at £5 per unit

1919thth The second batch is purchased at £6 per unit. The second batch is purchased at £6 per unit. Total value of the stock is (£6 x 60)+(£5 x 25) Total value of the stock is (£6 x 60)+(£5 x 25) = £485 or £5.71 per unit= £485 or £5.71 per unit

2222ndnd 40 units are issued at the average price from 40 units are issued at the average price from 1919thth March. This leaves 45 units @ £5.71 or March. This leaves 45 units @ £5.71 or £256£256

2525thth A batch is purchased at £7 per unit. Total value A batch is purchased at £7 per unit. Total value of the stock is now £256 + £420 =£676 or of the stock is now £256 + £420 =£676 or £6.44 per unit£6.44 per unit

2727thth The final issue is made at the above average The final issue is made at the above average price per unit and it leaves 50 in stock. Total price per unit and it leaves 50 in stock. Total value =50 x £6.44 = £322value =50 x £6.44 = £322

Comparing the resultsComparing the results

• The closing balances were as follows:The closing balances were as follows:– FIFO - £350FIFO - £350– LIFO - £280LIFO - £280– AVCO - £322AVCO - £322

• As it is based on an average it is not surprising that As it is based on an average it is not surprising that the AVCO figures is between the other twothe AVCO figures is between the other two

• Remember that the closing figure appears as a Remember that the closing figure appears as a current balance on the balance sheet and as a current balance on the balance sheet and as a positive item in the profit and loss accountpositive item in the profit and loss account

• The choice of stock valuation method will impact on The choice of stock valuation method will impact on the asset value in the balance sheet and on the the asset value in the balance sheet and on the profit figure in the profit and loss account profit figure in the profit and loss account

FIFO FIFO

Advantages Advantages • Realistic and logicalRealistic and logical• Assumes goods are valued Assumes goods are valued

in order of receiptin order of receipt• Easy to calculate closing Easy to calculate closing

stockstock• Closing valuation is at the Closing valuation is at the

most recent pricemost recent price• Acceptable under SSAP 9 Acceptable under SSAP 9

and for tax purposesand for tax purposes• Ensures balance sheet Ensures balance sheet

stock valuation is more stock valuation is more accurateaccurate

DisadvantagesDisadvantages• Prices at which goods are Prices at which goods are

issued are not necessarily issued are not necessarily the latest pricesthe latest prices

• Cost of production relates Cost of production relates to out of date pricesto out of date prices

• In time of rising prices In time of rising prices profits will be shown as profits will be shown as being higherbeing higher

• This goes against the This goes against the concept of prudenceconcept of prudence

• And increase tax liabilityAnd increase tax liability

LIFOLIFO

AdvantagesAdvantages

• Goods are issue at Goods are issue at the most recent the most recent pricesprices

• Production is Production is charged with costs charged with costs that are close to that are close to current economic current economic valuesvalues

DisadvantagesDisadvantages

• Illogical – assumes are issue Illogical – assumes are issue in reverse order from that in in reverse order from that in which they are receivedwhich they are received

• Closing stock is not usually Closing stock is not usually at the most recent prices- at the most recent prices- closing stock valued at out closing stock valued at out of date pricesof date prices

• Not acceptable for tax Not acceptable for tax purposespurposes

• When stocks are being run When stocks are being run down, issues will dip into old down, issues will dip into old stock at out-of date pricesstock at out-of date prices

AVCOAVCO

AdvantagesAdvantages

• Smoothes profits over a Smoothes profits over a number of accounting number of accounting periodperiod

• Fluctuations in purchase Fluctuations in purchase price are evened outprice are evened out

• Logical – same units Logical – same units bought at different time bought at different time have the same valuehave the same value

• Closing stock valuation Closing stock valuation close to current market close to current market valuevalue

DisadvantagesDisadvantages

• Difficult to calculateDifficult to calculate

• Issues and stock Issues and stock valuation may be at valuation may be at prices which never prices which never existedexisted

• Issues may not be at Issues may not be at current prices and in current prices and in times of inflation will be times of inflation will be below current pricesbelow current prices

In times of inflation…In times of inflation…

FIFOFIFO

• Shows lower costs.Shows lower costs.

• Gives a higher value Gives a higher value for closing stockfor closing stock

• Gives a higher profit Gives a higher profit figurefigure

• Ensures that stock is Ensures that stock is value at recent prices value at recent prices on the balance sheeton the balance sheet

LIFOLIFO

• Shows higher costs.Shows higher costs.

• Gives a lower value Gives a lower value for closing stockfor closing stock

• Gives a lower value Gives a lower value for profitsfor profits

• Undervalues stock Undervalues stock on the balance sheeton the balance sheet